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The Numbers Game: Manipulation of Financial Reporting by Corporations and their Executives

Why Accurate Financial Reporting Matters

April 10, 2006

Our financial reporting system is under siege as never before. Corporations are under intense pressure from shareholders to meet or exceed earnings targets. Globalization continues to relentlessly compress profit margins. The response from many companies has been dramatic: radically reduce expenses by slashing services, wages and benefits, raise prices whenever possible, and employ accounting gimmicks and sleight-of-hand to manipulate earnings whenever these measures fall short. These gimmicks, some quite elaborate, have resulted in a string of accounting failures and corporate scandals.

Accounting failures have become rampant and more pervasive, undermining the credibility of the accounting profession and the inherent reliability of the financial reporting model as an evaluative tool in shaping investor confidence and awareness. The financial statements, which include both quantitative and qualitative information, purport to transmit the financial data of an entity or group of entities into a prescribed format that stakeholders of that entity can use as a means of evaluating the financial health and viability of that entity.

Financial statements must be able to accurately and faithfully convey the economic substance of a transaction, over a period of time, and as of a given date. Financial information presented in these statements must be capable of accurate comparison to financial statements of other entities. These other entities may or may not be within the same industry as the target company, and the financial statements must convey the economic substance of the transaction rather than merely the economic form of it. This substance-over-form doctrine has been widely accepted as the prevailing standard in evaluating the nature of a transaction.

Transparency and comparability have been the goalposts toward which the accounting profession and the SEC have driven. Comparability between financial statements ensures that creditors and investors will make meaningful investing decisions based on financial statements that faithfully convey the underlying economic position of the entity. Lack of comparability ensures that the financial statements and any assessments derived from them are meaningless and will convey fiction rather than truth.

Earnings Management and Creative Accounting

Creative accounting and earnings management occur when organizations are tempted to manipulate earnings through the creative application of accounting principles, or through flagrant abuse in the application of those principles. Earnings management is a by-product of the perceived need to inflate earnings to meet or exceed Wall Street expectations, which are created as a result of consensus opinions by the hundreds of analysts on Wall Street. Failure to achieve or reach these expectations can create powerful downward pulls on company stock valuations and affect both shareholder value and employee compensation through the devaluation or worthlessness of stock option incentives. Powerful incentives to reach elusive earnings expectations can create serious conflicts of interest among corporate executives eager to meet these expectations.

Several academic theories have developed to both explain and regulate creative accounting and earnings management. Former SEC Chairman Arthur Levitt Jr. championed the most pervasive and widely accepted of these theories in 1998 in his speech to the New York State Society of Certified Public Accountants. In essence, this speech served as the bellwether for the SEC's efforts to enforce and prosecute those individuals and organizations it felt were engaging in widespread and pervasive earnings management. In it, Levitt characterized the process of earnings management as a game among market participants and one that would have serious repercussions and adverse consequences for America's financial reporting system.

The method of achieving earnings management involves the use of accounting techniques created primarily to allow and encourage companies to be flexible in the recording of their transactions in order to facilitate the goal of Generally Accepted Accounting Principles, that of ensuring substance over form in the recognition of an accounting transaction whenever possible. Earnings management occurs when this flexibility is exploited in an effort to conceal financial volatility. To this end, Levitt identified a series of methods and techniques that are commonly used to manipulate earnings. These methods include the manipulation of reserve accounts (i.e., “big bath” restructuring charges and “cookie jar” reserves), manipulation of materiality within the audit process, improper revenue recognition, and creative acquisition accounting.

The SEC's response to the methods of manipulating earnings has been to encourage stricter compliance with existing accounting rules, greater enforcement, policing efforts by the SEC, and widespread cultural change of the corporate ethos, which encourages such behavior. Levitt outlined a proposal whose common theme was hyper-technical reliance and adherence to the established standards and a call for greater specificity within those standards. Levitt's clarion call for a change in corporate culture failed to acknowledge the powerful countervailing forces poised to undermine the credibility and transparency of the financial reporting model. Corporate, shareholder, and auditor interests remain conflicted with the ideals of financial credibility and integrity. The unceasing demands of Wall Street ultimately dictate the financial reporting climate adopted by the subject companies. The pressure to accommodate is relentless and causes the subtle yet perverse degradation of accounting standards that ultimately leads to outright fraud. An alternative theory of corporate governance holds that Levitt's proposed solutions simply compounded the problems, rather than correcting them. These theorists argue that increasing compliance with the growing volume of rules and statutes has ironically rendered financial statements uninterruptible to the very consumers they purport to protect – the investing public.

An Alternative View of Earnings Manipulation

An exhaustive study of corporate failures in Australia by F.L. Clarke, G.W. Dean and K.G. Oliver, Corporate Collapse, Regulatory, Accounting, and Ethical Failure, explored the notion that greater compliance with prescribed standards and zealous enforcement of those standards would achieve serviceable financial standards that were informative and models of comparability, the SEC's over-arching concern for many decades. The Australian analysis concludes that even meticulous compliance with approved accounting standards and strict enforcement by the regulatory bodies may not produce useful financial statements: "compliance with standards then in vogue was as likely to have contributed to creative accounting as deviation from them. Perversely, corporate regulators and the accounting profession are calling for even more accounting and auditing standards."

