Think of a Number

Accountancy used to be boring. If only it still were. From ''Capitalism and Its Troubles: A Survey of International Finance.''
Matthew BishopMay 24, 2002

All through the long equity bull market, it was considered bad form to say anything nasty about General Electric. The stockmarket suspended its usual dislike of conglomerates to make this one of the world’s most valuable firms, cheek-by-jowl with Microsoft. Jack Welch, its combative chief executive (now retired), was lionised by the business press. When the European Commission dared to block the company’s acquisition of Honeywell because of plausible antitrust concerns, policymakers in Washington, DC, muttered about a trade war on America.

So an article by the head of America’s biggest bond-fund manager, published in March, came as a shock. Bill Gross, of PIMCO, argued that GE’s management had “not been totally forthcoming” about how its profits had managed to grow at “nearly 15% per year for several decades”. He noted that the firm had lots of debt, giving it “near hedge-fund leverage”. Without this leverage, its operations resemble “the failed conglomerates of yesteryear”. None of this information was exactly new. The days when GE’s accounts were taught at business schools as examples of conservative best practice were long gone. Mr Welch, it had become clear, liked to “smooth earnings” to deliver remarkably steady growth quarter after quarter, year after year.

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What was new was that Enron, which had appeared to be a highly profitable company until recently, had gone into bankruptcy after it was discovered to have cooked its books. The reason why GE’s shares have fallen sharply in recent months is that investors have rumbled that, to a greater or lesser extent, much of corporate America has been fiddling its accounts, and GE is a prime suspect. Nor are American companies alone in this: other countries’ accounting rules too offer plenty of opportunity for manipulation. After the Enron debacle, scores of companies with “accounting issues”, especially those that smoothed their earnings, have seen their shares tumble. Investors used to reward firms that showed steady profit growth because they disliked volatility. Now they think smooth means fake, and are demanding the truth.

Back in the 1950s, companies prided themselves on the conservatism of their accounting. What changed their mind? One factor was the rise of inflation, which widened the gap between a company’s book value on its balance sheet and its market value. Companies could book a profit simply by selling an asset at the higher current price and pocketing the difference over what they had paid for it. A second factor was the emergence of new sorts of assets and liabilities, says Baruch Lev, an accounting professor at New York University’s Stern School. A third was the evolution of the modern firm and the blurring of corporate boundaries. Joint ventures, leasing and special-purpose entities all made it harder to determine whether a particular activity should be consolidated into a company’s accounts.

The growing use of derivatives and off-balance-sheet financing and the rising importance of intangible assets such as brands and goodwill have all posed challenges to traditional accounting, none of which has been resolved entirely satisfactorily. And serious distortions have been introduced because share options awarded to employees, clearly an employment cost, are not charged against profits. In America, the Fed reckons that this has caused profits to be overstated by an average of 2.5 percentage points a year over the past five years.

There has also been a growing trend to take huge write-offs, and then announce pro-forma profits that supposedly reflect the firm’s normal business activities. AOL Time Warner recently wrote off $60 billion related to acquisitions it overpaid for. JDS Uniphase has written off $51 billion in goodwill and intangibles.

This can be helpful in several ways. First, if a write-off turns out to have been too large — which may have been the intention all along — some of it can be reimbursed later, directly adding to profits. Second, the firm can pick more or less whatever number it wants for its pro-forma profits. Ostensibly, these are the profits generated by normal business operations, ignoring non-recurring items such as write-offs. In the first three quarters of 2001 the 100 biggest Nasdaq firms reported pro-forma earnings of $20 billion. For the same period, they reported losses under America’s Generally Accepted Accounting Principles (GAAP) of $82 billion.

It All Depends

Over the years, accounting-standard-setters responded to these changes in the business environment at different speeds and in somewhat different ways. America’s GAAP, produced by the Financial Accounting Standards Board (FASB), tends to involve minutely detailed rules, spelling out precisely how a specific item is to be treated. By contrast, Britain’s Accounting Standards Board, and latterly the International Accounting Standards Board, have tended to set out broader principles, leaving it to the accountants to work out how these apply to a particular item. America’s approach has fostered “a technical, legal mindset that is sometimes more concerned with the form rather than the substance of what is reported”, in the words of Joseph Berardino, until recently boss of Andersen, Enron’s auditor until it went bust. America’s litigious environment reinforces this emphasis on playing by the rule book and not questioning whether the rules actually provide useful information.

In Britain, some accountants feel that their country’s broader, less pedantic approach would have prevented an Enron-like disaster. They also point out that Britain has much tougher rules than America to limit the creation of off-balance-sheet special-purpose entities. But Sir David Tweedie, chairman of the International Accounting Standards Board and former head of Britain’s Accounting Standards Board, is sceptical. “History is full of people who said ‘it couldn’t happen here’ and came to regret it,” he says about Enron. “I do not plan to repeat that mistake.”

For all their differences, accounting rules everywhere have become much more complex as rule-makers have responded to changes within firms and have tried to close loopholes. Martin Whitman of Third Avenue Funds, a veteran investor, agrees that today’s accounting is complex. But he blames this on the desire of accounting-standards-setters to meet the needs of the average investor — who tends to be obsessed with getting one “true” number, such as quarterly profits or cashflow per share from normal operations. Enron catered for that obsession, writing in its annual report that it was “laser-focused on earnings-per-share growth”. This Mr Whitman regards as folly: “GAAP can never produce a statement of true earnings.” He wants accounting to pursue a simpler goal, full disclosure, by providing plenty of useful information — “not truth” — so that trained analysts can judge the financial health of a firm for themselves. Deciding what the numbers in the accounts mean should be up to the users, not those who prepare them.

