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HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFETT PART 6

Income smoothing, also known as earnings management, exploits the flexibility of generally acceptedaccounting principles to classify transactions or allocate them by time periodto achieve favorable financial reporting. | C HARTER 10 MAKING UP NUMBERS Accounting shenanigans have plagued bookkeeping since it was invented by Luca Pacioli in 1494 and there is no reason to expect that the next 500 years will stray from the historical pattern. No amount of rule making from accounting auditing or elsewhere can ensure the integrity of financial reporting. Rules cannot eliminate managerial discretion and there will always be the possibility of imaginative unorthodox creative and even fraudulent financial reporting. Investors and managers should expect it and instead of wishing it away take pains not to be its victims or accomplices. Just think of the notorious accounting frauds of relatively recent memory from Leasco National Student Marketing and Penn Central in the late 1960s and early 1970s to Cendant MicroStrategy and Sunbeam in the late 1990s and early 2000s. These frauds sting investors and managers who engage in them should know they will be caught punished and made to pay though investors will not profit in the process . The nonfraudulent cases are often the trickier to deal with. They consist of a variety of smoothing techniques designed to massage the whole range of financial numbers from the ratios discussed previously to income itself. Income smoothing also known as earnings management exploits the flexibility of generally accepted accounting principles to classify transactions or allocate them by time period to achieve favorable financial reporting. PERENNIALS SEC Chairman Arthur Levitt delivered a series of major speeches in the late 1990s and early 2000s identifying several long-standing ac- 153 Copyright 2001 The McGraw-Hill Companies Inc. Click Here for Terms of Use 154 Show Me the Money counting issues that are hallmarks of earnings management. These techniques are as old as accounting itself and have been used to full advantage sometimes appropriately often not by managers over the centuries. Yet the contemporary problems are heightened according to Levitt by a managerial