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Abusive Earnings Management and Early Warning Signs
By Lorraine Magrath and Leonard G. Weld
In Brief
Fraudulent Accounting Leads to Staggering Losses
Over the last three years, SEC investigations have uncovered earnings management practices
that have pushed the boundaries of GAAP, even to the point of out-right fraud. In some
instances, independent auditors were blamed for not catching or correcting accounting
irregularities. In others, it is clear that management intended to deceive outside auditors and
audit committees. Regardless of fault, when earnings management and fraudulent accounting
schemes are uncovered, the monetary losses can be staggering.
Enron’s stock fell from its high of $90.75 to $0.68 after the SEC began investigating Enron’s
accounting practices. After the collapse in the market value of its stock, Enron was forced to
seek bankruptcy protection, resulting in the largest bankruptcy in U.S. history. A recent Financial
Executives International (FEI) report indicates that the stock market lost more than $34 billion
during the three-day period during which the three most egregious cases of abusive earnings
management in 2000 (Lucent Technologies, Cendant, and MicroStrategy) surfaced.
While SEC documents indicate that the accounting irregularities at Lucent, Cendant, and
MicroStrategy were primarily “abusive” earnings management schemes or outright fraud, all
three companies began their abusive and fraudulent practices by engaging in earnings
management schemes designed primarily to “smooth” earnings to meet internally or externally
imposed earnings forecasts and analysts’ expectations. Earnings management practices can be
designed either to assist managers in fulfilling their obligations to stakeholders or to deceive
investors. The SEC’s concept of “abusive” earnings management suggests analytical
approaches to uncovering such practices. In addition, the accounting profession has taken
steps to educate accountants about earnings management practices and their effects and
consequences. (See the Sidebar for further readings on abusive earnings management.)
Good Business Practice or “Abusive” Earnings Management?
In his 1998 “Numbers Game” speech, former SEC Chairman Arthur Levitt expressed his
concern that too many corporate managers, auditors, and analysts let the desire to meet
earnings expectations override good business practices. He called for a fundamental cultural
change on the part of corporate management and the entire financial comm...
Abusive Earnings Management and Early Warning Signs
By Lorraine Magrath and Leonard G. Weld
In Brief
Fraudulent Accounting Leads to Staggering Losses
Over the last three years, SEC investigations have uncovered earnings management practices
that have pushed the boundaries of GAAP, even to the point of out-right fraud. In some
instances, independent auditors were blamed for not catching or correcting accounting
irregularities. In others, it is clear that management intended to deceive outside auditors and
audit committees. Regardless of fault, when earnings management and fraudulent accounting
schemes are uncovered, the monetary losses can be staggering.
Enron’s stock fell from its high of $90.75 to $0.68 after the SEC began investigating Enron’s
accounting practices. After the collapse in the market value of its stock, Enron was forced to
seek bankruptcy protection, resulting in the largest bankruptcy in U.S. history. A recent Financial
Executives International (FEI) report indicates that the stock market lost more than $34 billion
during the three-day period during which the three most egregious cases of abusive earnings
management in 2000 (Lucent Technologies, Cendant, and MicroStrategy) surfaced.
While SEC documents indicate that the accounting irregularities at Lucent, Cendant, and
MicroStrategy were primarily “abusive” earnings management schemes or outright fraud, all
three companies began their abusive and fraudulent practices by engaging in earnings
management schemes designed primarily to “smooth” earnings to meet internally or externally
imposed earnings forecasts and analysts’ expectations. Earnings management practices can be
designed either to assist managers in fulfilling their obligations to stakeholders or to deceive
investors. The SEC’s concept of “abusive” earnings management suggests analytical
approaches to uncovering such practices. In addition, the accounting profession has taken
steps to educate accountants about earnings management practices and their effects and
consequences. (See the Sidebar for further readings on abusive earnings management.)
Good Business Practice or “Abusive” Earnings Management?
In his 1998 “Numbers Game” speech, former SEC Chairman Arthur Levitt expressed his
concern that too many corporate managers, auditors, and analysts let the desire to meet
earnings expectations override good business practices. He called for a fundamental cultural
change on the part of corporate management and the entire financial community.
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