This is the fifth in a series of eight articles examining different forms of accounting manipulation. Previous articles included pieces on channel stuffing and improper revenue recognition.
The practice violates the accounting principle of matching revenues and expenses at the time when they occur. While reserves are a legitimate way to account for future uncertainties, using them excessively to manage earnings misleads stakeholders and can erode investor trust. Many companies use reserves to smooth earnings but charges for this action are rare since it is difficult to conclusively demonstrate that a particular level of reserves was inappropriate.
The best way to learn about improper accounting practices is to see real-life examples. With this end in mind, we provide four famous examples of the improper use of cookie jar by General Electric, Microsoft, Nortel Networks and Olympus.
Where appropriate, we complement these examples with readings from the Transparently Risk Engine, an AI-powered system that detects accounting manipulation. The TRE scores the quality of a company’s accounting on a 0-100% scale, in the process assigning them a rating of A+ to F. In some of the cases below, the TRE certainly picked up risky signals well before the problems bubbled to the surface.
Two of these companies are now a shadow of their former selves. Nortel has disappeared. These examples illustrate the danger of aggressive accounting. Manipulation robs future earnings and allows management to hide problems that should be addressed, creating even greater difficulties at some future point. Those seeking a greater understanding of cookie jar reserves will find these companies a great place to start.
General Electric
General Electric (GE) was an important multinational conglomerate during the 1990s and early 2000s.The company was accused of using reserves to smooth their earnings.
During periods of strong earnings, GE allegedly created larger-than-necessary reserves for purposes such as insurance losses, restructuring costs, or potential bad debts. These excessive reserves reduced GE's reported profits in good times, creating a "cushion" of hidden profits which GE could release back to the income statement when the company faced earnings pressure or an economic downturn. This would boost reported profits and smoothing out any earnings dips.
After the financial crisis of 2008, GE was subsequently accused of understating reserves for its insurance business. This was essentially like using cookie jar reserves in reverse order.
The SEC investigated GE's accounting practices related to its reserves but did not bring any charges. However, the regulator did issue a comment letter in 2009 expressing concerns about GE's accounting for reserves and its impact on earnings quality. While GE maintained that its accounting practices were within the rules, the allegations of cookie jar accounting led to skepticism among some investors and damaged the company's reputation for transparency.
While not resulting in formal charges, highlights the challenges of using reserves in accounting. While reserves are a legitimate way to account for future uncertainties, using them excessively to manage earnings can erode investor trust and raise concerns about the sustainability of a company's financial performance.
Microsoft
Microsoft is another well-known company accused of using aggressive accounting with respect to cookie jar reserves.
In the late 1990s, Microsoft allegedly set aside larger-than-necessary reserves for various purposes, such as potential bad debts, product returns, or legal liabilities. These excessive reserves reduced Microsoft's reported profits in good times to be released in later quarters when earnings were soft. This smoothing allegedly created the appearance of a more conservative and sustainable earnings pattern.
The SEC investigated Microsoft's accounting practices related to its reserves but ultimately did not bring any charges. However, the SEC did issue a report in 2002 expressing concerns about Microsoft's accounting practices and calling for greater transparency in its financial reporting. In addition, Microsoft faced several class-action lawsuits from shareholders who alleged that the company's accounting practices had misled them about its true financial performance.
While Microsoft maintained that its accounting practices were within the rules, the allegations of cookie jar accounting damaged its reputation and raised concerns about earnings quality.
Nortel Networks
The Canadian telecommunications equipment company was embroiled in an accounting scandal in the early 2000s that involved the use of cookie jar reserves.
The pattern was the same as that described above. During periods of strong profitability, Nortel allegedly created larger than necessary reserves for purposes such as restructuring charges, bad debts, or inventory write-downs. These reserves were then released to the income statement when Nortel faced earnings pressure.
The SEC investigated Nortel and found that the company had engaged in a fraudulent scheme to manipulate its earnings. Nortel agreed to pay a $35 million penalty to settle the charges.
The company was forced to restate its earnings for several years, reducing its previously reported profits by billions of dollars. The accounting scandal, along with other factors, contributed to the company's decline and eventual bankruptcy in 2009.
The Transparently Risk Engine’s historical risk scores for Nortel peaked at 90% in 2005, putting the company in the worst 1% of companies globally for accounting quality. The system flagged many risk signals in Nortel’s accounts for that year, including smoothing activity, corporate governance and gearing.
Olympus
A notable example of a non-American company associated with aggressive practices related to cookie jar reserves is Olympus Corp., a Japanese manufacturer of optics and reprography products. While this scandal involved a broader scheme of accounting fraud, the use of reserves played a significant role.
For over a decade, Olympus engaged in a practice of concealing investment losses dating back to the 1990s. Senior management used a complex web of transactions and inflated fees to hide these losses from investors.
A key part of the scheme involved creating excessive reserves in profitable years and then selectively releasing these in later years to offset losses and smooth their earnings. This manipulation gave the appearance of stable financial performance, masking the underlying volatility and losses.
When the scandal came to light in 2011, Olympus's share price plummeted by more than 80%, wiping out billions of dollars in market value. Several top executives, including the CEO, were arrested and convicted for their roles in the accounting fraud. Olympus faced significant fines from regulators and suffered severe reputational damage, shaking investor confidence in Japanese corporate governance.
The Companies use “cookie jar reserves” to set aside excess reserves (profits) in good times and use them to boost profits in bad times. ’s historical risk scores for Olympus averaged around 60% in the late 2000s and peaked at 70% in 2009, putting the company in the worst 7% of companies globally for accounting quality. The top concerns flagged by the system in Olympus’ 2009 accounts were smoothing activity, corporate governance and accruals management.
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