Critics argue that some managers are intentionally abusing Gap’s afforded discretion to manage earnings. This can reduce the quality of the financial reporting process ND ultimately bring adverse effects on resource allocation in the economy. Not surprisingly, market participants, legislators, regulators, and academics are concerned with the need to control financial reporting abuses. In this paper we briefly review the recent literature on earnings management and show the incentives as well as the mechanics used by Lucent’s managers to manipulate earnings.
We found strong incentives for Lucent’s managers to report smooth and increasing earnings to: a) increase the firm’s market capitalization; b) enhance management compensation and job security; and c) reduce the company’s cost of capital. The evidence we found suggests that the managers used: a) big bath restructuring charges; b) miscellaneous cookie jar reserves; c) premature and aggressive revenue recognition; and d) creative acquisition accounting and purchased to manage earnings. Keywords: Financial statements. Manipulate earnings. Managers.
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A avid©NCAA encountered surge queue so egresses, Para Grecian so lucre’s, ashram: 1) a extras©gig De big bath Para so custom De restaurateurs; 2) reserves dividers do tip cookie jar; 3) o reconcilement premature e aggressive dad rend; e 4) a conciliated De sequoias creative e R&D acquired. 1 Tribal parenthood no XVII KNEEPAD, realized me Curtain/PR, no period De 25 a 29 set. 2004. Universe Contain, SINS 1809-3337, Blumenthal, v. 1, n. , p 101 2005. Feline Fossil Cannot De MOTOS – Mosaic Sandwich 102 Revisit -Ill,Jan. /bar. Palavers-shave: Demonstrate¶sees financiers. Germination De resultants. Gestures. 1 INTRODUCTION The primary objective of financial reporting is to provide information useful to investors, creditors and others for rational decision making. The Generally Accepted Accounting Principles (GAP) are a set of principles that guide managers in preparing financial statements.
These principles are flexible and allow managers to use their judgment to best report the underlying economics of their organizations. On some occasions, when it is unlikely that the firm will et certain financial expectations (such as earnings, revenues, return on investments, debt covenants or other measures) and the costs of not meeting them are considered to be too high, managers may use GAP’ flexibility to manipulate the accounting numbers. This is also known as earnings s management.
Because earnings management reduces the quality of financial reporting, it can interfere with the resource allocation in the economy and can bring adverse consequences for the financial market. Enron and World are recent examples of earnings management that need no additional comments because of the damages they brought to the economy. Therefore, it is not surprising that market participants, legislators, regulators, and academics are concerned with the need to control financial reporting abuses.
Responsible authorities seem to be concerned with the pervasiveness of earnings management. Since 1998, after Levitate’ speech addressing the need to control earnings s management, the Securities and Exchange Commission (SEC) has been on the lookout for selective disclosure. Business Week recently published that the number of restatements more than tripled in the last 3 years. In this paper we briefly review the recent literature on earnings management ND show the incentives as well as the mechanics used by Lucent’ managers to manipulate earnings. We identify strong incentives for earnings management and present several suspicious accounting practices consistent with these incentives. The remainder of this paper proceeds as follows: first, we succinctly define and comment the earnings management definition; next, we briefly review academic literature, present most common incentives for earnings management and show major empirical findings. Subsequently, we identify possible incentives for earnings management and show the mechanics used by Lucent’ managers to engage earnings.
Finally, we present our s conclusions and final remarks. 2 WHAT IS EARNINGS MANAGEMENT? Among the many definitions of earnings management, the one most frequently cited 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; WHALEN, 1999, P. 368).
Healy and Whalen (1999) observed that many aspects of this definition deserve additional comments. First, managers can use judgment in many different ways. For example, judgment is required to estimate future economic events such as salvage values of long term assets, obligations for pension benefits, losses from bad debt, asset impairment and many other events. Managers must also choose among acceptable accounting methods for reporting Universe Contain, SINS 1809-3337, Blumenthal, v. 1, n. 1, p 101 – Ill,Jan. /bar.
