Earnings Management Revisited: Further Suggestions in the Wake of Corporate Meltdowns

In the Jan./Feb. 2000 issue of The White Paper, the three authors of Earnings Management: When does Juggling the Numbers Become Fraud?" had the foresight to focus on a disturbing global trend. Certain large corporations would have done well to heed their words. ed.  

As we noted in our previous article in the Jan./Feb. 2000 issue of The White Paper, earnings management involves entity managers and accountants asking "How can we best report desired results?" rather than "How can we best report economic reality (the actual results)?"¹ When reported results are intentionally misstated, earnings management becomes fraud. Corporate scandals including Enron, and WorldCom, and these entities' external auditor, Arthur Andersen, are instructive on such accounting and business abuses. They also point to the critical need for further involvement of fraud examiners in assuring the verity of published financial information.

Accordingly, here we provide an update on earnings management, including the implications of the U.S. Sarbanes-Oxley Act of 2002, and offer suggestions for improving performance reporting in all countries.

Building Awareness of Earnings Management That has Become Fraud  

In our original article, we suggested that a short-term solution to the earnings management problem is building public awareness of what earnings management is and how it's done. One "benefit" of the recent corporate scandals is that they have indeed raised awareness of earnings management and, more to the point, focused attention on earnings management that has become fraud. Future efforts to prevent or detect fraudulent performance reporting depend on a clear understanding of the underlying causes and specific techniques that gave rise to reporting problems at so many entities in recent years. In particular, for our purposes it's instructive to consider "What happened at Enron and WorldCom?" And "Where was the external auditor, Arthur Andersen?"

A common thread among these and other recent scandals is a corporate culture that encouraged earnings management. Tom Tierney, author of a 2002 book on this subject notes, "A corporation's culture is what determines how people behave when they are not being watched."² Such behavioral determinates include the "tone" set by senior management and the board of directors and the accounting policies that reflect such a tone.

At Enron, for example, corporate greed and arrogance were apparent in the entity's aggressive use of "mark-to-market accounting" for its energy trading contracts. Under this "generally accepted accounting principle," entities are required to adjust the reported amounts of such contracts and record a gain (or loss) for any adjustment upward (or downward). By optimistically valuing its energy contracts, Enron was able to report significant unrealized gains in its profit numbers. In the year 2000, for example, more than half of Enron's $1.4 billion of pretax profit was made up of these unrealized gains. As Sherron Watkins, a former vice president at Enron, summarized, "Overall, investors lost over $60 billion on Enron in just under two years and Enron went bankrupt without ever declaring or having a poor quarter relative to recurring earnings."³

Charges of fraud at Enron have been asserted and are being addressed in the courts. But a couple of things are clear: It's the responsibility of an entity's management to publish financial statements that reflect economic reality, and the management of Enron failed in that responsibility. Also, it's the external auditor's job, Arthur Andersen in this case, to provide assurance that management's financial statements do in fact present actual results, but Andersen failed in its responsibility.

In a similar way, managers at WorldCom took advantage of "a company culture rife with conflicts of interest and lacking proper controls" to aggressively manage its reported earnings.⁴ As described by the bankruptcy-court examiner, WorldCom's "smorgasbord" of unacceptable accounting entries included improper revenue recognition and the use of "cookie jar" reserves. As an example of the latter technique, the entity set aside earnings in reserves for legal costs and bad debt (among others) to add between $374 million and $661 million to its quarterly reported earnings.⁵ To date, these and other earnings management techniques at WorldCom have resulted in billions of dollars of earnings restatements, and charges of fraud abound. WorldCom management failed in its financial reporting responsibilities and, like in the Enron case, the question arises: "Where was the external auditor, Arthur Andersen?"

On June 15, 2002, Arthur Andersen LLP was found guilty of obstruction of justice in the federal government's investigation into Enron. The firm consented to the revocation of its license to practice public accounting on Sept. 3, 2002. Similar to the downfall of Enron and WorldCom, critics said that Andersen's failures were rooted in its culture. Departing from its historical role as public watchdog, its culture had become heavily influenced by its business consulting activities. As a specific example, Enron outsourced its internal audit function to Andersen in the mid-1990s which, some contend, allowed Andersen to essentially audit its own work.⁶ More generally, such business consulting services created financial incentives for Andersen to retain Enron as an audit client. Additionally, some observers point to the close relationships among Andersen and Enron personnel and claim Andersen effectively became part of Enron's management team. All of this raises some questions. "Was this an isolated event in public accounting?" "Could what happened at Andersen also occur at any of the remaining 'Big Four' public accounting firms?"

