SEC Declares War On Corporate "Earnings Management"

hat can turn Sunbeam's 1997 $1.45 per share earnings into an 8 cents per share loss? "Technical accounting issues", according to Al Dunlap, former chairman of Sunbeam. Of course, the price of Sunbeam's stock has fallen from about $53 per share to about $5 per share.

Sunbeam joins a host of other rather well known companies that are catching the eye of the SEC. In fact, speaking of earnings management, otherwise known as accounting fraud, SEC Director of Enforcement Richard Walker said in April, "What alarms me is that we're seeing more of it and from companies we wouldn't expect". One reason may be that stock options, according to a 1996 study, represent at least 45% of executive compensation. Another reason is that accountants, once considered independent watchdogs performing independent audits, now earn more revenue rendering consulting/business services than they do performing audits.

Walker may be speaking about companies such as McDonald's, and America Online. The SEC told McDonald's that it had to treat its $190 million expense for kitchen refurbishment as an ordinary expense and not as a one time extraordinary charge. The impact is significant because expensing the $190 million will reduce McDonald's bottom line by about $25 million per quarter.

Likewise, the SEC forced America Online to write-off only 25% of its acquisition costs. America Online had sought to write-off 66%. The result is that more of the acquisition costs will affect the bottom line.

Other companies have succeeded in their accounting gimmicks. For example, until now Disney was been able to show better earnings because of a special reserve that it created in connection with its merger with Capital Cities/ABC. $2.5 billion was set aside so that it could absorb costs that otherwise would have negatively affected Disney's earnings.

Another example is Kellogg. Over the last 11 quarters, this company has taken 9 "non-recurring" charges to "streamline" operations. In a recent quarter, these "unusual" items amounted to 31 cents per share.

One of the most common tricks today is in the area of immediately writing off "in process research and development" of companies that are being acquired. Here the acquiring company claims that the research and development of the acquired company is worthless and will not lead to new products.. As an example 3Com immediately wrote off 88% of the entire acquisition cost of four companies, boosting its earnings by 20%.

These tricks deceive the investing public, and contribute to reporting uncertainty. The SEC has announced that its chief priority will be to crack down on accounting abuses. It filed 100 such cases last year and plans to file more this year.

However, while increased enforcement actions will help, it will be difficult to overcome the economic incentives of the corporate executives and the purportedly independent auditors who want to earn consulting revenues.

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