Introduction Lucent Technologies Lucent Technology is North America’s leading maker of telecom equipment and software, including switching and transmission equipment and business communications systems. Lucent Technologies, started trading publicly in 1996 with an initial public offering that was, at the time, the largest in domestic history (Hayes).
In December 1999, Lucent’s stock reached a high of $77.78 and was the nation’s fourth most widely held stock (Romero and Atlas). But by July 2001, Lucent’s stock was trading at $6.43, the SEC was investigating its accounting practices, and several former, high-level managers had been sanctioned by the SEC or were under criminal indictment for a wrong-doing while at Lucent (Romero and Atlas).
Prices start at $12
Prices start at $11
Prices start at $12
The plunge in stock value (exhibit 1) was primarily the result of a November 21, 2000, announcement in which Lucent said it had to restate its financial statements as a result of an internal investigation revealing accounting irregularities. Lucent’s restatement reduced revenues by $679 million (McGough, Bloomberg).
As early as June 2000, media attention had begun to be directed towards Lucent’s aggressive accounting policies. A Wall Street Journal article in June 2000 suggested that Lucent Technologies might be engaging in creative accounting practices, noting that Lucent’s receivables were rising at 49% while revenues were rising at only 20% (Wall Street Journal).
Accounting Policy Reporting objectives Lucent’s chief executive Richard McGinn had turned Lucent into a Wall Street star by increasing sales at a double-digit pace and was determined to maintain Lucent’s growth. Many observers believed that Lucent’s sales projections were imposed on sales executives by the chief executive who was intent on maintaining a 20 per cent growth rate (Berman and Blumenstein).
Don Peterson was appointed the executive vice president and CFO; he reported to CEO Richard McGinn and was accountable for the Corporate Finance Organization. Peterson explained in a 1999 article that revenue targets were attained because stock options were used as motivational tools (William, Hart).
Motivation to manage earnings was based on executive compensation for performing well on the stock market. One of Lucent’s revenue growth tactics included offering deep product discounts to induce customers to purchase products now instead of delaying these purchases.
The short term result of increased current period sales came at the expense of not realizing those sales in successive years. Other tactics designed to increase current period revenues and meet stated sales targets included the extension of generous credit terms to customers. Sometimes payment of principal was deferred for several years with Lucent even financing equipment engineering and installation.
Accounting Manipulation Lucent had used many aggressive accounting choices to boost its growth. One analyst estimated that Lucent had added about 27 cents a share to its earnings through “deft accounting moves,” including creative acquisition accounting (Mehta and MacDonald).
In October 1998, Business Week reported that Lucent avoided some goodwill amortization by writing off $2.3 billion of in-process research and development as companies were acquired. Lucent’s earnings also benefited from a $2.8 billion reserve for “big bath” restructuring charges that were recorded as part of Lucent’s spin-off from AT-T (McGough).
In addition to acquisition reserves and restructuring charges, they used other reserves to boost income. For example, although revenue and accounts receivable increased in fiscal 1999, Lucent lowered its bad-debt reserves (Byrnes, Melcher, Sparks). Lucent’s reserves and restructuring charges were properly disclosed in its external financial statements, it is possible that management’s intent with respect to accounting for reserves was to properly reflect the underlying financial condition of the company. Two-thirds of the $679 million reductions in revenue, or $452 million, was attributed to channel stuffing sales, in which transfers of products to distributors are recorded as sales although the products are not yet sold to end-users (Murphy).
The restatement also reduced revenues by $199 million because customers were promised discounts, credits and rights of return (Berman, Blumenstein). Lucent also cancelled out $28 million in revenue recognized on a partial shipment of equipment (Berman, Schroeder, Young).
By prematurely recording sales of maintenance agreements, by prematurely recording sales made to distributors and by offering discounts, onetime credits and other incentives for customers to order products in advance of their needs, Lucent’s practices borrowed heavily from future sales.
Management The earnings management practices were initiated at the top but eventually involved high-level managers and their subordinates (Magrath, Weld). Richard McGinn, the company’s CEO departed with an $11.3 million severance package before the company tanked.
Auditor Lucent’s books for the fiscal year 2000 were audited by PricewaterhouseCoopers.
PricewaterhouseCooper’s (PwC), failed to discover Lucent’s questionable earnings management practices and signed off on $679 million in inflated earnings. PwC failed to detect the fraud even though in 1999, Lucent lost $276 million on a cash flow basis, but earnings had surged 360% to $4.8 billion ( Birger). The SEC’s announced policy of enforcing action against companies engaging in abusive earnings management suggest that accountants and auditors should be more vigilant in their attempts to identify earnings management activities in its early stages (Magrath, Weld).
Audit committee “The primary role of the audit committee is to ensure that financial statements and external filings fairly represent the financial results of the company and to enable independent verification of the efficiency of systems and controls” ( Lavelle). Paul Allaire headed the Audit and Finance Committee at Lucent. The Audit Committee was composed of six directors. All six directors were on the Corporate Governance and Compensation Committee with Franklin Thomas, as chairman. The board met 11 times in 2000, and the committees met 11 times.
This meant that Allaire and Thomas had 22 Lucent board and committee meetings each while they were each outside directors of five other boards. The board was diversified, talented, and hard-working, but its six directors were just too busy and were not able to manage the number of problems they had to handle (Lavelle).
Conclusion The earnings management activities at Lucent took place over an extended period of time, escalating from questionable and improper revenue recognition practices to other forms of earnings management. It occurred because management was subjected to considerable internal and external pressure to meet sales goals and analyst’s predictions on a quarter by quarter basis. Over the past three years many high profile U.S. companies have been investigated for financial irregularities, and 464 firms have had to restate their earnings.
Experts say those charged with safeguarding the numbers for investors, outside auditors, analysts and boards of directors are often not doing their jobs Lucent’s problems could have been prevented if the auditor (PwC) and the audit committee had properly done their respective jobs. In light of this and other high profile cases audit reform is necessary to ensure public confidence in the financial markets.
The SEC has identified abusive earnings management as a primary target of its enforcement actions. The accounting profession and SEC have taken steps to improve the quality of financial reporting, for example by making corporate executives more accountable. By August 2002 the CEOs and chief financial officers of more than 700 publicly traded companies must have personally attested to the accuracy of their companies’ accounting, as ordered by the Securities and Exchange Commission in June 2002.
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