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The Accounting System Weaknesses And Loopholes

The ultimate objective of financial reporting is to provide useful information to investors, creditors and others for making rational and productive decision. The Generally Accepted Accounting Principles (GAAP) is a set of principles that provide a basic guideline to managers in preparing financial statements. These principles usually are flexible and allow managers to use their judgment to report the underlying economics of their organizations efficiently and effectively.

During 1996-1998, numerous articles and SEC investigations have brought to light practices that either push the boundaries of GAAP or are considered out right fraud. In some instances, the independent auditor has been blamed for not catching or rectifying entries that are questionable. Besides, it is clear that management intended to deceive outside auditors and audit committees. The most common offence method is by improper recognition of revenue. Companies have managed their earnings in a variety of ways ranging from over/under estimating bad debt expense to recording non-existent sales.

Earning Management

Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers (HEALY; WAHLEN, 1999, P. 368).

However, earning management seems to be a controversial matter as it depends mostly on manager judgment in making decisions. The judgment will vary in either ways and they will be pros and cons behind those decision. While the SEC and most academics consider the practice of earning management will mislead some users of financial information, on the other hands, some accountants and managers argue that some alternatives of earnings management legitimate managerial practices.

Dechow and Skinner (2000) figured out that it is difficult to identify earnings management when it occurs within the bounds of GAAP. According to them,

“While some financial reporting choices that clearly violate GAAP can constitute both fraud and earnings management, other choices, within GAAP, can constitute earnings management. The key point to be made is that there is a clear conceptual distinction between fraudulent accounting practices (that clearly demonstrate intent to deceive) and those judgments and estimates that fall within GAAP but may comprise earnings management depending on managerial intent. However, in the latter types of choice it would, in many cases, seem difficult, absent some objective evidence of intent, to distinguish earnings management from the legitimate exercise of accounting discretion.”

During 1998 speech at "The 'Numbers Game’, SEC Chairman Arthur Levitt expressed his concern that there are excessive corporate managers, auditors and analysts let the desire to meet earnings expectations override good business practices. His fear was that "Managing may be giving way to manipulation; Integrity may be losing out to illusion." Chairman Levitt stated that government regulation was not the solution to this problem.

Chairman Levitt identified five common accounting principles that have been used in manipulating earnings:

Lucent’s Manipulation Method

Possible Incentives

Stock market motivations

During its growth phase (from 1996 to 1999), Lucent's major incentive was to keep on reporting earnings and revenues above market expectation, as to increase their market capitalization (benefit from the premium that the investment community awards continuous high performance companies) (BARTH; ELLIOT; FINN, 1999). As virtually all companies, Lucent also has the strong incentives to smooth earnings to make it appear less volatile.

Contract motivations

Inflating earnings to increase management compensation is a strong incentive to manipulate earnings. According to the information displayed in the proxy statement for year 2002, all of the top managers and most of the directors have performance pay plans based upon some accounting measures such as earnings and revenues.

Besides, enhancing job security can be considered as an incentive to manage earnings to make the firm appear more profitable. Reducing the cost of capital can be considered another major incentive to managers. Because of adopting aggressive growth strategy, Lucent was constantly issuing debt to acquire irms. Therefore, the company will have strong incentives to present strong, healthy, and steady financial statements to reduce the cost of debt.

Manipulation Method

Miscellaneous cookie jar reserves and big bath restructuring charges

Lucent’s earnings are benefited from $2.8 billion reserve for “big bath” restructuring charges that were recorded as part of the process during the Lucent’s spin-off from AT&T (McGough 1999). By writing off several years worth of costs at once, Lucent eliminated future costs and automatically improved future earnings (Byrnes, Melcher, Sparks). Although recording restructuring costs is allowed by GAAP, some analysts believe Lucent put aside far more than was needed to cover restructuring expenses. The excess reserves helped Lucent smooth earnings by allowing it to add back $382 million to pretax income (Business Week—Byrnes, Mecher, Sparks)

In process research and development (IPRD) write-off

In October 1998, Business Week reported that Lucent had avoided some goodwill amortization by writing off $2.3 billion of in-process research and development for companies was acquired. Over its existence, Lucent has engaged in 40 acquisition transaction with other companies. An accounting expert and money manager notes that

In fiscal year 1996, Lucent actual earnings would have lost $49 million instead of $1.05 billion operating gains which it had reported,

Lucent’s fiscal 1997 earnings would have been $1.11 billion instead of $1.51 billion,

Earnings for the first three quarters of 1998 would have been $1.51 billion instead of the $1.74 billion reported if Lucent had not been engaged in the one-time charge and in-process research and development write off.(Byrnes, Melcher, Sparks)

Premature or aggressive revenue recognition

Two-thirds of the $679 million reduction in revenue was actually attributed to “channel stuffing” sales, whereby the transfers of products to distributors are recorded as sales even though the products are not yet sold to end-users (Electronic News, Feb 2001, Murphy). Other sales were nullified because

Customers were promised discounts, credits, and rights of return (WSJ March 2001 Berman, Blumenstein), or

Lucent had improperly recognized maintenance agreements as software license revenue (Internet Week, Moozakis).

Lucent had deducted $199 million in credits offered to customers and $28 million for a partial shipment of equipment as part of the December 2000 restatement. In addition, the company took back another additional $452 million in revenue for some products it had sent to its distribution partners but actually it never sold to end customers (WSJ, Feb 2001, Berman, Schroeder, Young). By prematurely recording sales of maintenance agreements, prematurely recording sales made to distributors, and offering discounts, one-time credits and other incentives for customers to order products in advance of their needs,

Lucent’s practices “borrowed” heavily from future sales (WSJ March 2001, Berman Blumenstein). As Lucent’s“debt” mounted from quarter to quarter, it became more and more difficult to meet analysts’ sales and earnings expectations. To maintain its revenue projections, Lucent had to scramble to book revenue at the end of each quarter. A former executive at AT&T noted that “At the end of each quarter, I’d get calls from the Lucent guys…They were offering screaming deals” (WSJ March 2001 Berman, Blumenstein). Shortly after fiscal year ending September 2000, a Lucent employee calculated that sales resulting from aggressive tactics such as giving customers one-time promises of credits toward future purchases totaled approximately $1.8 billion (WSJ March 2001 Berman, Blumenstein).

Revenue expenditure and Capital expenditure

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