According to Mr Whitman, even with today’s complexity, company accounts will tell seasoned analysts most of what they need to know. This may have been true even of Enron, if only people had cared to look. In a recent article, “Did Enron’s Investors Fool Themselves?”, Chris Higson of London Business School argues that the information in the firm’s published accounts should have set warning bells ringing long before the share price started falling. In particular, its operating return on capital and its return on equity declined sharply during 1996-2000, falling below the economic cost of capital. In other words, the publicly available data showed that the company was operating at a loss, says Mr Higson.

Jack Ciesielski of the Analyst’s Accounting Observer, a suddenly much-followed journal, agrees. He sees “a crisis on the user side of accounting too. There is a ton of good disclosure out there that nobody is getting excited about.” Disclosure in Enron’s books was incomplete, but there were plenty of footnotes that should have given analysts “a knot in the stomach”.

Hidden Meanings

None of this is to say there is no need for reform. “Accounting is being asked to do something it was never meant to do,” says Robert Merton at Harvard Business School. “It is like a road system built for when cars did 30mph being used by cars doing 60 — and then we wonder why there are accidents.” In particular, accounts simply provide a snapshot of a company that gives no indication of the firm’s exposures to different sorts of risk in the future.

The concern is not just about the derivatives and other financial engineering that firms increasingly use. Even the treatment of, say, the assets and liabilities of a company’s defined-benefit pension fund can be hugely misleading. Assume the pension fund has assets with a current market value of $100 billion. If the assets consisted entirely of shares, the fund would be much riskier than if they were all Treasury bonds. Yet the accounts would simply record the $100 billion, offering no clue about the level of risk.

This matters, because the assets of a defined-benefit fund are used as collateral to ensure there is enough money to pay pensioners. The collateral would be needed only if the firm did not have enough money to meet its legal obligation to deliver on its pension commitments. That is more likely to happen during an economic downturn, which might well coincide with low share valuations. Thus, if the pension-fund assets were in shares — especially the firm’s own shares — the collateral would be at its least valuable just when it was needed most.

A typical balance sheet is full of such oddities. Mr Merton’s solution is for companies to include something similar to the banks’ value-at-risk (VAR) measures in their accounts, which would make investors aware of the potential for big shifts in a firm’s net assets. Certainly, VAR is not perfect even for banks because the models often ignore the possibility of a truly bad day. It may be even less perfect for assessing the risk in corporate balance sheets because it is hard to gauge the value and potential price volatility of assets that are rarely or never traded. Yet for all its flaws, it is “a damn sight better than what we have now in the corporate sector,” says Mr Merton, who lived at close quarters with VAR during the crisis that brought down the hedge fund he co-founded, Long-Term Capital Management, and is adamant it was not to blame.

Number-Crunch Time

Immediately after Enron went bust, hopes were high that America would become disenchanted with GAAP and abandon its opposition to adopting the International Accounting Standards (IAS), opening the way to a single, worldwide set of accounting standards. This may happen eventually. But in the short term, the Americans are likely to resist the IAS and instead try to improve GAAP. At the same time the IAS — which currently are not quite as good as GAAP — will also be upgraded. These reforms may move in a similar direction. The incoming boss of FASB has served on the IASB, and the two bodies are likely to pursue a covert strategy of convergence on a common set of standards.

The IASB was reformed last year to make it less vulnerable to political pressures. It seems likely, therefore, that the reform of the IAS will proceed faster than that of GAAP, and that the IAS will, sooner rather than later, become superior to their American cousins. For instance, they will require the cost of share options to be charged against profits, which politics will probably prevent GAAP from doing. At that point, however, market forces will put huge pressure on America to upgrade GAAP to match the IAS, to avoid the risk of its firms and markets becoming uncompetitive internationally.

Already, Harvey Pitt, chairman of the SEC, has made it clear to the FASB that he expects it to do a better job, and has asked it to adopt tougher rules on off-balance-sheet special-purpose entities. The likely effect of this is that many of these entities will be reconsolidated on to balance sheets, particularly in the banking sector. Mr Pitt also wants firms to try harder to bring relevant information to the market at the earliest opportunity. He wants to go further than regulation “fair disclosure”, introduced by his predecessor, Arthur Levitt, which required firms to release material information to small punters at the same time as to professional investors. Mr Pitt wants firms to have a positive obligation to disclose. He also wants them to use plain English in describing their circumstances and prospects. This is wholly at odds with current practice.

Moreover, Mr Pitt has asked firms to spell out the main assumptions on which their accounts are based, and to state what the results would have looked like on a different set of assumptions. This is a small but welcome step in Mr Merton’s direction, giving investors a better sense of the sorts of risks to which a firm is exposed. However, this sort of information is more likely to appeal to professional analysts than to small-time investors, who will continue to search for the single, simple truth about corporate profits. In reality, there is no such thing. Managers will always have a measure of discretion over the way they present their figures.

That said, there is nothing in the present rules to stop managers from giving an accurate account of their company. But do they have the will, and are there enough incentives? It would certainly help if the market rewarded companies that provide full disclosure. Equally helpful would be good corporate governance. But that is another story.

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