Heard on the
Street
Many Accounting Practices Are Difficult to
Penetrate
By STEVE LIESMAN
Staff Reporter of THE WALL STREET JOURNAL
Just 30 years ago, the rules governing corporate accounting filled only
two volumes and could fit in a briefcase. Since then, the standards have
multiplied so rapidly that it takes a bookcase shelf -- a long one -- to
hold all the volumes.
As the collapse of Enron has made painfully clear, the complexity of
corporate accounting has grown exponentially. What were once simple and
objective concepts, like sales and earnings, in many cases have become
complicated and subjective.
Add the fact that many companies disclose as little as possible, and
the financial reports of an increasing number of companies have become
impenetrable and confusing. This is true not just for investors, but for
Wall Street analysts, corporate executives with master's degrees in
business administration and, sometimes, even the outside auditors
reviewing a company's books.
The result has been a rise in so-called black-box accounting: financial
statements, like Enron's, that are so obscure that their darkness survives
the light of day. Even after disclosure, the numbers that some companies
report are based on accounting methodologies so complex, involving such a
high degree of guesswork, that it can't easily be determined precisely how
they were arrived at. Hard to understand doesn't necessarily mean
inaccurate or illegal, of course. But, some companies take advantage of
often-loose accounting rules to massage their numbers to make their
results look better.
The bottom line: There is a lot more open to interpretation when it
comes to the bottom line.
In a number of cases, there is too much interpretation. The number of
accounting restatements -- in which companies have had to change, usually
lower, their previously reported sales or earnings -- averaged 49 annually
between 1990 and 1997, according to Financial Executives International.
The number ballooned to 91 in 1998 and to 156 in 2000, as companies found
they had wrongly accounted for revenue, inventory valuations, bad-debt
allowances and income taxes. In many cases, the restatements sent the
stocks plummeting, with losses to investors measured in the tens of
billions of dollars in recent years.
"The way business is conducted always seems to outstrip the ability of
accounting to keep up," says Robert Willens, accounting analyst at Lehman
Brothers in New York. Investors buying shares in these companies can't be
sure of what they are getting, noted Al Harrison, vice chairman of
Alliance Capital Management LP, a big money-management company, at a
meeting with reporters last month. "To some degree, they become 'faith'
stocks," he said. Alliance was the biggest holder of Enron shares last
fall.
In the wake of the Enron collapse, investors are likely to scrutinize
even more closely the books of companies they find hard to understand,
such as Williams,
International
Business Machines, Coca-Cola,
General
Electric and American
International Group.
Not-So-Great Recent Moments in
Accounting
GE: Some Seek More Light on Its
Finances
AIG: A Complex Industry, a Very
Complex Company
Williams: Enron's Game, but Played
With Caution
IBM: 'Other Income' Can Mean Other
Opinions
Coca-Cola: The Real Thing Can Be
Hard to Measure
* * *
See full coverage of the Enron saga.
How much do you trust the financial
statements of companies you invest in? Participate in the
Question of the Day. |
Why has corporate accounting become so difficult to understand? In
large part because corporations, and what they do, have become more
complex.
The accounting system initially was designed to measure the profit and
loss of a manufacturing company. Figuring out the cost of producing a
hammer or an automobile, and the revenue from selling them, was relatively
easy. But determining the same figures for a service, or for a product
like computer software, can involve a lot more variables open to
interpretation.
Moreover, growing competition, globalization, deregulation and
financial engineering all have made the nature of what companies do more
complicated, says Baruch Lev, accounting and finance professor at New York
University.
As a result of competition, companies have evolved ever-more-complex
ways to limit risk, Mr. Lev says. A venture into foreign markets creates a
need for a company to use derivatives, financial instruments that hedge
investments or serve as credit guarantees. Many companies have turned to
off-the-books partnerships to insulate themselves from risks and share
costs of expansion. Pressure to develop new technologies, drugs and other
products drives companies into ventures with rivals that limit
exposure.
This is where the accounting has a hard time keeping up -- and keeping
track of what is going on financially inside a giant, multifaceted
multinational. Accounting rules designed for a company that makes simple
products can end up being inadequate to portray a concern like Enron,
which in many ways exists as the focal point of a series of contracts --
contracts to trade broadband capacity, electricity and natural gas, and
contracts to invest in other technology start-ups.
Accounting standards that deal with recording the value of derivatives
run several hundred pages. Philip Livingston, president of Financial
Executives International, a professional group, called the new rules for
derivatives "a monstrosity of accounting standards that nobody
understands," including accountants and chief financial officers.
"The boundaries of corporations are becoming increasingly blurred,"
says Mr. Lev. "It's very well defined legally what is inside the
corporation but ... we must restructure accounting so the primary entity
will be the economic one, not the legal one."
To be sure, figuring out corporate finance has always been challenging,
because a company is only required to reveal certain data. But where once
the risk for outside investors was making sure they weren't missing any
important numbers, the new problem is for investors to figure out how
accurately the numbers reflect a company's business.
Because of the leeway in current accounting rules, two companies in the
same industry that perform identical transactions can report different
numbers. Take the way companies can account for research-and-development
costs. One company could spread the costs out over 10 years, while another
might spread the same costs over five years. Both methods would be
allowable and defensible, but the longer time frame would tend to result
in higher earnings because it reduces expenses allocated annually.
Another area that allows companies freedom to determine what results
they report is in the accounting for intangible assets, such as the value
placed on goodwill, or the amount paid for an asset above its book value.
At best, the values placed on these items as recorded on company balance
sheets are educated guesses. But they represent an increasing part of
total assets. Looking at 5,300 publicly traded companies, Multex.com, a
research concern, found that their intangible assets have grown to about
9% of total assets, from about 4% five years ago.
Companies and their accountants can decide how to value an intangible
asset, and how that value changes from quarter to quarter. While there are
tests to determine the change in value, in practice it is difficult for
outside investors to understand how the figures were arrived at or to
challenge the changes, which can affect earnings.
Further complicating matters for investors, many companies have taken
to providing pro forma earnings that, among other things, often show
profits and losses without these changes in intangible values. The result
has been virtually a new accounting system without any set rules, in which
companies have been free to show their performance any way they deem
fit.
Finally, add to the equation the increasing importance of a rising
stock price, and investors face an unprecedented incentive on the part of
companies to obfuscate. No longer is a higher stock price simply
desirable, it is often essential, because stocks have become a vital way
for companies to run their businesses. The growing use of stock options as
a way of compensating employees means managers need higher stock prices to
retain talent. The use of stock to make acquisitions and to guarantee the
debt of off-the-books partnerships means, as with Enron, that the entire
partnership edifice can come crashing down with the fall of the underlying
stock that props up the system.
And the growing use of the stock market as a place for companies to
raise capital means a high stock price can be the difference between
failure and success.
Hence, companies have an incentive to use aggressive -- but, under the
rules, acceptable -- accounting to boost their reported earnings and prop
up their stock price. In the worst-case scenario, that means some
companies put out misleading financial accounts. "The argument that
honesty is the best policy does not work in such markets, since firms
would not be around in the future to reap the benefits of their honesty,"
wrote Harvard University professors Andre Shleifer and Gene D'Avolio,
along with Efi Gildor of Gildor Trading, in a research paper last
year.
Write to Steve Liesman at steve.liesman@wsj.com |