By SARA FISHER
Over the last year, a spate of major U.S. public companies have incurred the scrutiny of the Securities and Exchange Commission for alleged accounting irregularities, sparking widespread concern across corporate America. More prevalent, however, are the companies that use creative but technically legal accounting tactics to announce overly rose-colored earnings performances.
E. John Larsen, a professor of accounting at the University of Southern California’s Elaine and Kenneth Leventhal School of Accounting, discusses how and why these distorted accounting methods are becoming more common, and what can be done about it. Larsen has written five books on accounting practices and was awarded the Distinguishing Professor Award from the California Society of CPAs in 1990.
Question: The use of legal but misleading accounting practices seems to have grown into a more common practice among public companies only recently. What has changed to cause this shift in the accounting world an industry that once was considered above reproach?
Answer: There absolutely has been an increased amount of restated or challenged financial figures over the last couple years. The biggest cause seems to be a combination of competition and the relatively new consulting side of accounting firms. The auditing field has become more competitive, with firms fighting for a shrinking pool of clients. Meanwhile, the consulting practice is the lucrative side of the business and has subordinated the auditor’s practice. Arthur Andersen is an example of how the tail is wagging the dog, where auditing has become a commodity that firms see as an entree into the consulting practice.
One end result may be these problems that we’ve seen recently. Consulting brings in the money, but I am concerned that accounting firms have become too lax about conflicts of interest. When a firm does both accounting and consulting for the same client, it is very difficult to have the same hard-nosed approach for both jobs. That’s the nature of the beast.
Q: The problem can’t just come from the accountant’s side. What motivates the public companies to use manipulated figures?
A: Pressure to meet Wall Street expectations appears to be intensifying. If a company fails to meet earning expectations even by the smallest margin, there is a sudden backlash in the stock value. This was especially true when the market was so healthy, since companies were almost expected to do well.
In this environment, I’ve seen some CPAs cross from public accounting into a (chief financial officer) or controller position and completely lose their sense of serving the public. I’ve even seen some former students do that. Either the bottom line, the need to meet the forecasts, or the stock price serves as an inducement to use “cute accounting” or outright fraudulent methods. It’s very painful to see.
Q: What constitutes that “cute accounting?”
A: Many of the generally accepted accounting principles (GAAP) have some wiggle room, and the attitude in public companies often is that if the book doesn’t prohibit it, they’ll do it.
The name of that game is to enhance earnings, mostly done by the premature recognition of revenue and improper deferral of expenses. One of the most popular tricks comes from restructuring costs. Folks who are looking to stretch accounting rules combine years of expected future expenses and write them off as a one-time charge. By getting them off the balance sheet, future earnings will appear higher.
We’re also seeing more companies taking R & D; charges, which means they write off the acquired companies’ research and development that has not yet shown itself to be commercially valuable. Expensing the R & D; immediately will increase the future earnings. To the same end, companies also are avoiding goodwill charges, which require amortization (depreciation) and consequently depress earnings.
These tricks really only appeared in the late ’80s when M & A; activity was high, so it didn’t attract concern until relatively recently. The SEC is now very worried.
Q: Are there any industries more prone than others to use these tricks?
A: Technology companies tend toward the in-process R & D; charges since the R & D; portion of their businesses usually are valuable. Other than that, I haven’t really seen a pattern.
Q: Why does the GAAP allow for so much wiggle room in audit practices?
A: When developed, the standards were designed to be somewhat flexible to accommodate the varied cases that accountants handle. The standards’ flexibility was intended to help the auditors, and it’s a valid point. However, the standards for M & A; accounting are badly in need of reform, as obvious from our discussion of the “cute accounting.” The Financial Accounting Standards Board (an industry group chartered by the SEC) is finally starting to examine this issue.
Q: Why is the SEC only now taking action against shady practices that have gone on for years?
A: The SEC has rightly pointed out that they shouldn’t be playing the “daddy role.” The first line of defense in accurate financial reporting is supposed to be the CFO of a company. The second line of defense is supposed to be the auditing profession. The SEC shouldn’t have to play the authority figure and doesn’t want to completely take over auditing functions. No one wants that.
Having said that, the SEC is looking at the rising number of complaints with concern. The new SEC chief accountant, Lynn Turner, and the chief accountant for the enforcement division have indicated that they will be more militant than their predecessors in going after fraudulent or misleading SEC reporting.
Q: What can the SEC do to curb the problem other than help rewrite accounting principles?
A: The SEC needs to stage more public hangings. In the past, the SEC has prohibited major accounting firms that have violated the rules from having any SEC dealings for 30 days. They also were barred from accepting new clients. This punishment would be deadly, especially for a worldwide company. That may be the wake-up call needed to scare people straight.