Interesting. The question is whether Arthur Levitt's 1998 speech, in which he seems so aware of fraud potential (though he doesn't ever use the term fraud, he uses words like 'hocus pocus'), wasn't just a well designed excuse for the SEC's inaction:
"I am also calling
upon a broad spectrum of capital market participants, from
corporate management to Wall Street analysts to investors, to
stand together and reenergize the touchstone of our financial
reporting system: transparency and comparability."
Calling how? The fact is there was a merger (not to mention stock market) boom going on, and though somewhere within Levitt's lofty generalities, there was an awareness of the accounting and earnings manipulation that could result, there's no way he believed that Wall Street was about to shut off its fee taps by monitoring itself. Also, Levitt was careful not to name names - hard to believe there was no company he could think of as an example. Hank Paulson, CEO of Goldman Sachs, was equally elusive last summer in his call for stricter corporate governance.
"This is a financial community problem. It can't be solved by a
government mandate: It demands a financial community response."
So, a sentence later, Levitt deftly shifts responsibility away from the SEC and towards Wall Street.
"So what are these illusions? Five of the more popular ones I want to discuss today are "big bath" restructuring charges, creative
acquisition accounting, "cookie jar reserves," "immaterial"
misapplications of accounting principles, and the premature
recognition of revenue."
What's very interesting about Levitt's 1998 speech is that each of these five ways of manipulating earnings were blatant in so many corporate documents his commission reviewed yet did nothing about.
Using WorldCom as an example: the SEC received their filings regularly but saw no cause for alarm bells during their 13 years lifespan as a public company. Putting that aside, in 1998 when WorldCom was trying to acquire MCI, after having acquired like 60 other companies, the SEC received all merger related documents for inspection: annual reports, reasons for the merger, advantages of 'synergy', financial soundness opinions (provided, of course, by Wall Street), etc.. The SEC saw no potential danger in that merger, nor did the FCC or the DOJ. Let's say, for arguments sake that was because they were so understaffed - well, even so, you'd think that the biggest in merger in US history (which at the time it was) warranted some closer examination.
WorldCom played all five accounting games that year:
1) 'Big Bath' restructuring and 2) creative acquisition accounting - that was how WorldCom thrived, it certainly wasn't because of their actual balance sheet, in which their annual revenues rarely outpaced their debts. Pages of murky documents explained how all their post acquisition figures were 'constructed'.
3) 'cookie-jar' reserve accounting - WorldCom was busted this year for 1999, 2000, 2001, 2002 - But, looking at pre-MCI documents, there's more to come there. Though, since the SEC has effectively pardoned WorldCom, it probably won't matter.
4) Premature recognition of revenue - WorldCom capitalized billions of dollars of line costs. And, how would the SEC have caught that in advance? Well, in 1997 WorldCom documented that their line costs would decrease by virtue of the MCI acquisition (synergy and all). No one questioned exactly why, except the CWA who was ignored. Costs went down all right - via well-executed fraud.
5) immaterial application of accounting principles - in all their post 1996 deregulation documents, WorldCom goes on at length about how accounting for new technology is confusing and evolving. So does most of the telecom industry. Accounting principles weren't outpacing technology, and the 'smart' teleco's took advantage.
Fast forward to today - of the $107billion assets in WorldCom's bankruptcy filing - $50 billion were acquisition related (goodwill) and still need to be restated, $9bln were capitalized line costs and 'cookie jar' reserve manipulation. Additionally, $42bln of debt was accumulated cheaply by this cheating company, that managed to keep its balance sheet rosy enough to remain investment grade until last April. Now, all their monthly operating statements show negative profits - even without having to pay off that debt.
In general, with respect to post -1999 earnings readjustments, I'd expect them to reduce profits further as Doug says, particularly since fraud cases (that uncover the need to restate earnings) have been increasing: 58% of 2001 financial fraud cases involved companies that restated earnings, 47% in 2000. (I don't know the 2002 figures, but since fraud cases more than doubled, that percentage has probably increased dramatically). And the restatement amounts are huge - take AOL's $54bln goodwill draw down last year.
Also, most mergers since 1990 happened between 1998 -2000. Each one provided an opportunity to manipulate earnings - via exaggerated goodwill estimates, throwing offsetting operating costs back and forth between the acquiring company and the acquired company and moving reserves back and forth, particularly for earnings announcements (WorldCom altered revenues $5bln between announcements in 2001).
As Doug said, if August 2003 BEA reports include 1999 revisions, they will be lowered. But, once profit numbers get adjusted back through 2000 and 2001, and additional 1998 and 1999 merger related restatements are accounted for, there should be even bigger declines.
Nomi