The demise of Arthur Andersen LLP, while distinct in its impact on the public's perception of the accounting profession, is characteristic of a fundamental shift in the culture of public accounting. Like Andersen, critics assert the remaining Big Four public accounting firms (Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers) increasingly relied on business consulting activities. In a July 2003 Harvard Business Review article, Paul Healy and Krishna Palepu trace such increased reliance on consulting to the severe pricing pressures from the audit being viewed as a commodity.⁷ Healy and Palepu emphasize that "in the absence of differentiated audits, auditors became desperate to please clients."⁸

Each of the Big Four firms is associated with recent business scandals.⁹ As examples, Deloitte & Touche audited Adelphia Communications, which allegedly was looted by the company founder and some of his family. Ernst & Young audited HealthSouth. Top executives there allegedly engaged in an enormous accounting fraud to show increased profits. KPMG audited Xerox, which restated multiple-year revenue figures downward to the tune of several billion dollars, allegedly due to earnings management and fraudulent accounting practices. And PricewaterhouseCoopers audited Tyco, a company that issued materially misstated financial statements for a number of years and whose CEO and CFO have been charged with stealing millions of dollars from the company. While the culpability of the public accounting firms in these cases and others has yet to be fully determined, it's unlikely any of the scandals will lead to the demise of a Big Four firm. But now the question that arises is "Will recently passed regulations prevent scandals and performance reporting abuses in the future?"

Sarbanes-Oxley and Improved Corporate Governance  

On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. (See The White Paper, March/April 2003.) The act has been described as "mandating the most far-reaching changes Congress has imposed on the business world since FDR's New Deal."¹⁰ These changes apply to public-traded entities and their external auditors and are designed to improve corporate governance and performance reporting in the United States, although a spillover effect could certainly occur in other countries and a "trickle-down" impact on private companies throughout the world is possible, too.

For the auditors of public-traded entities, SOX effectively strips the accounting profession of its privilege to self-regulate. As Rep. Michael Oxley, coauthor of the act, emphasized, "What we did was tantamount to federalizing the accounting profession because self-regulation didn't work."¹¹ In particular, the Public Company Accounting Oversight Board is charged under SOX with the responsibility to register, monitor, and discipline public accounting firms, as well as to establish or adopt the rules that govern financial statement auditing. Moreover, SOX imposes restrictions on non-audit services offered contemporaneously with the audit of public-traded clients. Among the services prohibited is the outsourcing of internal audits to external auditors, like that which occurred at Enron in the mid-1990s. Essentially, SOX prohibits external auditors of public-traded entities from auditing their own work, from acting as advocates for their clients, and from otherwise performing management functions.

SOX also requires the board of directors' audit committee of publicly traded entities to preapprove both audit and non-audit services offered by the entities' public accounting firms. Thus, audit committees play key roles in hiring, monitoring, and compensating entities' external auditors. Other key provisions include protection for whistle-blowers who report fraudulent accounting and business practices and a requirement that CEOs and CFOs personally certify their entities' SEC filings are fairly presented and complete. Additionally, the entities' management must offer an assessment of the effectiveness of internal controls and procedures for financial reporting and the entities' external auditors must report their evaluations of that assessment.

While we see "federalizing the accounting profession" as a heavy-handed response to a politically charged problem, some of the act's provisions do address fundamental weaknesses in our corporate governance structure and performance reporting system. We agree, for example, that removing the perceived threat to auditor independence from auditors providing non-audit services is important. A clear lesson from the recent scandals is that the financial statement auditor must not only be independent but must be perceived to be independent by the users of accounting information. In particular, "to have confidence in external auditors' representations, users must believe these auditors are objective and free from bias."¹² Such public confidence in performance reporting is likely to be further enhanced by the act's provisions that a public entity's audit committee must preapprove audit and non-audit services and also that the audit committee include at least one "financial expert."

We see the board of directors' audit committee as a critical component of a performance reporting system. SOX requires audit committee members to be independent; they may not receive any monies from the entity other than fees for their service on the board (i.e., directors who sit on an entity's audit committee must come from outside the entity). In fact, results of a recent study show that earnings management occurs less frequently when there is greater independent representation on the board of directors, especially when members of the board's audit committee possess the financial sophistication to understand and interpret accounting numbers.¹³ In our view, independent audit committee members with financial expertise are more important than ever and are in an excellent position to be what former SEC chairman Arthur Levitt called "the most reliable guardians of the public interest."¹⁴

The audit committee can be a watchdog over entity management, as well as a watchdog over the external auditor. As one of us noted almost two decades ago, "Scrutiny of external auditor affairs by corporate audit committees has significant benefits: to some extent the auditor-management relationship is held in check, appropriate auditing firm quality controls are more assured, and financial statement users are likely to form an appropriate perception of auditor independence."¹⁵ We agree with current SEC chairman William Donaldson, who recently said, "The audit committee, and the audit itself, is the bedrock upon which corporate governance has to be built."¹⁶

