Joseph B. Hillstead and Dr. Ted Christensen, School of Accountancy and Information Systems
In the wake of catastrophic accounting scandals involving companies such as Enron, WorldCom, and Andersen, investors and the Securities and Exchange Commission have become increasingly concerned about the quality of reported earnings. Wall Street earnings expectations may be overriding common-sense business practices. In a zeal to satisfy consensus earnings estimates and project a smooth earnings path, wishful thinking may be winning the day over faithful financial representation. In this current era, gray-area accounting is sometimes misused; managers are cutting corners; and earnings reports reflect the desires of management rather than the underlying financial performance of the company.
Accountants are wise enough to know they cannot anticipate every business structure or transaction, so they develop principles that allow for flexibility to adapt to changing circumstances. Flexibility in accounting allows it to keep pace with business innovations. However, abuses, such as earnings management, occur when people exploit this flexibility. One of the more popular abuses is “cookie jar reserves.”1 A cookie-jar reserve is a way of building up a reserve of income (or expenses), such as unrealized gains (or losses), to strategically manage earnings in future periods. Companies can use accounting rules related to marketable securities as a “cookie jar reserve” to manage their earnings.
Under FAS 115, investment securities are classified into one of three categories: held-tomaturity, available- for-sale, or trading. Available- for-sale (AFS) securities are carried at market value with unrealized gains and losses included in accumulated other comprehensive income in stockholders’ equity. By classifying their investments in marketable securities as available- forsale, companies are not required to report their unrealized gains and losses from these securities in their earnings. Only by selling the securities classified as available- for-sale can the company report the associated gain or loss on the income statement. Due to the bull market of the midand late-1990s, many companies’ marketable securities appreciated in value. Basically, these companies used the appreciation of their available- for-sale securities to stash future earnings in cookie jars during the good times so that they could reach into these reserves when needed in future bad times.
My objective was to discover if companies strategically used their available- for-sale securities to manage their earnings. Prior to the research, I hypothesized that a large percentage of firms used their available- for-sale securities to manipulate earnings for the following reasons: 1. to meet external expectations, 2. to avoid an earnings decrease, and 3. to avoid reporting a loss. Using the Wharton Research Database2, a sample of 320 firms from the fiscal years of 1996- 2000 and from all major industries was collected. In order to focus on firms that have significant portfolios of short-term investment securities with unrealized gains large enough to materially affect earnings, I required that firms included in the sample have at least 5% of their total assets in the form of investment securities. Then, in order to focus on firms which had made large sales of investment securities, I only included firms which had sold at least 50% of their short-term investment portfolio during the year. Finally, I only included firms which increased their total short-term investment portfolio by less than 25%. Additionally, no financial institutions were included in the sample.
After collecting this initial sample, I analyzed the firms’ annual SEC form 10-K filings (available on the SEC website)3 to determine the realized gains or losses from the sale of available- for-sale securities. Along with realized gains and losses, the following additional data was collected for each company: gains from the sale of trading and held-to- maturity securities, cash proceeds from the sale of available-for-sale securities, cash purchases of available- for-sale securities, and unrealized gains and losses on available-for-sale securities. This process was by far the most difficult and time consuming part of the research. The reason for the difficulty was the differences in the way each firm reported its marketable securities. Consequently, of the 320 sample companies that met the original screens, I was only able to analyze 79 firms’ SEC form 10-K filings. Of the 79 firms analyzed, only 56 companies had earnings forecast data on the I/B/E/S database.4 In order to test whether or not the companies used available- for-sale securities to meet external expectations, I converted the companies’ net gains/losses to a per share basis. Then, I removed the effects of the sale of AFS securities from the company’s actual earnings per share (EPS). I then used this “adjusted” earnings figure to determine whether the company strategically sold AFS securities to achieve one of the three earnings benchmarks discussed above. This analysis yielded the following results:
Although less than expected, between 10.7% and 12.5% of the companies sampled used their available-for-sale securities to meet or beat analysts’ expectations.
Avoiding an earnings decrease and avoiding a loss are other hypothesized reasons why managers manipulate earnings using available-for-sale securities. Surprisingly, only one firm of the 79 firms analyzed used its available- for-sale securities to convert an earnings decrease into an earnings increase. Also, not one of the 79 firms sampled used it available-for-sale securities to convert a net loss into a net profit. These findings are somewhat unexpected, as I had estimated a larger portion of the sample used their available- for-sale securities to manage earnings.
Although these initial findings are less than anticipated, they are still encouraging. Companies will continually try to meet or beat Wall Street earnings projections to grow market capitalization and increase the value of their stock options. Their ability to do this depends on achieving the earnings expectations of analysts. In the future I hope to continue researching the other 241 firms and by doing so, I hope to gain a better understanding of the quality of reported earnings.5
References
and Business, New York, NY, September 28, 1998