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SEC Seeks Crackdown on Inflated Earnings

Regulation: The agency's chief condemns an 'erosion in the quality' of financial reporting by companies.

September 29, 1998|JUBE SHIVER Jr. | TIMES STAFF WRITER

WASHINGTON — With stocks rocketing upward again, the head of the Securities and Exchange Commission on Monday called for a government and industry crackdown on businesses suspected of contributing to the market's euphoria by exaggerating their earnings.

"I fear that we are witnessing an erosion in the quality of earnings and, therefore, the quality of financial reporting," SEC Chairman Arthur Levitt said in prepared remarks released before his speech at New York University. "Managing may be giving way to manipulation; integrity may be losing out to illusion."

Levitt said he will push for SEC rule changes to more harshly penalize companies that report inflated earnings. He urged public companies and their accountants to redouble their oversight of the financial reporting process.

Levitt's comments came as his agency is wrapping up a sweeping examination of corporate earnings reporting that has focused, in part, on the penchant of some high-tech companies to immediately write off charges for so-called in-process research and development at newly acquired businesses.

The speech also came on a day when America Online, after three months of talks with federal securities regulators, announced that its fourth-quarter earnings were reduced by a one-time charge of $88.2 million, mostly because of its purchase of two Internet-related start-ups earlier this year.

The SEC has not accused any company of wrongdoing as part of its probe. And Michael Kelly, chief financial officer of AOL, said he was "satisfied" with the outcome of AOL's negotiations with the SEC. He added that the delayed reporting of earnings, though not common, is not unusual among publicly traded companies grappling with emerging gray areas of accounting practices.

The SEC's examination of such practices, however, is sending shudders though the high-tech industry, which has led a red-hot bull market that has put many companies under intense pressure to produce exponential growth.

The Internet, said Kate Delhagen, an analyst at Forrester Research in Cambridge, Mass., represents a "very different business model" in which earnings are just an afterthought for firms seeking to quickly build a business to sell to a bigger company.

Indeed, a buoyant stock market has ignited an explosion of corporate mergers and acquisitions that has focused SEC concern on the lucrative write-offs that became popular in high-tech after IBM used them following its acquisition of Lotus Development in 1995. By quickly taking the R&D charges upfront, companies avoid potential hits to future earnings. But critics say these fast write-offs--which can amount to as much as 50% of the purchase price--often boost earnings artificially.

The R&D write-off, Levitt said, is just one of several bookkeeping practices his agency has become concerned about. He said the SEC is also targeting other "accounting hocus-pocus," including unwarranted restructuring charges, premature recognition of revenue and reliance on what he termed "cookie jar" reserves, or companies using unrealistic assumptions to estimate future financial liabilities.

Levitt vowed to "formally target reviews of public companies that announce restructuring liability reserves, major write-offs or other practices that appear to manage earnings."

One such company that has drawn SEC scrutiny is CyberGuard Corp. of Fort Lauderdale, Fla. The company appointed a new chief financial officer and hired the accounting firm Price Waterhouse Coopers to go over its books earlier this month after it received an SEC inquiry about its decision to restate third-quarter financial results and suspend its chief financial officer.

Officials of CyberGuard, an Internet software development company, could not be reached for comment.

But acting Chairman Shelly James said in a statement that CyberGuard took the management initiatives "to address existing management vacancies . . . [and] auditing practices and" generate additional capital.

* AOL ACCORD

AOL reaches agreement with the SEC on stating acquisition charges. D4

* 2 THUMBS DOWN

Michael Hiltzik and James Peltz take a look at AOL. D7

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