Cookie Jar Reserves

All publicly held companies are required to file periodical reports with the SEC, and all of these reports are available to the public through the SEC's Electronic Data Gatheing, Analysis, ans Retrieval (EGDAR) database. The key periodic reports that should be reviewed by an investor are the company's Forms 10-K, Forms 10-Q, and Forms 14-A.
 
A Form 10-K is an annual report that is required to be filed with the SEC. It contains a description of the company's business, risk factors, properties, legal proceedings, matters submitted to a vote of security holders, highs and lows of the market price of the company's stock, consolidated financial data, management's discussion and analysis, forward looking statements, audited financial statements, and disclosure of holders of five percent or more of the company's stock.
 
A Form 10-Q is a quarterly report that is required to be filed with the SEC. It is similar to a Form 10-K. However, it contains unaudited financial statements and it is less discussion because it references portions of the Form 10-K.
 
By reading these documents with a focused eye, you should be better able to weed out the investments that you should be avoiding. The first thing to look for is "cookie jar" reserves, because the existence of such reserves is an indication of a systemic and well-planned scheme to manipulate reported earnings, and a complete lack of management integrity.
 
Accepted accounting rules permit a company to record charges to earnings (expenses) for the purpose of establishing reserves for probable losses. In violation of this rule, when earnings expectations are exceeded, some companies fraudulently reduce their earnings by recording charges to establish unwarranted "cookie jar" reserves. The reason for the establishment of "cookiejar" reserves was well articulated by Lynn E. Turner, a former SEC Chief Accountant, who described "cookie jar" reserves as "reserves set aside in good times or under the guise of a large one time charge. Later on they are often bled back into earnings when needed." This is accomplished by reversing the charge to earnings that originally served to establish the reserve. Arthur Levitt, former Chairman of the SEC, described the scenario as follows: "Companies stash accruals in cookie jar reserves during the good economic times and reach into them when needed in the bad times."
 
"Cookie jar" reserves have been used by some of the largest company's to manipulate their reported earnings. For example, National Medical Care Inc., a health care subsidiary of W.R. Grace & Co., experienced sveral quarters of significant unanticipated increase in revenues and earnings due to changes in Medicare reimbursement. In order to manage reported earnings, members of National Medical senior management deferred some of the quarterly unanticipated income by increasing or establishing reserves (an expense). These "cookie jar" reserves, which became known within the company as the "excess reserves", reached a level of between $10 and $20 million, when Grace management directed that National Medical maintain the excess reserves and report Health Care Group earnings consistent with Grace's targeted levels. Thus, rather than report its actual earnings, National Medical, at the direction of W.R. Grace senior management, under-reported its earnings.
The "cookie jar" reserves were used for profit manipulation purposes (i.e., to bring the Health Care Group's quarterly reported results of operations in line with W.R. Grace's targets for the Health Care Group). For example, during one quarter. W.R. grace directed National Medical to release $1.5 million of the excess reserves to income because it needed the additional income to reach its earnings per share target.
 
Similarly, Symbol Technologies, Inc. used "cookie jar" reserves to disseminate fraudulent financial statements to the investing public. Robert Korkuc Symbol's Director of Corporate Accounting and Chief Accounting Officer played a central role in the fraud.
 
Each quarter, Korkuc prepared an internal consolidated financial report for senior Symbol management which was referred to as the "Tango sheet." The name was fitting because the document was used to dance away from the company's true financial results in order to fraudulently report predetermined earnings which met the market's expectations.
 
Korkuc's Tango sheets reported the company's raw consolidated financial results and compared those results to the forecast (which reflected market expectations) that management had provided to the board of directors. In addition, the Tango sheets identified bogus adjustments that would enable the raw numbers to manage earnings and, in the process, reach the forecasted quarterly and year end goals.
 
Members of senior management authorized and approved those adjustments and, in some cases, directed Korkuc to make other, more advantageous adjustments. The nature, size and timing of the Tango sheet adjustments depended on the variance between the raw results and the forecast, and the opportunities for manipulation that Korkuc and the others were able to identify.
 
One such improper adjustment was the creation of an unwarranted $10 million reserve for obsolete inventory. This $10 million reserve was a "cookie jar" reserve designed for use when the operations division failed to meet its quarterly forecast, and it exceeded any reasonable estimate of Symbol's exposure for obsolete inventory. Subsequently, Korkuc reversed the excess $10 million into earnings in order to be able to report a profit, instead of a loss and hit the quarterly forecast right on the nose.
Xerox's improper use of "cookie jar" reserves, referred to internally at Xerox as "cushion" reserves, resulted in the recordation of $396 million of bogus earnings for a three year period. Discovery of this led to an SEC enforcement action charging the company with fraud and, ultimately, to what (at that time) the SEC announced as "the largest fine ever obtained by the SEC against a public company in a financial fraud case."
 
It is not easy to detect the existence of a "cookie jar" reserve. Even trained professionals have difficulty determining whether a reserve is excessive and unsupportable at the time it is established. The easiest way for an investor to spot a "cookie jar" reserve is after the fact when they are "bled back into earnings when needed." This involves a careful reading of `the Management Discussion And Analysis section of the company's periodic filings with the SEC, and critical review of the company's financial statements and appended notes, paying particular attention to any reversals, revisions or changes in an estimate.