Fraud examiners need to understand the underlying causes and specific techniques of earnings management that become fraud to help them prevent business and accounting scandals and assist in unraveling frauds when they do occur. More specifically, the increased importance of the corporate audit committee presents a significant opportunity for fraud examiners who possess financial expertise in addition to fraud deterrence and detection knowledge. For example, very useful to an audit committee would be fraud examiners who are capable of applying various models, based on financial reporting data, to detect earnings management as well as earnings management that has become fraud. (See "The Financial Numbers Game: Detecting Creative Accounting Practices" by Charles Mulford and Eugene Cominsky.¹⁷)

Fraud examiners who have financial expertise could be prime candidates for board audit committee positions. Alternatively, audit committees could retain the services of fraud examiners with financial expertise on an as-needed basis. In fact, SOX contains a provision giving audit committees the authority to engage advisors to assist in carrying out audit committee duties.

Whether the Sarbanes-Oxley Act will be effective in preventing scandals and performance reporting abuses remains to be seen. However, the long-term solution to such problems isn't more regulation. Rather, as we advised in our original article in The White Paper, "managers, accountants, and boards of directors--through their audit committees--must fully accept and fulfill their reporting responsibilities, balancing their self-interests with the interests of the public. They need to focus on making good decisions and reporting the outcome of those decisions in a manner that best portrays economic reality."¹⁸ Indeed, recently surveyed corporate managers emphasize that "rules, standards and frameworks can only do so much. It will take demonstrated commitment to transparency, accountability and integrity to regain public trust."¹⁹

Since the publication of our original article, the public has lost confidence in managers, accountants, and boards of directors--and with good reason. The advice we offered in 2000 is the same advice we offer now--only now it is more crucial than ever that it be heeded.

Stephen D. Makar, Ph.D., CPA, is an associate professor of accounting and Oshkosh Truck Endowed Professor at the University of Wisconsin in Oshkosh. Pervaiz Alam, Ph.D., CPA, is a professor of accounting at Kent State University in Kent, Ohio. Michael A. Pearson, D.B.A., CFE, CMA, CPA, is a professor of accounting at Kent State University in Kent, Ohio and a member of the ACFE's Editorial Review Board.  

1 Makar, S.; Alam, P.; and Pearson, M., "Earnings Management: When does Juggling the Numbers Become Fraud?" The White Paper, Jan./Feb. 2000, pp. 31-33.
2 Tierney, T., Aligning the Stars: How to Succeed When Professionals Drive Results, Harvard Business School Press, 2002.
3 Klein, M., "Whistleblowers, Con Artists and Corruption Top Slate at ACFE Confab," Accounting Today, Sept. 2-22, 2002, pp. 3-4.
4 Sandberg, J., and Pulliam, S., "Examiner Accuses WorldCom of Series of Fraudulent Activities," The Wall Street Journal, Nov. 5, 2002, pp. A1, A11.
5 Ibid.
6 Byrnes, N.; McNamee, M.; Brady, D.; Lavelle, L.; and Palmeri, C., "Accounting in Crisis," Business Week, Jan. 28, 2002, pp. 45-48.
7 Healy, P., and Palepu, K., "How the Quest for Efficiency Corroded the Market," Harvard Business Review, July 2003, pp. 76-85.
8 Ibid.
9 "Scandal Scorecard," The Wall Street Journal, Oct. 3, 2003, pp. B1, B4.
10 Miller, R., and Pashkoff, P., "Regulations Under the Sarbanes-Oxley Act," Journal of Accountancy, Oct. 2002, pp. 33-36.
11 "Oxley: Law Key to Economic Viability," Accounting Today, Feb. 24- Mar. 16, 2003, p. 3.
12 Pearson, M., "Enhancing Perceptions of Auditor Independence," Journal of Business Ethics, Feb. 1985, pp. 53-56.
13 Xie, B.; Wallace, D.; and Dadalt, P., "Earnings Management and Corporate Governance: The Role of the Board and the Audit Committee," Journal of Corporate Finance, 2003, pp. 295-316.
14 Levitt, A., "The Numbers Game," speech delivered at New York University, New York, N.Y., Sept. 28, 1998.
15 Pearson, "Enhancing Perceptions of Auditor Independence," p. 56.
16 "SEC Adopts New Audit Committee Rules," Accounting Today, Apr. 21- May 4, 2003, p. 3.
17 Mulford, C., and Cominsky, E., The Financial Numbers Game: Detecting Creative Accounting Practices, John Wiley & Sons, 2003.
18 Makar, Alam, and Pearson, "Earnings Management: When does Juggling the Numbers Become Fraud?" p. 33.
19 Whitman, J., "Sarbanes-Oxley Act Begins to Take Hold, Survey Says," The Wall Street Journal, Mar. 25, 2003, p. C9.