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October 2002; Volume 20, Number 10

The Great Accounting Scam

by James M Sheehan

The US government is attacking capitalism under the guise of cracking down on "corporate criminals." Corporate CEOs are being demonized and blamed for the collapsing stock market Bubble.  Exploiting the Enron and WorldCom bankruptcies, Washington DC has imposed the most sweeping accounting and securities laws since the 1930s.  

Unfortunately, the political class that granted itself sweeping new power over corporations lacks even a basic understanding of financial reporting, investing, or the stock market.  New "corporate responsibility" laws will make financial reports less informative to the average individual investor.

The myth driving federal legislation in 2002 is that accounting is largely unregulated.  In reality, there have been too many accounting regulations spawned by a dysfunctional regulatory and legal climate. The federal government has mandated a national set of accounting standards, set by the Financial Accounting Standards Board (FASB), there is no competition in this role.  One set of rules often gets imposed, to the exclusion of other.  FASB is a so-called Self Regulatory Organization, but in practice it is supervised, influenced, and heavily politicized by regulators at the Securities and Exchange Commission.  

In the past, financial reporting was based on broad principles that were relatively easy to apply.  International and British accounting standards are still based on broad principles that govern basic situations.  They do so on the theory that detailed rules are too easy to evade and give a false sense of certainty regarding the accuracy of a financial statement at a given point in time.  

In the US, the SEC's regulatory zeal has pushed accounting rules in the direction of excruciating detail.  The SEC now attempts to prescribe increasingly specific accounting rules for every ambiguous situation, in order to prevent every conceivable fraud or misleading representation.  The auditors welcomed these detailed rules, in order to better defend themselves against the frivolous lawsuits the government allows to be filed against them in courts.

Accounting rules have become highly complex, even confusing.  Like alcohol prohibition laws, they are easily evaded.  Some companies evade them to improve accuracy, while others do it to artificially inflate their earnings. Slightly altering the nature of a transaction can generate a unique set of circumstances not covered by the overly specific accounting rules.  By micromanaging accounting standards, the government has merely encouraged firms to expend resources restructuring their transactions to achieve accounting results that conform technically to the rules. Granting the SEC more power, larger budgets, and staff will not solve anything, because accounting rules cannot possibly keep up with rapidly changing events in business.

The pols have demanded that corporations present their financials in "black and white."  There should be no gray area in the reporting of a company's profits.  Yet in practice, accounting is full of gray areas. This is the textbook definition of accrual accounting.  It means documenting the expected cash consequences of all business transactions.  Expectations involve assumptions, estimates, and interpretation.

The "matching principle" of accounting says that expenses should be recognized in the period when the revenue they generate materializes.  But there are exceptions to this rule, such as when the expenses cannot be reasonably estimated yet.  Sometimes, the value of expenses is hard to define, or spread out over multiple accounting periods. Corporate assets are becoming more difficult to value since they increasingly consist of intangibles such as intellectual content, goodwill, and brand names.  Management is in the best position to determine the expected value of its assets, and must be given some discretion in doing so.  Sometimes, the accuracy of management forecasts will not become apparent for several quarters or even years.  For regulators and politicians to pretend otherwise is pure folly.

Clamping down on auditors will not help.  Outside auditors and regulators cannot possibly know how to estimate such things as the life of a fixed asset.  These things vary greatly even within the same industry. All an auditor can do is to vouch that a financial statement is broadly consistent with Generally Accepted Accounting Principles (GAAP), and to make a professional judgment about the integrity of the reported numbers.  The auditor must take at face value many of the numbers presented to it by the company, which is why a nationally reputable auditor like Arthur Andersen was not able to detect accounting abuses committed by Enron.  No amount of regulation can stop human beings from committing fraud if they are determined to do so.

Attempts to mandate greater precision will only curtail management discretion, resulting in less informative accounting. Overly rigid accounting standards the product of past government reforms have already created perverse incentives in the marketplace. Corporations know that some FASB rules paint a misleading picture about their businesses.  In order to provide investors and analysts with a more accurate presentation, they sometimes present supplemental metrics such as "pro forma" earnings.  This consists of an earnings figure that has been adjusted for various accounting distortions and non-recurring events.

The concept of EBITDA (Earnings Before Interest, Depreciation and Amortization) was popularized to offset accounting rules that misrepresented economic reality.  In the late 1980s, the cable television industry recognized that accounting rules for depreciation were inappropriate since cable assets held their value over time.  Because the government protected them from competition, cable companies did not need to upgrade their infrastructure frequently.  It was misleading to pretend that cable assets depreciated as rapidly as assets in other industries.  Removing depreciation from GAAP earnings gave better information to investors and shareholders, and permitted apples-to-apples comparisons between firms.

