Chapter 3
To Manage or Not to Manage Earnings?
Why You Shouldn’t Even Think of Manipulating Financial Information
In This Chapter
Surprise, there is no “truth” in accounting information.
GAAP to the rescue of truth, sort of.
Why do managers manipulate financial information and how do they do it?
The harsh consequences of manipulation for investors and managers.
Just don’t manipulate; there are better alternatives.
On September 12, 2007, the SEC charged former top executives of Nortel Networks, a Canadian telecommunications equipment maker, with accounting and reporting fraud aimed at beautifying reported earnings.1 Specifically, the SEC alleged that in 2002 Nortel executives created accounting reserves, in violation of GAAP, by artificially lowering the company’s earnings, which happened to be higher than internal and analysts’ estimates. These reserves were quickly put to good use: nearly $350 million of them were reversed and credited to income to inflate reported earnings—magically turning losses in the first two quarters of 2003 into profits—to impress investors and generate executive bonuses.
You will see in this chapter that Nortel is far from an aberration. In fact, financial reporting manipulation, ranging all the way from small tweaks of accounting estimates to beat analysts’ consensus forecasts by a penny to egregious multibillion-dollar frauds, is quite common. Manipulation is perhaps even increasing, as indicated by the frequency of corporate restatements of previously reported information, mostly, corrections of previous misreporting: from 614 restatements in 2001 to a whopping 1,795 in 2006, decreasing gradually thereafter to 1,217, to 923, and to 674 in 2007, 2008, and 2009, respectively.2 The total number of restatements from 2006 to 2008, a staggering 3,935, indicates that over half of public companies corrected previously reported earnings during those years. That’s seriously disturbing. The number of annual SEC Accounting and Auditing Enforcement Releases is rising too—from 134 in 1997 to 180 in 2009. You will see later that the incentives to manipulate reported information are strong and varied, making “earnings management”—an elegant euphemism for manipulation—an issue that most managers face. Yet, the costs of manipulation to investors, employees, society at large and, not the least, to managers are onerous. I focus in this chapter on the most critical circumstance leading to manipulation—a business slowdown causing managers to miss the consensus estimate or report decreasing earnings—discuss the means and consequences of manipulation, and conclude with operating instructions.
Truth in Accounting?
Lying in financial reporting as elsewhere is universally condemned. An absolutist rejection of lying, on moralistic grounds, has a long-standing tradition. The ninth of the ten commandments delivered by Moses from Mount Sinai states emphatically: “You shall not bear false witness against your fellow.” St. Augustine adds: “Now it is evident that speech was given to man, not that men might therewith deceive one another, but that one man might make his thoughts known to another. To use speech, then, for the purpose of deception, and not for its appointed end, is a sin.” Fast-forward fourteen centuries to hear Immanuel Kant declare that a lie is “a crime of man against his own person and a baseness which must make a man contemptible in his own eyes.” When asked if a lie is permitted to save a life, Kant answered: “To be truthful (honest) in all declarations, therefore, is a sacred and absolutely commanding decree of reason, limited by no expediency.”3
Realists, keen observers of life and human nature, have taken a more pragmatic and nuanced approach to deception. Plato “had allowed that in his ideal Republic, rulers, the very topmost executives of the state, might find it ‘necessary’ to lie for the good of the community, and Machiavelli most wholeheartedly agreed with him.”4 Iris Murdoch sarcastically noted: “We have to mix a little falsehood into truth to make it plausible.”5 In a competitive environment, marked by the struggle to survive, lies and deceptions are often a part of life. Jeremy Campbell notes the following:
In the world of life, even fairly primitive life, Darwin recognized that falsehood and chicanery are part of the game of survival. Writing in the Descent of Man, he commanded as “admirable” a paper by the entomologist Henry Walter Bates on mimicry in nature…. Mimicry in effect was a pretense, a form of lying, a means of gaining an edge on survival by deceiving predators as to the “real” character of their potential victims6 … Adaptation to the conditions of life … can and does involve deception. That is a major theme of evolutionary studies today. Certain species flourishing now might be extinct if they had depended on truthfulness to increase and multiply.7
It may seem a short step from deception by species for survival to the fiercely competitive business world, where the struggle to prevail and prosper is as fierce as in nature. This, however, is a step fraught with danger. Truthfulness is the bedrock of all social and economic arrangements. No economic institution, be it a corporation or a stock market, can survive if falsehood in loan or labor contracts, manipulation in financial statements, or fraud in auditors’ reports are tolerated. Who will work, lend money, or invest in securities when lies are permitted in contractual agreements? Obviously, for economic and social institutions to survive, truth must govern all arrangements, a theme I emphasize throughout this book. But, and this is the crux of the issue, what is truth and its converse—a lie?
Simple. Truth is universally believed to be correspondence with facts. Lying, with misstating facts. Thus, for example, in the early 2000s when Parmalat, a large Italian dairy company, presented on its balance sheets multibillion-dollar deposits in the Bank of America, where there were none, it lied. Things become murkier with accounting estimates, prevalent in financial reports. Consider a 12 percent annual depreciation expense on a firm’s machinery. True, or deceptive expense intended to inflate earnings? That’s hard to say, since depreciation is an estimate derived from a prediction of the future useful life and productivity of the machinery. There are no facts to substantiate the 12 percent rate and, therefore, no unequivocal answer to the true-or-false question.8 The situation is similar to a bank’s loan loss reserve, a major expense item, which is based on estimated future losses from delinquent borrowers. There are no corresponding facts here either at the time the estimate is made—just managers’ judgment of the creditworthiness of borrowers. Even if it were to turn out later on that managers had seriously underestimated the loan loss reserve, it would be next to impossible to prove that at the time they made the estimate it was fraudulent. And what about the impairment or loss of value charges of long-term assets or goodwill, which are based on estimated future cash flows from these assets? There are no facts here either. And how about the ultimate noncorrespondence with facts—the marked-to-market toxic assets of banks during the financial crisis from 2007 to 2008, when no market for these assets in fact existed? Mark-to-myth would be a better description, quipped Warren Buffett. The list of estimates, forecasts, and subjective judgments underlying financial information covers most balance sheet and income statement items. Thus, unbeknownst to nonaccountants, in corporate financial reports, there are very few facts to establish truth or duplicity.9 What then substitutes for correspondence with facts as a truth criterion in financial information?
GAAP to the Rescue, Sort Of
Consider i2 Technologies, a developer and marketer of supply chain management solutions, which, according to the SEC, “overstated approximately $1.0B of software license revenues” by frontloading sales from 1998 to 2002.10 This enabled i2 to report an