EARNINGS MANAGEMENT: THE CASE OF LUCENT TECHNOLOGIES 103 the same economic transactions, such as straight-line or accelerated depreciation methods or LIFO, FIFO or weighted average inventory valuation ethos. Managers must also use judgment to manage working capital (inventory management, timing of shipments and purchase of supplies and receivables policies, to name a few), which affects cost allocations and revenues. Managers also use judgment to make or defer expenditures such as R&D, advertising, and maintenance.
Finally, they must also decide how to structure transactions, for example: lease contracts can be structured so that lease obligations are on or off balance, and equity investments can be structured to avoid consolidation. The authors also noted that the definition frames the objective of earnings management as misleading stakeholders about the economic performance of the firm. Obviously, managers can also use accounting judgment to make financial reports more informative for users. This can arise if certain accounting choices or estimates are perceived to be credible signals of a firm’ financial performance.
Decisions to use accounting judgment s to make financial reports more informative for users do not fall within the definition of earnings management. Finally, the authors pointed out that management’ use of judgment in financial reporting has both costs and benefits. The costs are potential misapplications of resources that arise from earnings management. Benefits include potential improvements in management’ s credible communication of private information to external stakeholders, improving resource allocation decisions. Earnings management seems to be a rather controversial matter.
While the SEC and most academics consider it misleading to some users of financial information, some accountants and managers consider some alternatives of earnings management legitimate managerial practices. L Techno and Skinner (2000) noted that it is difficult to spot earnings management hen it occurs within the bounds of GAP. According to them, while some financial reporting choices that clearly violate GAP can constitute both fraud and earnings management, other choices, within GAP, 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 GAP 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.
Therefore, not surprisingly, it is not easy to identify whether earnings management has occurred, and academics find it difficult to document it convincingly. A common approach used by them is, first, to identify conditions in which managers’ incentives to manage earnings are likely to be strong, and, then, to test whether patterns of unexpected accruals or accounting choices are consistent with these incentives. In the following section, we present the major academic findings. EVIDENCE OF EARNINGS MANAGEMENT Healy and Whalen (1999) reviewed the academic literature on earnings management.
They identified three major factors that could create incentives for earnings management. These factors are: a) capital market expectation and valuation; b) contracts written in terms of accounting numbers; and c) anti-trust and other government regulations. 104 -111, Jan. /bar. 3. 1 Capital market motivations The widespread use of accounting information by market participants to assess firm’ s economics can generate incentives for managers to manipulate earnings in tempt to influence short term stock price performance.
Academic research reviewed by Healy and Whalen (1999) documented that at least some firms attempt to influence short-term stock price performance by managing earnings. The evidence is consistent with firms managing earnings in periods surrounding capital market transactions and when there is a gap between firm’ performance and analyst’s s investor’ expectations. However, there is little evidence on the frequency of the practice, and s about the effect on resource allocation. Additionally, it is also unknown which accruals are used to manipulate earnings. 3.
Contracting motivations The financial statements are widely used to assess management compensation and to regulate lending contracts. Since the accounting data are used to monitor and regulate the contracts between the firm and its stakeholders, it is possible to assume that there are incentives for earnings management. In short, academic research findings suggest that compensation and lending contracts induce at least some firms to manage earnings to: a) increase bonus awards; b) improve job security; and c) mitigate potential violation of debt covenants.
However, there is little evidence of whether this behavior is dispersed or infrequent, no evidence of which specific accruals are most likely being used to manage earnings and no evidence of its effect on resource allocation. 3. 3 Regulatory motivations Virtually all industries are regulated to some degree. For example, in the U. S. , banking and insurance industries are required to meet certain financial health criteria. Utilities have historically been rate-regulated to earn profits consistent with its business risks. Clearly, the need to comply with such regulations can trigger accounting manipulation.
In addition, firms undergoing an anti- rust investigation and firms seeking a government subsidy or protection may have incentives to manage earnings to appear less profitable. The earnings management literature has covered the effects of two forms of regulation: a) industry specific; and b) antitrust. Healy and Whalen (1999) cited that the literature on earnings management strongly suggests that regulatory considerations induce firms to manage earnings. However, there is little evidence of whether this behavior is widespread, and no evidence of the effect on resource allocation. 4 TESTS OF DISTRIBUTION OF REPORTED EARNINGS
Healy and Whalen (1999) also noted that some recent studies adopted a new approach to document earnings management. These studies examined the distribution of reported earnings to assess whether there is evidence of earnings management. The studies assumed that managers have incentives to avoid reporting losses or reporting declines in earnings, and examined the distribution of reported earnings around these benchmarks. The findings 105 strongly suggest that some firms engage in earnings management when they anticipate: a) reporting a loss; b) reporting an earnings decline; or c) falling short on investors’ expectations.
