Earnings management and audit committees.

• Author: KOLINS, WAYNE A.

How earnings management was a key driver behind the new audit committee rules, and what the new rules do to combat earnings management.

THE SHAREHOLDER MEETINGS SEASON is almost upon us, and a key topic of discussion will likely be the implementation of new rules in mid-2001 that will have a major impact on the role of public company audit committees. Corporate boards of directors have already been wrestling with the coordinated new rules issued by the Securities and Exchange Commission, the securities exchanges, and the AICPA Auditing Standards Board that greatly increase the responsibilities, time commitment and risk of audit committees and committee members.

A key driver behind the new rules is a practice known as earnings management. In a September 1998 speech entitled, "The Numbers Game," then-SEC Chairman Arthur Levitt expressed concern that the quality of financial reporting in Corporate America was eroding. He indicated that companies, motivated to meet Wall Street earnings, were "managing" earnings through a variety of accounting practices.

To combat earnings management, Levitt outlined a comprehensive action plan requiring a cooperative effort within the entire financial community. The plan involved tightening the accounting rules, improving audit quality, and strengthening the audit committee. Most importantly, the plan called for a cultural change on the part of corporate management and Wall Street that insists on the integrity of the numbers in financial reporting.

According to Levitt, the following accounting practices had been used by companies in managing their earnings:

* "Big Bath" Charges -- Cleaning up the balance sheet through large restructuring charges, thereby eliminating and/or reducing negative impacts on future earnings.

* In-Process R&D -- Allocating significant portions of the purchase price to in-process research and development, thereby writing off the amount as a onetime charge without negatively impacting future earnings.

* "Cookie Jar Reserves" -- Creating excessive liabilities based on unrealistic assumptions (e.g., sales returns, loan losses, warranty costs, and restructuring costs) in good times and reducing such liabilities (and creating income) in bad times.

* Materiality -- Misusing the concept of materiality to intentionally record errors within a predefined percentage ceiling.

* Revenue Recognition -- Recognizing revenue before a sale is complete, before the product is delivered to the customer, or before the customer loses the ability to cancel or delay the sale.

Reflecting the urgency of the problem, on the same day as Levitt's speech, the SEC, the New York Stock Exchange, and the National Association of Securities Dealers announced the appointment of a Blue Ribbon Committee (BRC) intended to make recommendations to strengthen the role of audit committees in overseeing the corporate reporting process. In a testament to the significance with which the financial community viewed the SEC's concerns, the Blue Ribbon Committee's Report and Recommendations were issued just five months after the Chairman's speech. The groundswell created by Levitt's initiative also was evident when comparing the similarities between the Committee's recommendations and the resulting recent actions by regulators and the accounting profession and in...