Only auditors can stop AEM

Should British investors be worried about aggressive earnings management (AEM)? If you believe leaders of the accountancy profession – bodies such as the Auditing Practices Board (APB) – then the answer is yes. But the evidence to date in the UK is far from conclusive.

From a European perspective, AEM seems a US failing. Recently, Xerox became the latest in a series of US mega corporations to have their names blackened by being hauled up before the SEC. In this case the SEC’s complaint alleges that from 1997 to 2000 (and maybe longer), Xerox used a variety of what it called “accounting actions” and “accounting opportunities” to meet or exceed Wall Street expectations and disguise its true operating performance from investors. The SEC says these actions, most of which violated generally accepted accounting principles (GAAP), accelerated the company’s recognition of equipment revenue by $3bn and increased pre-tax earnings by approximately $1.5bn.

Xerox and others demonstrate vividly what all FDs know – that financial reporting is a game played by directors and auditors, with investors spectating.

The spectators egg on the directors to produce the best performance they can and grow their companies quickly. So why should we be surprised when directors are forthright when they present their performance?

This means trying to stop AEM through financial reporting alone is a waste of time. And that is precisely why the APB – which has the narrow task of setting auditing standards – last summer made the defensive move of launching a consultation paper. The APB didn’t want the auditing profession to be landed with the problem so the idea of the consultation was to spread the responsibility as widely as possible.

The responses to the APB have now been published, although apparently not with the same thirst for attention as the original consultation because they were rolled in with the APB annual report. They suggest a whole host of bodies that should play a part in curbing AEM. These include the Department of Trade & Industry (which should make the Operating and Financial Review mandatory); the Financial Services Authority (which should remind directors of their responsibilities under the Combined Code on corporate governance); and the Accounting Standards Board (which needs to sort out a standard on revenue recognition). Meanwhile, the APB has a list of projects including revisiting its guidance SAS420 on ‘Audit of accounting estimates’.

This will all take time. More immediately if you want an indication of how seriously the accountancy profession takes AEM in the UK then look out over the next few months to see what the ASB’s sister body, the Urgent Issues Task Force (UITF) produces. It is looking hard at various AEM-related issues, including some accounting practices in the telecoms sector.

But, like all other regulators, the UITF cannot block off AEM on its own. As long as there are incentives for putting the best gloss on results, that is exactly what directors will do. That is their objective in the financial reporting game. Research in the US – there doesn’t appear to be any in the UK – has shown AEM is most prevalent among companies that are looking to raise money. As the academics from the University of Washington noted in August 2000: “Our results indicate the pre-IPO abnormal accruals are positively related to initial firm value. Entrepreneurs may seek to increase their offering proceeds, temporarily deceiving investors by opportunistically manipulating earnings through accruals management before going public.”

At other times, directors may want their results to look a little off-colour. It is not unknown for companies to aggressively manage earnings downwards – especially this year as they slash costs in response to the business slowdown. Non-execs and auditors should look out for management trying it on with unjustified provisions in order to make the future look brighter.

However, if you have introduced AEM accounting policies into your company’s reporting over the past few years, then maybe this is the time to ease off a little. To help you in your decision, the APB is urging auditors to demonstrate greater professional scepticism. After the events of the last few months and the extraordinary implosions of Enron and Andersen, you can bet that any sign of AEM will be well and truly jumped on.