Corporate Finance

Misreporting Accounting Results

Recent accounting frauds may point to deeper problems. But it will take more than new accounting rules to solve them.
Stephen BarrDecember 1, 1998

Two weeks after taking over as the Securities and Exchange Commission’s chief accountant last summer, Lynn Turner began holding secret meetings with business executives and accounting experts. Turner suspected that the recent accounting disasters at Cendant Corp., Sunbeam Corp., and Waste Management Inc. were part of a general trend. The SEC had already stepped up efforts to challenge companies over so-called big-bath accounting–where even those in strong financial shape take so-called nonrecurring charges year after year to bury ongoing expenses and inflate future earnings. Now Turner wanted to know if there were still “breaks in the process” that were encouraging companies to push the limits on this practice and others.

Turner did not stop at accounting. He also wanted to know about auditors who go easy on management, audit committees that lack independence and financial expertise, and analysts who provide little more than cheerleading services. He did not like what he heard. Particularly upsetting, he says, were widespread reports of pressure on executives to manage earnings to meet Wall Street estimates. One CFO told of the time he gave an analyst a heads-up that the company might fall 1 to 3 cents short for the quarter. Rather than accept the need to adjust his estimates, the analyst responded that the executive was “a very bright CFO” and could “move the numbers around and make it.”

Turner suspected that such tactics would only intensify with the stock market and economy showing increasing signs of strain. With earnings under pressure and executive compensation linked to stock prices, more companies could be expected to use accounting tricks to compensate for any profit shortfalls. “If we didn’t do something now,” Turner contends, “the problem would be systemic eventually.”

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Nods and Winks

The meetings culminated in a speech at New York University last September, in which SEC chairman Arthur Levitt condemned the “game of nods and winks,” in which accounting rules were badly bent, if not broken. “I fear we are witnessing an erosion in the quality of earnings, and, therefore, the quality of financial reporting,” Levitt said. “Managing may be giving way to manipulation; integrity may be losing out to illusion.” And he announced a nine-point action plan for new guidelines and rules to fix the problems.

Some observers see Levitt’s speech as part of a natural give-and-take over accounting practices. “As corporations learn to play the game better over time, ostensibly within the rules, their tactics periodically have to be offset,” says Martin S. Fridson, a managing director at Merrill Lynch & Co. and a financial- reporting expert. “We’re at that point. This was putting companies on notice.”

But Levitt is after bigger game. He described a new era in American business in which the temptation to boost earnings and stock prices through accounting legerdemain threatened to become impossible to resist. Levitt called for a “cultural change” in which managers and investors look after the long-term interests of the corporation instead of trying to meet Wall Street’s short-term expectations.

Easier said than done, of course. Yet even before the SEC chairman’s speech, there were signs that investors were taking accounting issues more seriously, and not just in the above-mentioned cases. Several other companies, including Resource America, Bally Fitness, Costco, and B.J.’s Wholesale Club, were hammered by investors, not because they had reported earnings that were slight disappointments– heretofore the usual red flag–but because of accounting irregularities.

Elsewhere, however, irregularities continue to be rewarded. Consider 3Com Corp. In March, the SEC compelled the company to reduce its restructuring charge for the 1997 purchase of U.S. Robotics Corp. to $279 million from $426 million, because 3Com had overestimated the associated expenses. And because it would recognize the costs as they occurred, rather than account for them in the quarter when the deal closed, 3Com had to revise its six previous earnings statements downward.

Yet the price of 3Com’s stock climbed in response. “The stock went up because management announced that the accounting disallowance would not hurt future EPS,” says David Tice, an investment adviser based in Dallas. “I have a hard time believing that. But it’s like committing a crime, and if you’re caught there’s no real price to pay.”

That suggests the age of irregularities won’t be short-lived. “We’re in an environment where the credibility of management has been seriously damaged,” says Pat McConnell, an accounting expert at Bear, Stearns & Co. “The real fundamental issue concerns the whole ethical fabric of management.”

