Professor David Heier, CPA, MBA
11 June 2014
This paper looks at the speech entitles “The ‘Numbers Game’” that SEC chairman Arthur Levitt delivered at the NYU Center for Law and Business regarding earnings management in 1998. While companies use many techniques and illusions to improve their numbers, this paper will only look at three: “Cookie-Jar” Reserves, “Big Bath” Charges, and Revenue Recognition. After discussing and using real world examples of these techniques, this paper will examine ethical questions related to the selection of audit committee members such as qualifications and independence.
Cookie Jar Reserves
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Big Bath Charges
Big bath charges occur when a company already experiencing a bad year will take a one-time charge to lower earnings even further in the current period in order to be offset by better earnings the next year. They classify this as additional restructuring costs (Gaffney). When FASB released SFAS No. 142 in 2002, which no longer allowed companies to amortize goodwill, they gave way to bath restructuring allowing companies to write-down their intangibles. Companies took advantage of this by overstating these restructuring charges (Jordan).
In 2007, a year before Levitt’s Speech, Meryll Lynch, Citigroup, and GM all were suspected to have incurred massive big bath charges. Citigroup wrote down over $8 billion in a single quarter, and GM wrote down over $39 billion again in a single quarter. Both of these are staggering amounts of money. The trouble is that it is difficult to prove that any fraud occurred in both of these situations (The Accounting).
Aggressive or untimely Revenue recognition is arguably the most common of the three discussed earnings management techniques and it goes directly against both matching, revenue recognition, and the time period assumption. Since there are so many times that companies recognize revenue, there are a myriad of opportunities to fudge the numbers. The SEC SAB No. 104 illustrate many of these situations. The basic concept behind this is to record sales early in order to meet estimates in the current period, or to record contractual revenue with very liberal estimates (Gaffney).
A real-world example of this is a company called Sunbeam, who’s most famous brand is Mr. Coffee. In late 2000 the SEC charged them with early revenue recognition related to sales promotions they offered retailers in 1997. In 1998, their CEO was fired, and then in 2000, they received the charges (McGregor).
Audit Committee Independence
Concluding his speech, Levitt discusses the audit committee by comparing and contrasting two scenarios: a vastly unqualified committee which meets twice a year, and a qualified on who meets 12 times a year. He makes the point that an audit committee should have no ties to the company and should all be well versed in financial management (Levitt).
Levitt’s position makes perfect sense. Without independence, the audit committee will choose an auditor which will best serve the interests of the company rather than that of the end use of the...