Although Healy and Whalen (1999) asserted that there is not enough evidence to determine which accruals or accounting methods have been most frequently used for managing earnings, Levitate (1998) pointed out the 5 most popular mechanisms that firms are using to manage earnings:2 a) big bath restructuring charges; b) creative acquisition accounting and purchased R; c) miscellaneous cookie jar reserves; d) intentional errors deemed to be immaterial and intentional bias in estimates; and e) premature or aggressive revenue recognition.
Moreover, Sherman and Young (2001 ) noted that recent history has shown hat businesses with the following characteristics are more likely to feature manipulation of accounts: a) high growth company entering a low growth phase; b) companies that receive extensive coverage in the business and popular press; c) new businesses where there are ambiguities about how key transactions are and should be measured; d) weak control environments in which managers can manipulate reported financial results with relative impunity; e) companies that are followed by a small number of analysts; and f) companies with complex ownership and financial structures.
The majority of he academic studies usually examine large samples of firms to document earnings management. The research methodology adopted in these studies relies upon statistical measures to identify earnings management. As result, these studies often present general conclusions about earnings management and their tests are often not powerful enough to identify managers of specific firms that managed earnings. In this paper, contrary to the bulk of academic research, we examine the occurrence of earnings management within one given firm.
We chose to study Lucent Technologies because we knew that the many: a) restated earnings for the fiscal years of 1998, 1999, and 2000; b) was under investigation by the SEC; and c) was subject to a number of articles in the financial press that suggested that the managers manipulated earnings. To perform our analyses, we first searched for information about Lucent in the financial press and then looked for possible incentives and evidence of earnings management in the financial statements consistent with the practices described or suggested in the articles reviewed.
We find this alternative approach to document earnings management useful to market participants, regulators, academics and students, because in addition to showing the innovations of creative accounting, it also illustrates the “mechanics” of earnings management. In the next section we present our analyses. First, we briefly describe the company and, then, identify possible incentives for earnings management and look for possible earnings manipulation consistent with these incentives. EARNINGS MANAGEMENT IN LUCENT TECHNOLOGIES’ FINANCIAL REPORTS 5. 1 Company background and business summary Lucent Technologies (www. Lucent. Com) was formed in 1996 as an AT&T spin- off. Essentially, the firm designs and delivers networks for the world’ largest communications s 106 service providers. Lucent’ main business segments are: research and development, mobility, s optical, data and voice networking systems, and software development. Lucent’ competitors vary widely among the company’s various product and s businesses categories.
Its main competitors are: JDK-Unappeased, Peril, Fajitas, Motorola, Texas Instruments, Nortek, Cisco and Locate. Most of Lucent’ clients are high tech and s telecoms firms. During the high tech golden years (from 1997 to 1999), Lucent was he largest manufacturer of telecoms equipment and one of the most prominent corporations in the U. S. 5. 2 Evidence of earnings management In this section we identify some evidence that suggests that Lucent managed earnings. Yet, we first highlight the major incentives that could have possibly motivated earnings management. 5. . 1 Possible Incentives a) Stock market motivations During its growth phase (from 1996 to 1999), Lucent’ major incentive was to keep on s reporting earnings and revenues above market expectation, to increase market capitalization (benefit from the premium that the investment community awards mutinous high performance companies) (BIRTH; ELLIOT; ANN, 1999). As virtually all companies, also Lucent has strong incentives to smooth earnings to appear less volatile. B) Contract motivations Inflating earnings to boost management compensation is a strong incentive.
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 accounting measures such as earnings and revenues. Enhancing job security can also be considered an incentive to manage earnings to make the firm appear more profitable. Reducing the cost of capital can be considered a major incentive. Because of its aggressive growth strategy, Lucent was constantly issuing debt to acquire firms.
