Cookie Jar Reserves

1. Cookie jar reserves are an accounting practice in which a company uses generous reserves from good years against losses that might be incurred in bad years. An example of a cookie jar reserve is a liability created when a company records an expense that is not directly linked to a specific accounting period - the expense may fall in one period or another. Companies may record such discretionary expense when profits are high because they can afford to take the hit to income. When profits are low, the company reduces the liability (the reserve) rather than recording an expense in the lean year. The usual result of cookie jar accounting is a "smoothing" of net income over the course of several years. The United States Securities and Exchange Commission (SEC) does not permit cookie jar accounting by public companies because it can mislead investors regarding a company's financial performance. Enron's stock fell from its high of $90.75 to $0.68 after the SEC began investigating Enron's accounting practices. After the collapse in the market value of its stock, Enron was forced to seek bankruptcy protection, resulting in the largest bankruptcy in U.S. history. A recent Financial Executives International (FEI) report indicates that the stock market lost more than $34 billion during the three-day period during which the three most egregious cases of abusive earnings management in 2000 (Lucent Technologies, Cendant, and MicroStrategy) surfaced. While SEC documents indicate that the accounting irregularities at Lucent, Cendant, and MicroStrategy were primarily "abusive" earnings management schemes or outright fraud, all three companies began their abusive and fraudulent practices by engaging in earnings management schemes designed primarily to "smooth" earnings to meet internally or externally imposed earnings forecasts and analysts' expectations. Earnings management practices can be designed either to assist managers in fulfilling their obligations