By and large, corporate executives dispute the impression left by Levitt’s speech. These executives worry that he has overreacted to a few well-publicized frauds, and that he will cast doubt on the integrity of all financial reports by launching a meddlesome, politically motivated crusade.

“To say the accounting community has gone to hell in a hand basket–I don’t see it,” says Jim Schneider, senior vice president of finance at Dell Computer Corp. Schneider isn’t alone. P. Norman Roy, president of the Financial Executives Institute, says that many FEI members were incensed by the “broad-brush sweep” of Levitt’s attack. “Our concern is that initiatives like this tend to end up with more regulations,” Roy argues. “We think enforcement deserves more attention than going back to the drawing board to rewrite the standards and rules.”

Levitt’s views were seconded by attendees at a conference sponsored by CFO magazine in October. Asked about the need for action to address accounting abuses, two-thirds of the survey respondents agreed that something should be done. This despite the finding that current problems have less to do with fraud than with aggressive accounting. A good proportion–45 percent–had been asked to misrepresent financial results. Fully 38 percent of that group did so. But a whopping 78 percent had been asked to use accounting rules to cast results in a better light. Half of that group acceded to the request. “There have been some ‘creative’ practices applied, but used in the parameters of GAAP, as a matter of interpretation,” wrote one respondent to the CFO survey.

Although that survey represents a small sample, the results substantially back up a survey conducted at a Business Week magazine CFO conference, which found that 55 percent of CFOs had been asked to misrepresent results. Seventeen percent met the request.

The CFO survey respondents also support Levitt’s contention that the drive to meet Wall Street earnings expectations has influenced accounting practices. Sixty percent of the respondents characterized analyst pressure as high or moderately high.

Treating Symptoms

These results suggest that stricter accounting standards by themselves won’t produce the cultural change that Levitt seeks. Accounting games will continue as long as the incentives for all parties to play them remain as strong as they are today. Compensation packages are tied to stock prices. And both brokerages and accounting firms are subject to conflicts of interest that could compromise their integrity. Levitt can probably do little or nothing to decouple compensation packages and stock prices. Yet if he focuses on accounting standards instead of conflicts of interest, Levitt will be aiming at the wrong target. And with companies likely to fight back, he may end up wasting time and energy better spent elsewhere.

“If companies are being tempted to engage in earnings management, we should look as much at the cause as at the symptoms,” says Robert Herz, a partner in PricewaterhouseCoopers LLP. “‘The real issue is, why do companies feel it is so important to go out of their way to make sure they don’t disappoint the analysts?”

Dell’s Schneider agrees that accounting irregularities are merely a symptom of a deeper problem. When, for instance, stock prices rise for companies that take big charges, Schneider says, it’s only logical that others would want to participate. “As long as the market reacts positively,” he says, “people are tempted to put as much as they can into these charges and err on the high side.”

David Tice concurs: “Most analysts don’t mind write-offs, and are glad to see the high earnings-per-share in the future.”

Yet accounting standards continue to be the subject of intense attention by the SEC. Consider the brouhaha over write-offs for in- process research and development. This 23-year- old accounting rule was virtually ignored for years. Then, in 1986, SEC accountants began pushing acquirers to use it in order to put the accounting treatment of acquired and internal R&D on equal footing. Only more recently have shrewd companies seized the opportunity to take advantage of the standard, by writing off as large a portion of the purchase price as possible, minimizing the ongoing earnings hit from goodwill.

A 1997 study by Baruch Lev, a professor of accounting and finance at New York University’s Stern School of Business, found that only 3 companies wrote off part of their acquisitions as in-process R&D during the 1980s, compared with 389 between 1990 and 1996. The average write-off between 1980 and 1996 was 72 percent of the purchase price.

“The SEC insisted that companies do it,” scoffs one finance executive, “and now they’re screaming that people are doing too much.”

And in-process R&D was but one standard that Levitt identified as an area of serious abuse. He also complained about companies that went beyond accepted revenue recognition practices, the abuse of materiality, and unrealistic assumptions that go into creating “cookie jar” reserves, as well as restructuring and merger- related charges.