By explicitly imposing detailed standards on the financial statements, auditors could essentially shield themselves from liability by citing express provisions of GAAP in defense of the accounting positions taken, and thereby avoid being held directly responsible for making those judgments. Auditors would also reduce the tendency to opinion-shop by stressing the unyielding nature and detail of the standards in defense of the positions taken. The Australian study instead focuses on the product of the accounting process, the financial statements, and their ability to convey data accurately, without misrepresentation and lack of comparability, as opposed to singularly focusing on the process of accounting and its methodology.

“Accounting standards have failed to match the admirable claims of the leaders of the profession – namely, that compliance with them would reduce the diversity of accounting practices and thereby provide data relevant to the making of informed financial assessments," the authors add. "Defying financial common sense, complying with certain practices endorsed by the accounting profession itself, producing the standard nonsensical, fictional financial outcomes, are not regarded by either the regulators or (so it seems) the accounting profession to be a willful indulgence in creative accounting."

Control of the process by which standards are developed and applied and zealous enforcement of those standards through strenuous regulatory activity over behavior deemed non-compliant appears to be the principal mechanism to ensure the stability of the financial reporting model worldwide. This attempt to excise and regulate judgment from financial reporting, a position strikingly similar to that held by the SEC and Levitt, ultimately obviates the need for serious discussion regarding the quality of the output, rather than the behavior of the input.

Fictional Reporting and its Consequences

Financial reporting practices produce fictional and sometimes aberrant statements that are misleading if not outright fraudulent. For example, consolidated financial statements are traps for the unwary, hiding and masking transactions through Byzantine group structures and idiosyncratic consolidating techniques.

Consolidation procedures require that inter-group transactions be eliminated when the financial statements of the group are consolidated, on the theory that this procedure eliminates transactions between the group that are not at arm’s length and which may in fact be shams. But consolidation accounting has another, less obvious yet insidious result – it purposely conceals and buries subsidiary information within the group's consolidation, hiding both the enlightening and damaging aspects of subsidiary performance within the whole.

Consolidation accounting purports to represent the economic activity of a group of legally separate and unique entities under the fictional mantra of the group, relying on economic form over legal form and financial substance. They obfuscate, confuse, and conceal data that might normally be available to users of financial statements, and may serve to hide data from shareholders and creditors that is damaging or otherwise disparaging. Data not found in unconsolidated financial reports mysteriously appear in consolidated statements under the guise of economic substance, yet bear little relation to real-world substance and the individual, disaggregated accounts of the subsidiary. This theory of aggregation is contrary to the norms found in GAAP – that of full disclosure and careful consideration of an entity’s viability as a going concern.

Prevailing consolidation techniques ignore the legal and financial implications that the aggregated assets and liabilities are neither owned nor made available to the group. This group mentality encourages users and readers of financial statements to view the entities of the consolidated group as virtual branches of the parent, again creating a dangerous fiction rendering the financial statements less meaningful. The grandest of these fictions, though, is the assumption engendered by consolidation accounting that profits and losses of the subsidiary entities will pass through to the parent entity through dividend payments.

The Failure of Current Wisdom and the “Cookbook”

The substance of Levitt’s criticisms focus on individual misdeeds and the need for greater regulatory efforts, rather than on the serviceability of the financial reporting model as presently structured. This "cult of personality" has in fact diverted attention away from fundamental restructuring towards individual scapegoats and single instances of ethics failure, bad management, and inadequate educational resources.

While the trend towards increased vigilance of earnings management and zealous enforcement may sometimes deter the brazen and unscrupulous, it will not, however, prevent the honest application of accounting standards to financial data, often leading to bizarre and unintended results. The failure of accounting is often the result of poorly constructed standards that have no legal or economic basis. The mantra of substance over form fails to reveal and clarify the arcane ambiguities of consolidation accounting and historical, cost-based financial reporting.

The real issues have yet to be addressed by any private or governmental regulatory agency. The captains of industry, board members of the regulatory agencies, and members of the national accounting firms share common ground in seeking to avoid disruptive change. The accounting industry seeks, most importantly, to avoid liability, and the cookbook standards pervasive today well accomplish that goal. Captains of industry seek to manipulate accounting data to create financial reports that present their organization in a favorable light. Regulatory agency members are often products of private industry, as many are tapped directly from the boardrooms of corporate America and the accounting industry; hence, they too have no incentive to seek substantive reform of our financial reporting system.

Substantial modification of the financial reporting model would involve, for example, reform of financial consolidation principles to reflect the legal and economic reality of the corporate structure. A shift to fair value accounting would prevent the gross miscalculations of value that continue to plague analysis of corporate stability and liquidity. Indeed, fixed asset depreciation models and real property accounting are little more than cookbook applications having little economic substance.

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