The Aftermath of Enron:
Earnings Management Transparency Rules
Return to the Recent Commentaries page
By Edward D. Hess,
Distinguished Executive in Residence and
Adjunct Professor of Management, Goizueta Graduate School of Business
Emory University
Atlanta, Georgia
edward_hess@bus.emory.edu
Enron, Tyco, Qwest, Global Crossing, Xerox, Waste Management, Worldcom, etc. and the list goes on and on. Earnings restatements are occurring frequently. No wonder the investor community does not know who or what it can rely on. And even now no one is talking about the real problem: Earnings management by corporate executives has become the norm. And earnings management does not discriminate between the types, quality, or source of earnings so long as GAAP accounting standards are complied with and fraud is not committed.
We have created a system which economically rewards management for managing earnings and the framework in which this can occur is the flexible GAAP accounting rules which call for many estimates by management. The individual investor does not understand the degree of flexibility, ambiguity, and estimates allowed by GAAP accounting rules. Compliance with GAAP is a minimum threshold of the system which allows earnings management and manipulation so long as management does not break the law.
Secondly, the assumption that companies can and should grow quarterly earnings smoothly and not too quickly, nor with volatility, creates the need to manage an otherwise volatile multivariate environment. The inherent volatility of a company, its products, management, and competitor lifecycles makes this assumption suspect and illuminates the question of how all this smooth growth can occur absent earnings management. The smooth earnings growth assumption creates the need for Wall Street to produce sophisticated earnings management tools to be sold to corporations. These sophisticated financial, tax, and M&A products comply with GAAP while creating earnings which are qualitatively different than organically produced earnings. Yet, the marketplace does not yet discriminate between the types of earnings.
A fundamental problem with this over-emphasis on quarterly earnings is that it may penalize or deter companies from making long-term investments if those investments hurt earnings in the short-term. Growth and innovation investments are necessary and should be encouraged.
Lastly, when you tie management compensation (options) to earnings (including financially engineered earnings), the self-interest of management is to play the earnings management game. Earnings created by financial engineering, or acquisitions, or by the flexibility of GAAP are much easier to produce or buy than producing earnings the old fashioned way. And if it is hard for anyone to determine how management created the earnings and if as a result all types of earnings are valued the same, then you guessed it - management plays the earnings management game and earns substantial financial personal rewards for doing so.
So what should we do about this underlying earnings management game which is a root cause of our investor crisis of confidence. First, let's be realistic. We are not going to fundamentally change GAAP to eliminate the flexibility, manipulability, and judgment quotient. Secondly, we will not eliminate stock options nor can we effectively regulate the creativity or ingenuity of Wall Street's best and brightest. But what we can do is to illuminate the earnings management game through new disclosure rules. We can make earnings management transparent.
The SEC should require corporations quarterly and annually to disclose in detail how they produced their earnings - penny by penny. Let's make earnings management transparent and give the individual investor a clear understanding of how a company is producing its earnings and let the investor make his or her own judgment about the quality of those earnings. Along with this disclosure should be similar disclosures about balance sheet management. This type of disclosure will also relieve the investor from today's primary reliance upon Wall Street analysts for this type of analysis and their inherent conflicts about illuminating the earnings management game. Earnings management can legally occur under GAAP and is necessitated by the market assumption that smooth repeatable growth is optimal and is rewarded through stock option plans. Disclosure of the earnings management game will go along way toward regaining confidence in our financial markets.
| |
|
| |
| | |
Copyright © 2002