Regulators first grew concerned about the increasing number of corporate restructuring charges in 1994, when the Financial Accounting Standards Board’s Emerging Issues Task Force (EITF) issued new guidelines on what qualifies as a liability as part of restructuring or acquisitions.

“The EITF took a fairly hard line on that treatment, and the SEC has been challenging companies for not adhering to [the guidelines],” says former FASB chairman Dennis Beresford, who is executive professor of accounting at the University of Georgia in Athens. “The concern among corporate officers is that they’re applying the existing guidelines in good faith, and the SEC is going beyond what the current guidelines call for.”

The SEC’s Turner counters that a review of filings shows that an increasing number of companies have failed to comply with the 1994 guidelines that require companies to have detailed plans worked out before they take restructuring charges. “We found people had been accruing for costs before they had their plans worked out,” Turner complains, “and they made adjustments up and down later.”

In his action plan, Levitt called on FASB to move fast on a project involving liabilities. In the meantime, he has called on the SEC staff to develop a Staff Accounting Bulletin that will address the types of costs that can be put in reserves. The bulletin would also amend disclosure rules to provide greater visibility on what is going on in those accounts.

Finance executives are leery, because restructuring charges are based on subjective assessments. “You don’t always get it exact,” says Schneider of Dell. “The rules are appropriate [to assert that you should take] a charge, but you don’t have the same precision as with other parts of accounting.”

Moreover, there is concern that efforts by FASB to attack the liability question will generate more restrictions and limitations. “Here there will be significant resistance from the business community,” Beresford predicts.

Auditors vs. Consultants

To be fair, Levitt recognizes that new accounting rules alone will not solve the larger problem he sees. His speech at NYU cast auditors in a harsh light. “I can’t help but wonder if the staff in the trenches of the profession have the training and supervision they need to ensure that audits are being done right,” Levitt said.

In fact, for several years the SEC has looked askance at auditors who overlook aggressive accounting, or who go easy, to avoid jeopardizing the consulting work that the firm does for the company. According to Public Accounting Report, the Big Five accounting firms derive as much as half their revenues from general consulting and merger advisory services, which are also more profitable than auditing a company’s books.

“The auditors aren’t challenging companies, and that has to do with their reluctance to offend their consulting clients,” says Peter Knutson, an accounting professor at the Wharton School of Business.

Not surprisingly, the accounting industry disagrees. Last year, the American Institute of Certified Public Accountants (AICPA) claimed in a white paper that “there is no evidence that the supply of nonaudit services threatens auditor independence.” PricewaterhouseCoopers’s Herz is more direct: “Our firm’s revenues are $14 billion. No one client, no matter how big, is worth doing a shoddy audit for. The lawsuits and the reputational damage are too great.”

While the Independence Standards Board, set up by the SEC in 1997 to address such concerns, has proposed that auditors send a form letter to directors each year stating that they are independent, the SEC is looking for more. In August, Turner proposed to the ISB that auditors meet annually with company directors to outline the consulting services they provide to the company, the cost of those services, and why they did not impair independence.

As part of Levitt’s nine-point plan, Turner called on the Public Oversight Board, an arm of the AICPA, to study and possibly hold public hearings on the “efficacy of the audit process.” In a letter to the board’s chairman, he questioned recent changes in the audit model used by accounting firms, where the emphasis is more on risk assessment and analysis than on intensive fact-finding and verification of figures. Turner also lambasted the reliance of accounting firms on new hires with minimal business and professional experience to perform the audit work.

But past recommendations by the Public Oversight Board have fostered little change. Four years ago, the board suggested that outside auditors should go beyond auditing the books for compliance with GAAP and tell the audit committee the degree of aggressiveness that management was practicing in the application of GAAP. Only recently has Arthur Andersen developed a scale for identifying aggressive accounting. Its auditors will begin using it soon.

The AICPA has expressed support for the board’s inquiry, but Herz, for one, is skeptical about how much muscle can be put back into the audit process. A fundamental problem, he argues, is that auditors have minimal contact with their clients when they’re not performing the annual audit. Herz would welcome an SEC mandate that auditors do a detailed quarterly review of their clients’ books, but notes that the agency has not pushed for that in the past.