Therefore, the company has incentives to present strong, healthy, and steady financial statements to reduce the cost of debt. 5. 22 Earnings management a) Miscellaneous cookie jar reserves and big bath restructuring charges Recent history has proven that investors panic when reported earnings fall below expectations and reward firms that consistently report earnings that are above expectations. In a technologically dynamic and fast growing industry such s the telecoms, one might expect earnings to be highly volatile. However, for Lucent they were not.
It has become a common practice among managers to take excessive restructuring charges (GAP requires companies to estimate the future costs they expect to incur to carry out the restructuring plan) to clean up their balance sheet, giving the company a big bath. Popular belief says that investors will look beyond a one time loss and focus only on future 107 earnings. 3 In addition, it is not unusual practice to reverse the overly conservative reserves to smooth out earnings whenever the company needs omen extra revenue to meet certain accounting numbers (these reserves are also known as cookie jar reserves).
The combination of the big bath with the cookie jar reserves is a convenient income smoothing device. At the time of its spin off, Lucent set up a $2,801 billion reserve to cover future costs of restructuring its operations. As it turned out, Lucent overestimated these future costs. Over the following 4 years, the company reversed more than $500 million to pretax income, increasing and smoothing out what would otherwise have been a more volatile earnings. It seems that at the spin off, Lucent took a big bath and expensed $2,801 billion.
In the subsequent years, managers reversed part of the charge and enhanced revenue to smooth out earnings and to help to keep on reporting a pattern of constant revenue and earnings growth. B) In process research and development (BIRD) write-off In the last decade, there were many consolidations, acquisitions and spin-offs. GAP allows firms to use discretion in accounting for acquisitions. In a purchase transaction, the acquiring company records the current market value of the purchased firm.
The gap between the purchase price and the value of the purchased assets is called ‘goodwill’. Goodwill represents the value of the target to the acquiring firm, above the fair market value of all assets that can be identified. According to GAP, firms must amortize goodwill over time. This amortization reduces future earnings and managers rarely like them. For high tech firms, where the bulk of the assets are intangibles that cannot be identified, a significant part of the purchase price can be goodwill.
When a firm invests in a tangible asset, the cost is charged against the revenue over the asset’ useful life. But for many s intangible assets, because of the high uncertainty of future revenue associated tit their useful life, GAP requires firms to expense them. In an acquisition, the acquirer can include in the purchase price its own estimate of the future value of R in the target company. In this way, it is possible to reduce the goodwill and the associated amortization charges on future earnings. Over its existence, Lucent has acquired 40 companies. Naturally, one might suspect that a possible area for earnings management is in-process research and development (PR) write-off. Katz (2000) noted that Lucent has avoided $2. 5 billion in goodwill and the associated drag on earnings since 1996. Although her analyzes does not provide irrefutable evidence of earnings management with PR write-off, she suggested that Lucent conservatively expensed PR to avoid large future amortization charges of goodwill. ) Premature or aggressive revenue recognition The most widely earnings management practice is premature or aggressive revenue recognition. In other words, managers recognize revenues before they have been earned or become realized. 5 In 1999, in order to keep up with revenue and earnings growth as well as with the competition, Lucent adopted an aggressive market strategy. The firm decided o finance customers to buy its equipment and to offer substantial discounts for anticipated purchases.
By early 2000, even though many of its clients were signaling financial trouble, Lucent, possibly pressured to meet the numbers, offered significant discounts on purchases on account, continued to offer new loans to troubled companies, and expanded credit to client companies. Although such aggressive strategies can substantially increase current sales, the extra revenue is often generated at the expense of future sales at list price. These strategies Revisit Universe Contain, SINS 1809-3337, Blumenthal, v. , n. 1, p 101 – 111, Jan. / bar. 2005. 08 can constitute normal and legitimate business practices, but they can also be misleading to investors reading the financial reports, especially if managers engage in these transactions specifically to meet financial targets at the very end of the accounting period and chose not to fully disclose the details of the deal in the footnotes. 6 The increase of the Accounts Receivables (AIR) to Revenues ratio suggests that the company has been aggressively booking revenues. It can be seen from the company’s financial statements that the ratio increased by more than 50% from 998 to 2000.