The Board of Directors 525numbers would have been more fair.^4 The audit committee’s task is to decide
whether the directors should concur with the outside auditor ’s opinion and, oc-
casionally, to resolve differences when auditors are unwilling to give a clean
opinion on the numbers that management proposes.
Management has some latitude in deciding the amounts to be reported,
especially the amount of earnings. Since managers are human beings, it is
reasonable to expect them to report performance in a favorable light. Examples
of this tendency, discussed next, are: (1) accelerating revenue, (2) smoothing
earnings, (3) reporting unfavorable developments, and (4) the “big bath.”
Much of the discussion of these topics is complicated by differences in the
meaning of “materiality.” The SEC has tried to lessen the reliance on material-
ity by publishing detailed descriptions of what the term means.
Accelerating Revenue
A company may go to great lengths to count revenues actually earned in future
periods as revenues in the current period, even though this decreases the next
period’s revenues. The following example illustrates:
The SEC sued two executives of Sirena Apparel Group for misleading revenue
estimates for the quarter ended March 31, 1999. They instructed employees
daily to set back the computer clock that entered the dates on invoices until a
satisfactory revenue amount was recorded. Invoices dated from April 12, 1999,
were set back.^5Not all attempts to accelerate revenue recognition are improper. There
are documented stories of managers who personally worked around the clock
at year-end, packing goods in containers for shipment. This enabled them to
count the value of the packed goods as revenue in the year that was about to
end. Counting goods that actually were shipped as revenue is legitimate.
Smoothing Earnings
There is a widespread belief (not necessarily supported by the facts) that ideal
performance is a steady growth in earnings, certainly from year to year, and
desirably from quarter to quarter. Within the latitude permitted by GAAP,
therefore, management may wish to smooth reported earnings—that is, to
move reported income from what other wise would be a highly profitable pe-
riod to a less profitable period. The principal techniques for doing this are to
vary the adjustments for inventory amounts and bad debts, and estimated re-
turns, allowances, and warranties.
The audit committee, therefore, pays considerable attention to the way
these adjustments and allowances are calculated and to the resulting accounts
receivable, inventory, and accrued liability amounts. Changes in the reserve
percentages from one year to the next are suspect. The audit committee toler-
ates a certain amount of smoothing, within limits. Indeed, it may not be aware