The Irony of Creative Accounting
By Mark A. Sellers
Disclosure: As an undergraduate at Michigan State, I studied accounting. If you decide to stop reading right here and never believe another word I write, you probably won't be alone. These days, the word "accountant" carries a negative connotation in many people's minds.
But that's not fair. The typical accountant is trustworthy and honest. (Some of them, like Bob Newhart, can even be funny.) High-profile cases of alleged accounting fraud, à la Enron, are the exception, not the rule. In this case, employees of accountant Arthur Andersen shredded key documents related to the Enron case. While this situation is a shocking example of an accounting firm's inability to guarantee its client's books aren't cooked, this alleged wrongdoing isn't exactly unprecedented. Massive meltdowns happen in every bear market as the excesses of the previous bull market are wrung out and unscrupulous managers engage in desperate attempts to meet their forecasted profit targets.
Much more common than outright Enron-style fraud, however, is "creative" accounting. Companies can downplay their bad news by planting it in arcane financial statement footnotes. There are lots of other games companies can play, too, such as "stuffing the channel"--increasing this quarter's sales at the expense of next quarter's--or subtly increasing the expected rate of return on pension assets to pump up reported earnings. In the late 1990s, these types of shenanigans became more common than lawyers at an asbestos trial, and many of them are still going on today.
Massaging the numbers may be slightly less unethical than outright fraud, but it's just as stupid. Eventually, the skeletons find their way out of the closet.
Who's to Blame?
In most cases, the auditors who sign off on the books are following the letter of the law, but they have little power to enforce the spirit of it. Since they're profit-making enterprises, accounting firms are under immense pressure to sign off on a client's financial statements. If they don't sign off, they risk being fired, or they may be forced to resign. In other words, commit a form of professional suicide.
The auditors are just one piece of this convoluted conundrum, though. Wall Street analysts also share some of the blame. Analysts often put a tremendous amount of pressure on company executives to make quarterly targets. Ironically, this quarter-by-quarter mentality ends up being bad for shareholders because management spends too much time thinking about "managing earnings," a process that often conflicts with long-term strategic goals.
Executives want to make their numbers at all costs to help drive up the firm's share price, as opposed to increase its dividend payout. Not only are senior managers now disproportionately incented with options--which pay off only if the stock goes up--but a rising stock price has become a crucial tool for retaining talented mid-level employees. Ask the CEO of almost any high-tech company--Sun Microsystems (Nasdaq: SUNW - News), Cisco Systems (Nasdaq: CSCO - News), EMC (NYSE: EMC - News)--and you'll get the same answer: Our stock price and our employee morale are highly correlated.
But by bending accounting rules to their breaking point, management teams are trying to put one over on their shareholders. I find this ironic, because it inevitably backfires. Accounting earnings often diverge from economic reality over the short term, but over the long run, the stock market reflects business reality. Even over the short term, studies have shown that it's tough to fool the stock market through accounting tricks. Eventually, the market punishes companies that engage in such gimmickry with a lower P/E multiple, leaving these companies worse off than if they hadn't tried to trick investors in the first place. That doesn't stop management teams from trying anyway, though. Sadly, many top executives--including chief financial officers--don't seem to have a full understanding of how sophisticated the capital markets are.
Our Own Worst Enemy
But we shouldn't blame just the management teams, analysts, and auditors for the poor quality of earnings among public companies. Investors must also look in the mirror. Most mutual-fund managers, for example, risk getting fired if they have one or two really horrible years compared with their peers, so they diversify their portfolios so much that they mimic the benchmark against which they're being judged (to my knowledge, no one's ever been fired for equaling the return of the S&P 500 index).
When managers "benchmark," they have a tendency to grow passive. These investors hold so many companies in their portfolios that they don't have time to scrutinize every one, let alone spend time on such matters as proxy fights or other forms of shareholder activism. Without close scrutiny, public companies can get away with murder--at least for a while.
Of course, the reason institutional investors engage in benchmarking is that individual investors demand it. Whenever a fund suffers a really lousy one-year period, investors start yanking their money out faster than you can say "Janus."
Thus, an argument can be made that investors--both institutional and individual--have mainly themselves to blame for getting burned. Enron was outright fraud, no doubt about it, but recent accounting questions at Qwest (NYSE: Q - News), Computer Associates (NYSE: CA - News), Tyco (NYSE: TYC - News), and others have all been brought up before--but until recently, no one wanted to hear bad news because everyone was fat and happy and, in a world of 20% equity returns, investors were happy just to equal the benchmark.
Half Full or Half Empty?
If there's a bright side to the recent hullabaloo over accounting, it's that lots of investors have opened their eyes for the first time in years. Today, no one brushes aside the naysayers. In fact, one could argue that Chicken Little is running the show these days. The slightest whiff of accounting impropriety causes investors to sell now and think later. As with all cases of financial hysteria, this one has probably gone too far too fast, though it isn't over yet.
But once the dust settles, conservative accounting may mount a comeback. Accounting could even become a form of competitive advantage. Companies such as Southwest Airlines (NYSE: LUV - News), Berkshire Hathaway (NYSE: BRKB - News), Dell Computer (Nasdaq: DELL - News), and others displaying honesty, candor, and financial transparency would be rewarded with a higher P/E multiple, improving employee morale and pleasing investors and lenders. This would allow them to attract more talented employees and raise capital more easily.
That day isn't quite here yet, but as more and more investors open their eyes to the games being played at public companies, it may be inevitable. Let's hope so. |
