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In This Chapter

 Surprise, there is no “truth” in accounting information.

 GAAP to the rescue of truth, sort of.

 Why do managers manipulate financial information and how do they do it?

 The harsh consequences of manipulation for investors and managers.

 Just don’t manipulate; there are better alternatives.

On September 12, 2007, the SEC charged former top executives of Nortel Networks, a Canadian telecommunications equipment maker, with accounting and reporting fraud aimed at beautifying reported earnings.¹ Specifically, the SEC alleged that in 2002 Nortel executives created accounting reserves, in violation of GAAP, by artificially lowering the company’s earnings, which happened to be higher than internal and analysts’ estimates. These reserves were quickly put to good use: nearly $350 million of them were reversed and credited to income to inflate reported earnings—magically turning losses in the first two quarters of 2003 into profits—to impress investors and generate executive bonuses.

You will see in this chapter that Nortel is far from an aberration. In fact, financial reporting manipulation, ranging all the way from small tweaks of accounting estimates to beat analysts’ consensus forecasts by a penny to egregious multibillion-dollar frauds, is quite common. Manipulation is perhaps even increasing, as indicated by the frequency of corporate restatements of previously reported information, mostly, corrections of previous misreporting: from 614 restatements in 2001 to a whopping 1,795 in 2006, decreasing gradually thereafter to 1,217, to 923, and to 674 in 2007, 2008, and 2009, respectively.² The total number of restatements from 2006 to 2008, a staggering 3,935, indicates that over half of public companies corrected previously reported earnings during those years. That’s seriously disturbing. The number of annual SEC Accounting and Auditing Enforcement Releases is rising too—from 134 in 1997 to 180 in 2009. You will see later that the incentives to manipulate reported information are strong and varied, making “earnings management”—an elegant euphemism for manipulation—an issue that most managers face. Yet, the costs of manipulation to investors, employees, society at large and, not the least, to managers are onerous. I focus in this chapter on the most critical circumstance leading to manipulation—a business slowdown causing managers to miss the consensus estimate or report decreasing earnings—discuss the means and consequences of manipulation, and conclude with operating instructions.