The advent of "tougher" federal accounting standards will actually diminish earnings quality.  Under heightened legal scrutiny by government bureaucrats, no company will want to make risky forecasts or assumptions in its accounting.  Internal forecasts and assumptions the company actually uses in its business planning will be kept out of published financial reports. Information that is potentially useful to investors will tend not to be disclosed, lest the forecasts turn out to be slightly wrong and become the subject of criminal fraud proceedings against the CEO.

As it obscures accounting data, government intervention will also provide false assurances regarding the accuracy of reported figures.  After all, the SEC has overseen the process, so why should investors do their own analysis of a company's books?  We have already seen this phenomenon at work. Many institutional investors falsely assumed that serious accounting irregularities at Enron would have been caught by the SEC in its periodic review of corporate regulatory filings. The SEC failed to do its job, and investors who relied on the agency were harmed.

Even if the government doesn't know how to regulate accounting, many observers think that mandating more disclosure will help investors discover fraud on their own. Unfortunately, investors do not know how to evaluate the "transparent" data.  Only a tiny proportion of ordinary investors actually reads a company's financial statements before buying the stock.  A smaller number understand what they are looking at.  The average investor is not inclined to engage in detailed analysis, nor is he capable of it.  Those who are trained in financial statement analysis already do it, and more rules will not help them.

The most notable disclosure regulation sought by legislators is the expensing of employee stock options. The lawmakers who want to mandate this practice think the market would have shunned high tech companies that offered extensive stock options to their employees.  But all of the available information about stock options is already fully disclosed.  In footnotes to their 10-K filings, companies are already required to state what net income would be if the fair value of stock options were expensed.  Moving this disclosure out of the footnote and into the main report is only a cosmetic change, and will not alter economic reality for any investor who was paying the slightest bit of attention.  

Institutional investors, who are the largest holders of company stock, do pay attention.  They constantly question management's accounting judgments, and adjust net income to reflect their own preferences. If investors think option expenses are not accounted for properly, they can make their own assumptions.  Nothing about the financial condition of the firm changes by including estimated options expenses in net income rather than in a footnote.  If options expensing is mandated, some investors will wind up having to adjust net income back to what they consider a more accurate accounting.

Expensing of employee stock options runs the risk of creating even more confusion.  Stock options are difficult to value.  Either the Black-Scholes formula or complex binomial methods must be used to make crude approximations of the options' price if they were trading in a hypothetical market.  However, these formulas are subject to large errors.  Employees cannot buy and sell their options in a marketplace, so there is no liquidity.  In addition, the value of options fluctuates constantly along with changes in the company's stock price.  Thus, they must be expensed over multiple accounting periods in the time before they are exercised.  According to traditional accounting principles, expenses that cannot be quantified accurately need not be expensed until such time as value becomes clear.  Expensing them before that actually violates accounting conservatism.

Expensing of options may actually lead to the misstatement of corporate earnings.  Changes in the stock price will change reported earnings, because the options expense will rise or fall.  A company could be seen to artificially boost net income not because of firm performance but simply because the stock price has fallen and hence the options are worth less. Such situations could lead to charges that companies are reporting inaccurate earnings. A much simpler solution would be for Congress to repeal its perverse tax policies that penalize executive salaries and encourage the over-use of options.

If Congress really wants to help the situation, it should focus not on accounting but on its own policies that caused an unsustainable tech boom.  Murky accounting was, if anything, a symptom of the Greenspan Bubble the direct result of excessive credit creation by Keynesian planners at the Federal Reserve. Artificially inflated stock prices attracted speculative investors.  It was the investors not accounting firms who decided to relax all valuation standards during the wild bull market.  

The hysteria surrounding accounting fraud is just that. Of the companies whose financial statements were called into question in recent months, few appear to be cases of outright fraud.  Most appear to be valid accounting simplifications or legal profit smoothing techniques that investors yearned for in years past. What was legal and expected before is about to be outlawed.

The new "corporate responsibility" law is a sham. Accounting will not be made more informative because of the introduction of vague new rules and harsher criminal penalties.  The crisis atmosphere created around major corporate bankruptcies is being used to justify a federal power grab, with budget increases of nearly $800 million for the SEC.  An accounting oversight board will not be run by accountants, but will have independent taxation authority over all publicly traded companies.  Four large accounting firms will have a permanent, legally impenetrable cartel over the auditing industry.  Perhaps this is the best we can expect from a self-aggrandizing political class that is demonstrably incompetent in its own financial and ethical affairs.  


James Sheehan, an adjunct scholar of the Competitive Enterprise Institute, works at a Wall Street investment bank.


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