526 Making Key Strategic Decisions
that smoothing has occurred. Outside these limits, however, the committee is
obligated to make sure that the reserves and accrual calculations are reasonable.
Management may also recommend terminology that does not affect net
income but does affect income from operating activities. Examples are earn-
ings before marketing costs, cash earnings per share, earnings before losses on
new products,and pro forma earnings.None of these terms is permitted in
GAAP; they appear in press releases and speeches.
Reporting Unfavorable Developments
The Securities and Exchange Commission requires that its Form 8-K report be
filed promptly whenever an unusual material event that affects the financial
statements becomes known. The principal concern is with the bottom line, the
amount of reported earnings. Management, understandably, may be inclined
not to report events that might (or might not) have an unfavorable impact on
earnings. These include the probable bankruptcy of an important customer, an
important inventory shortage, a reported cash shortage that might (or might
not) turn out to be a bookkeeping error, a possibly defective product that could
lead to huge returns or to product liability suits, possible safety or environ-
mental violations, an allegation of misdeeds by a corporate officer, the depar-
ture of a senior manager, or a lawsuit that might (or might not) be well founded.
It is human nature to hope that borderline situations will not actually have a
material impact on the company’s earnings.
Furthermore, publicizing some of these situations may harm the company
unnecessarily. Disclosing a significant legal filing against the company is nec-
essary, but disclosing the amount that the company thinks it might lose in such
litigation, in a report that the plaintiff can read, would be foolish.
In any event, the audit committee should be kept fully informed about all
events that might eventually require filing a Form 8-K. One might think that
the CEO would welcome the opportunity to inform the board of these events
because this shifts the responsibility for disclosure to the board. But managers,
like most human beings, prefer not to talk about bad news if there are reason-
able grounds for waiting a while.
Occasionally, a manager may attempt to “cook the books,” that is, to pro-
duce favorable accounting results by making entries that are not in accordance
with GAAP. The audit committee must rely on the auditors (or occasionally on
a whistle-blower) to detect these situations.
The Big Bath
A new CEO may “take a big bath”; that is, the accounting department may be re-
quired to write off or write down assets in the year he or she takes over, thereby
reducing the amount of costs that remain to be charged off in future periods.
This increases the reported earnings in the periods for which the new manage-
ment is responsible. Since the situation that led to the replacement of the former