Stirring a Backwater

In a press briefing prior to his speech, Levitt also cited the importance of the audit committee, long a backwater of corporate boards, whose members often are celebrities, retired political leaders, and cronies of the CEO. Lacking any background in finance and accounting, these directors are rarely in any position to challenge management or external auditors.

Levitt groused about audit committees that convened for a few minutes before regular board meetings and had what he described as “thoroughly unqualified” members. He cited one company with a professor, a politician, and an engineer on its audit committee, and another with a school instructor, a nurse, and a nonprofit executive.

“There’s nothing wrong with those professions,” Levitt said, “but audit committees must really represent the watchdog for a corporation.”

Observers agree. Nell Minow, a principal at LENS Inc., a shareholder advisory firm in Washington, D.C., notes that the governance practices of several companies with recent accounting problems have been woeful. Waste Management’s audit panel didn’t review the work of the outside auditors for three years, while Cendant’s, in the year prior to the CUC merger, met only twice. “The compensation committee met eight times,” Minow notes. “Doesn’t that just say it all?”

But by calling for a “blue ribbon” panel to develop best practices to “empower” the audit committee, Levitt is treading on vague and well-worn terrain. A 1993 report by Price Waterhouse noted that “highly publicized frauds and business failures” had “raised questions about the adequacy of corporate governance.” Since then, reports by various groups of experts have also called attention to the need for more independence of and expertise on audit committees.

Currently, the stock exchanges require only that listed companies have an audit committee consisting of outside directors, but do not spell out qualifications or re-sponsibilities. As a result, says Frank Borelli, CFO of Marsh & McLennan Cos. and a member of the blue- ribbon panel: “Some are comprehensive, and some are quite light.”

The panel could “go far,” Borelli contends, in tightening the listing standards. The panel is likely to urge the review of work by external and internal auditors. Borelli also favors, for example, a recommendation that the committee meet a minimum of four times a year and go over specific ground, and that the committee have a charter that spells out its duties and responsibilities.

But he expects the question of spelling out committee-member qualifications to be “more difficult to sell” because it would call on companies to judge the financial talents of highly successful people. Indeed, he notes, recruiters are already adding more CFOs to their board searches.

Borelli predicts that the panel will stop short of that recommendation, but believes a disclosure change– requiring a discussion like that of the compensation committee already in the proxy statement–could have a far-reaching effect.

All of this is overdue, says Minow: “If we’ve learned anything lately, it’s that we can’t count on audit committees.” The question is, How far will Levitt’s blue-ribbon panel go to help change that?

Beyond Reach

While Levitt spoke derisively of the intense focus on earnings expectations, his action plan stops well short of proposing to do anything about it. He did not even mention such issues as compensation packages tied to stock prices or collusion between the underwriting and research operations of Wall Street firms. Some observers suggest his hands are tied here. “Part of the problem is the way Wall Street looks at things,” Tice says. “If analysts don’t want to look at restructuring charges, price/book value, and shareholder equity, there’s nothing Arthur Levitt can do to make them.”

And while there are so-called Chinese walls separating the research and underwriting arms of brokerage houses, Tice contends they are easily breached. “Wall Street serves as an intermediary to help companies procure financing. They make more money from investment banking than commissions, and they want to keep CFOs happy,” he says.

A recent study by Boston investment research firm First Call Corp. has shown that negative research reports make up barely 1 percent of all reports from major Wall Street firms. And a study by the National Investor Relations Institute, in Vienna, Virginia, found that 86 percent of top U.S. companies got to review the coverage in advance. “When companies are shown reports prior to publication, you have no idea how analysts have tailored what they write,” says Bob Renck of R.L. Renck & Co.

Furthermore, a study of research reports by Siva Nathan, of Georgia State University’s School of Accountancy, found that analysts at firms with investment-banking ties had 6 percent higher earnings forecasts and nearly 25 percent more buy recommendations than analysts at firms that had no such ties.

