SEC Chairman Criticizes Financial Reporting Abuses

By Danielle D'Angelo

In a strong criticism of public companies, auditors, and audit committees, Securities and Exchange Commission Chairman Arthur Levitt took issue with what he termed "earnings management," the use of controversial accounting methods to manipulate earnings to meet analyst's expectations.

In a speech at New York University, Levitt criticized five accounting methods: "big bath" restructuring, in which companies overstate expenses so future earnings appear stronger; creative acquisition accounting, which involves writing off a significant portion of acquisition costs at one time to avoid showing a long term impact; "cookie jar" reserves, that is, recording additional expenses in good times to provide an extra cushion for tougher financial periods; misuse of materiality criteria; and improper revenue recognition, where management boosts earnings by prematurely recording revenue.

"Too many corporate managers, auditors, and analysts are participants in a game of nods and winks," said Levitt. "In the zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful representation."

To address these concerns, Levitt called for the financial community to join together to improve the accuracy of financial reporting. Specifically, the SEC announced the following actions:

* The SEC will formulate and augment new and existing accounting rules and interpretations for revenue recognition, restructuring reserves, materiality, and disclosure;

* The New York Stock Exchange and National Association of Securities Dealers will sponsor a blue ribbon panel to improve audit committee performance, which will report back to the SEC in 90 days;

* FASB will prioritize current standard setting projects, particularly those relating to the definition of "constructive" liability;

* The AICPA's Auditing Standards Board will give greater guidance to heighten auditors' scrutiny of problematic accounting practices;

* The SEC proposed that the Public Oversight Board create a panel to review the effectiveness of recent changes in the audit process;

* The SEC Enforcement Division and Corporation Finance Division will vigorously identify and pursue accounting fraud; and

* Corporate management and Wall Street need to undergo a cultural change, rewarding those who practice greater transparency in publishing earnings and punishing those who do not.

The AICPA applauded the SEC's efforts and vowed to work with the Commission to increase investor protection.

The action plan is one in series of recent measures the SEC has taken to address perceived weaknesses in the accounting profession. The Commission also recently announced new rules of improper conduct of CPAs, and is examining how providing consulting services to audit clients impacts auditor independence.

SEC Chairman Arthur Levitt announces a broad plan to improve financial reporting.