Typically, the market price of a company’s shares takes a beating when the company announces that it has not met analysts’ expectations. As a result, many companies are under a lot of pressure to meet analysts’ revenue and earnings projections. Internet startups that have gone public fall into this category. To manage (i.e., to inflate or smooth) earnings, managers sometimes record revenue that has not yet been earned by the company and/or delay the recognition of expenses that have been incurred.

Some examples illustrate how companies have attempted to manage their earnings. On March 20, 2000, MicroStrategy announced that it was forced to restate its 1999 earnings; revenue from multi-year contracts had been recorded in the first year instead of being spread over the lives of the related contracts as required by generally accepted accounting principles (GAAP). On April 3, 2000, Legato Systems Inc. announced that it had restated its earnings; $7 million of revenue had been improperly recorded because customers had been promised that they could return the products purchased. America Online (AOL) overstated its net income during 1994, 1995, and 1996. In May 2000, upon completing its review of the company’s accounting practices, the U.S. Securities and Exchange Commission (SEC) levied a fine of $3.5 million against AOL. Just prior to the announcement of the fine levied on AOL, Helane Morrison, head of the SEC’s San Francisco office, re-emphasized that the investigation of misleading financial statements is a top priority for the agency.

Required:

Write a memorandum to your instructor that answers the following questions. Use headings to organize the information presented in the memorandum. Include computations to support your answers, when appropriate.

1. Why would companies be tempted to manage earnings?

2. If the earnings that are reported by a company are misstated, how might this affect business decisions made about that company (such as the acquisition of the company by another business)?

3. What ethical issues, if any, arise when a company manages its earnings?

4. How would investors and financial analysts tend to view the financial statements of a company that has been known to manage its earnings in the past?