Why didn’t Levitt propose to further separate the research and underwriting functions? In response to CFO’s question, a spokesman for the SEC says that the commission can’t tackle all the issues at once.

To be sure, Levitt set a strict deadline of December 31 for new Staff Accounting Bulletins and recommendations from the blue-ribbon panel on audit committees, and has asked FASB to pick up its notoriously slow pace. Turner contends that the SEC’s plan is more comprehensive and well-thought-out than previous efforts. “In the past, we didn’t go through the fact-finding and pinpoint solutions,” he says. And Beresford notes that the SEC is taking the virtually unprecedented step of doing some rulemaking of its own.

But skeptics still believe that its efforts will miss the mark, if only because it is so elusive. Eighty-one-year-old Abraham Briloff, professor emeritus at Baruch College, City University of New York, and a noted accounting gadfly, says the complexity of the issues that have given rise to recent accounting problems is unprecedented.

“Where did integrity get lost?” Briloff asks rhetorically. He answers his own question by suggesting that it may take a bear market to find it again.

———————————————– ——————————— A Rumble Over R&D?
Days before Securities and Exchange Commission chairman Arthur Levitt made a widely publicized speech on accounting irregularities, the SEC made examples of two high-profile companies, America Online and MCI WorldCom, that it felt were pushing the limits of acceptable accounting with write-offs for research-and-development efforts at acquired companies.

“Writing off in-process R&D is required in current accounting, but it leads to inflated profitability,” says Baruch Lev, a professor of accounting and finance at New York University.

Yet SEC scrutiny may already have had a chilling effect. A recent analysis by Robert Willens, an expert in acquisition accounting at Lehman Bros. Inc., found that the size of R&D write-offs, as a percentage of the total purchase price, had fallen during the past three years, from the 80-to-90-percent range to the 40-to-50-percent range.

The SEC is nonetheless committed to turning up the heat. In the wake of Levitt’s speech, the SEC’s chief accountant, Lynn Turner, called on the AICPA to provide members with better guidance on purchased R&D write-offs.

Turner, who specialized in high technology at Coopers & Lybrand and later was CFO of Symbios Inc., a manufacturer of semiconductors and storage systems in Fort Collins, Colorado, cited five cases in which “the facts appear at odds with the fair value assigned to the asset as part of the purchase-price allocation.” One company, he noted, based its R&D charge on forecasted revenues for a product not yet in development, while another took a write-off even though an appraiser questioned the very existence of the technology.

Turner also demanded stricter standards than the accountants had been using for estimating future revenues and cash flows from the purchased R&D and determining a fair value that should be written off. And he vowed that the SEC would require restatements if the value assigned to purchased R&D is deemed “materially misleading.” A working group organized by Robert Herz, a partner in PricewaterhouseCoopers LLP and the chair of the AICPA’s SEC Regulations Committee, is expected to develop clearer guidance for accountants in the next few months.

The rule was designed to put those that acquire R&D and those that spend internally on R&D on a level playing field. But experts say that acquirers need better guidance, especially now that they have seen the SEC go toe-to-toe with heavyweights like AOL and MCI WorldCom.

And some CFOs ardently defend the write-off. The finance chief at one high-tech company says he typically pays as much as 10 times revenue for companies with no earnings and an infant technology. He usually gets two appraisals of the future value of the R&D expenses, and writes off as much as 80 percent of the purchase price as an intangible asset. “For those of us who play in that space, it’s a very appropriate practice,” he says, noting that any effort to eliminate the standard would provoke a furious response.

The Financial Accounting Standards Board may try to steer around that by folding the issue into its long-running project on business combinations. One outcome that experts say is likely: the standards board would eliminate the R&D write-offs and pooling-of-interest transactions at the same time, and make purchase accounting more palatable by allowing acquirers to avoid the charge to earnings from amortizing goodwill.

———————————————– ——————————— By the Numbers

A rundown of the SEC’s nine-point plan of attack on accounting irregularities outlined by Chairman Levitt

(Chart omitted)

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