The high number of financial restatements has alarmed investors and analysts recently. But one accounting professor welcomes the announcements. In fact, he suggests that companies revise portions of their financial statements every year.
Baruch Lev, a professor at the Stern School of Business at New York University, wants companies to continually update former estimates when the real numbers become available. The novel approach is part of his proposal to take some of the commonplace fudging out of corporate accounting.
“Earnings manipulation within GAAP is hard to identify,” says Lev, “and practically all of it is done with missed estimates.” He says that estimates of such items as bad debt reserves, restructuring charges, pension plan rates-of-return, and contingencies (like warranties) are usually wrong, yet the real results are never publicly disclosed after the year’s annual report is filed. “There’s no way to mandate good estimates,” argues Lev.
He suggests that CFOs review real results of the previous year’s estimates, as well as those from three years ago (to account for longer-term estimates like those for capital projects or restructuring plans). In addition, if the actual numbers vary materially — 10 percent, for example — the company would have to restate its earnings, suggests Lev. Although this plan wouldn’t prevent fraudulent estimates, he hopes the increased public scrutiny would encourage managers to do a better job of estimating up front. “Currently, it’s safe to repeatedly lower bad debt reserves to increase earnings,” says Lev. “But it’s different if every year you have to tell people why you’ve adjusted earnings.”
Some critics contend, though, that separating out all the estimates is difficult. “Every line item has some sort of estimate in it,” says Jenni Sullivan, a Financial Accounting Standards Board project manager. “If you take out the estimates, you don’t have much left.” However, FASB has recognized that mixing pure estimates with more factual figures on an income statement could be misleading for investors. Its Financial Performance Reporting project, still in its early stages, is examining how fully estimated numbers could be listed separately from those harder numbers in a financial statement, as well as other changes.
Still, Lev says that’s a far cry from requiring companies to report their actuals on an ongoing basis. He is seeking companies that are willing to do a confidential test case to see how useful it is. If it turns out to be valuable for companies, he’ll push to get official consideration of the idea.