MANIPULATING PROFITS:

HOW ITS DONE

Life is not smooth, as an auditor for a large accounting firm restates the truism. Neither
are the year to year performances of corporations, but that doesnt keep executives from trying to
purge the wiggles and spikes from the lines that chart their profits. Managers dont have to cook
the books to manipulate earnings; they often have all the power they need in the leeway built into
accounting rules.
Sometimes flexibility in calculating earnings comes from having several strikingly
different ways to account for a single set of facts. Sometimes managers have leeway because
situations call for highly subjective estimates. While there is a lot less room to manipulate
earnings today than a decade ago, the rules still are mighty spacious.
The bailout of the Continental Illinois National Bank nhas focused new attention on
extraordinary discretion that banks have in establishing loss reserves and accruing intereston
shaky loans. The present system allows banks to report rising earnings even as loans sour. The
Securities and Exchange Commission has made inadequate bank loss reserves a top enforcement
priority.
Figuring out which companies fine-tune profits is difficult, but the practice appears
widespread. Extreme efforts to manage earnings occasionally surface. As fortune disclosed in
1982, Aetna Life and Casualty was boosting results by including anticipated tax benefits in
earnings. The SEC subsequently required Aetna to stop the practice and restate 1982 earnings.
Most well-known instances of managed earnings involve companies trying to make
profits look robust. But the process often is considerably subtler. Most executives prefer to report
earnings that follow smooth, regular, upward path. They hate to report declines, but they also
want to avoid increases that vary wildly from year to year: its better to have two years of 15
percent earnings increases than a 30 percent gain one year and none the next. As a result, some
companies bank earnings by understanding them in particulary good years and use the banked
profits to polish results in bad years.
Fortune asked experts at several Big Eight accounting firms to calculate how much some
of the most common tools for managing earnings could pump up the income of a mythical $10
billion a year conglomerate. (This company, its assumed, runs a specialty steel division, a
consumer products company, and a property and casualty insurance subsidiary). The experts say
that such a company, using a combination of techniques that do not have to be disclosed in
financial statements could easily raise earnings by 10 percent to 15 percent enough booster
power to transform a modest profit decline into a small increase.
To perform such alchemy, executives sometimes pay more heed to the accounting
consequences of major decisions than to the economics. Management might sell of the
headquarters building, for example, to enhance current income by realizing a big gain, even
though it might be more sensible over the long run to keep the building. One auditor describes
that as letting the accounting tail wag the economic dog.
Managers devote such attention to earnings because they think thats what matters most
to shareholders. What the stock market likes, says Abraham Briloff, a professor of accounting at
Baruch College in New York City and one of the most vociferous critics of the accounting
profession, is a nice, smooth, predictable earnings trajectory. Reports that please share holder
serve the managers self interest. why do they manage the bottom line? asks Briloff. because
its their report card. Executives like their bonuses and the other perquisites that are tied to
reported earnings.
A recent study by accounting professor Paul Healy of the Massachusetts Institute of
Technology bolsters Briloffs assertions. Healy documents a connection between bonus schemes
and the accounting choices executives make. Executives whose bonus plans rewarded them up to
a ceiling tended to choose accounting options that minimized reported profits, while executives
on bonus plans without upper limits chose profit-boosting options. In other words, if no
additional bonus is paid once profits hit a certain level, its not in the executives interest for
reported earnings to exceed that amount. Hes better off deferring any profits above the
maximum bonus level until he needs them to sustain his own income.
Most techniques for managing earnings can be grouped in three broad classes changing
accounting methods, fiddling with managers estimates of costs, and shifting the period when
expenses and revenues are included in results.
Choosing a different accounting method gives rise to the greatest and most permanent
impact on earnings. The impact is also the most easily recognizable because changes in
accounting procedures usually are disclosed in a companys reports.
 The oil industry offers one of the best examples of how different accounting options can
drastically alter reported income. In mid-1978 Occidental Petroleum changed the way it
accounted for the costs of finding oil and gas. The change, which was merely a different way to
record the same economics events, slashed reported profits by a third. Under the old method
Oxys earnings per share were $2,92 in 1977. Restated 1977 earnings dropped to $1,93 a share.
Companies cant switch back and forth between accounting methods. But the fact that
they can change to preferable methods stirs up critics who argue that if there is a preferable
way, there ought not to be another way. Says John C. Burton, a former chief accountant for the
SEC and now dean of Columbia Universitys Graduate School of Business.: I feel very strongly
that there should be fewer areas where alternative accounting principles are permitted.
When companies change accounting methods, they often pick one that gives reported
earnings a lift. Most academic researchers doubt that investors are fooled by higher accounting
income that doesnt bring any extra cash flow along with it. But Thornton Oglove, an
independent security analyst, takes a different view. For the past 15 years Oglove has published
a newsletter for instutional investors called the Quality of Earnings Report, in which he dissects
income statements, pointing out soft earnings that investors should be wary of. Ordinarily,
earnings that arise purely from accounting changes go in the flabby category. But when the
changes are great, Oglove thinks the earnings may harden over time.
He cites the case of Union Carbide, which in 1980 lengthened depreciation periods for
machinery and equipment, and started taking the benefits of investment tax credits into
accounting profits in the year they arose instead of spreading the credits over time. Both changes
increased reported earnings. Oglove figures the new procedures contributed 18 percent of Union
Carbides earnings per share in 1980 and 15 percent, 28 percent, and 26 percent the following
three years, but did not affect income tax payments or cash flow. As the company stated in its
1980 annual report.
Oglove has tracked Union Carbides stock price, and the stock prices of six competitors,
since the changed. Ranked by price-earnings multiples, Union Carbide shot from last place to
second. what these efficient-market professors dont realize, says Oglove, is that the higher
earnings are embedded for infinity, but Wall Street forgets about the accounting change after a
couple of years.
 The second broad category of ways to manage earnings is dominated by one particularly
malleable element: judgment. Any company with a substantial inventory, for example, must
estimate how much of it is absolute. The answer gets deducted from current income. Companies
must predict what portion of their accounts receivable will be uncollectible. Future costs of
honoring warranties must be projected. Many companies must also estimate how much it will
cost to settle pending litigation.
But the opportunity for judgment in accounting matters to affect earnings is most potent
in two industries-banking and property and casually insurance. Bank must make a provision to
cover loans that will ultimately go bad. Property and casually companies establish reserves to
cover claims they ultimately will pay out on current insurances policies. These amount are
deducted from profits in the year they are added to reserves, not in the year a claim is paid or a
loan becomes worthless. When a loan is written off, for example, the bank removes it from assets
and deducts an equal amount from the pool of loss reserves; thats a bookkeeping entry that
doesnt affect the income statement.
Ideally, the total amount held in reserve should be just enough to cover all loans on the
books that the bank has reason to believe will eventually go bad. The addition to reserves that is
charged against income each year should be just enough to keep total reserves at the appropriate
level.
A companys management and its auditors sometimes have different opinions about what
level of reserves is approproiate. But they can generally agree on a range of acceptable estimates.
Within this range earnings can be managed. Since total reserves can exceed a banks annual
earnings, a small percentage variation in the loan loss estimate can have a huge effect on the
bottom line, says Roger Cason, a partner at Main Hurdman/KMG, a New York accounting firm.
John Gutfreund, co-chairman of Philbro-Salomon, the securities and commodities firm,
characteristic reserve juggling thus: My guess is that when things are going well executives try
to legitimately squirrel away reserves. Those squirreled-away reserves, which reduce reported
profits, are kept in places like the cupboard and the corporate sugar bowl. When earnings
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