January 23, 2002  






Heard on the Street

Many Accounting Practices

Are Difficult to Penetrate








Just 30 years ago, the rules governing corporate accounting filled only two volumes and could fit in a briefcase. Since then, the standards have multiplied so rapidly that it takes a bookcase shelf -- a long one -- to hold all the volumes.


As the collapse of Enron has made painfully clear, the complexity of corporate accounting has grown exponentially. What were once simple and objective concepts, like sales and earnings, in many cases have become complicated and subjective.


Add the fact that many companies disclose as little as possible, and the financial reports of an increasing number of companies have become impenetrable and confusing. This is true not just for investors, but for Wall Street analysts, corporate executives with master's degrees in business administration and, sometimes, even the outside auditors reviewing a company's books.


The result has been a rise in so-called black-box accounting: financial statements, like Enron's, that are so obscure that their darkness survives the light of day. Even after disclosure, the numbers that some companies report are based on accounting methodologies so complex, involving such a high degree of guesswork, that it can't easily be determined precisely how they were arrived at. Hard to understand doesn't necessarily mean inaccurate or illegal, of course. But, some companies take advantage of often-loose accounting rules to massage their numbers to make their results look better.


The bottom line: There is a lot more open to interpretation when it comes to the bottom line.


In a number of cases, there is too much interpretation. The number of accounting restatements -- in which companies have had to change, usually lower, their previously reported sales or earnings -- averaged 49 annually between 1990 and 1997, according to Financial Executives International. The number ballooned to 91 in 1998 and to 156 in 2000, as companies found they had wrongly accounted for revenue, inventory valuations, bad-debt allowances and income taxes. In many cases, the restatements sent the stocks plummeting, with losses to investors measured in the tens of billions of dollars in recent years.


"The way business is conducted always seems to outstrip the ability of accounting to keep up," says Robert Willens, accounting analyst at Lehman Brothers in New York. Investors buying shares in these companies can't be sure of what they are getting, noted Al Harrison, vice chairman of Alliance Capital Management LP, a big money-management company, at a meeting with reporters last month. "To some degree, they become 'faith' stocks," he said. Alliance was the biggest holder of Enron shares last fall.


In the wake of the Enron collapse, investors are likely to scrutinize even more closely the books of companies they find hard to understand, such as Williams, International Business Machines, Coca-Cola, General Electric and American International Group.


Why has corporate accounting become so difficult to understand? In large part because corporations, and what they do, have become more complex.


The accounting system initially was designed to measure the profit and loss of a manufacturing company. Figuring out the cost of producing a hammer or an automobile, and the revenue from selling them, was relatively easy. But determining the same figures for a service, or for a product like computer software, can involve a lot more variables open to interpretation.


Moreover, growing competition, globalization, deregulation and financial engineering all have made the nature of what companies do more complicated, says Baruch Lev, accounting and finance professor at New York University.


As a result of competition, companies have evolved ever-more-complex ways to limit risk, Mr. Lev says. A venture into foreign markets creates a need for a company to use derivatives, financial instruments that hedge investments or serve as credit guarantees. Many companies have turned to off-the-books partnerships to insulate themselves from risks and share costs of expansion. Pressure to develop new technologies, drugs and other products drives companies into ventures with rivals that limit exposure.


This is where the accounting has a hard time keeping up -- and keeping track of what is going on financially inside a giant, multifaceted multinational. Accounting rules designed for a company that makes simple products can end up being inadequate to portray a concern like Enron, which in many ways exists as the focal point of a series of contracts -- contracts to trade broadband capacity, electricity and natural gas, and contracts to invest in other technology start-ups.


Accounting standards that deal with recording the value of derivatives run several hundred pages. Philip Livingston, president of Financial Executives International, a professional group, called the new rules for derivatives "a monstrosity of accounting standards that nobody understands," including accountants and chief financial officers.


"The boundaries of corporations are becoming increasingly blurred," says Mr. Lev. "It's very well defined legally what is inside the corporation but ... we must restructure accounting so the primary entity will be the economic one, not the legal one."


To be sure, figuring out corporate finance has always been challenging, because a company is only required to reveal certain data. But where once the risk for outside investors was making sure they weren't missing any important numbers, the new problem is for investors to figure out how accurately the numbers reflect a company's business.


Because of the leeway in current accounting rules, two companies in the same industry that perform identical transactions can report different numbers. Take the way companies can account for research-and-development costs. One company could spread the costs out over 10 years, while another might spread the same costs over five years. Both methods would be allowable and defensible, but the longer time frame would tend to result in higher earnings because it reduces expenses allocated annually.


Another area that allows companies freedom to determine what results they report is in the accounting for intangible assets, such as the value placed on goodwill, or the amount paid for an asset above its book value. At best, the values placed on these items as recorded on company balance sheets are educated guesses. But they represent an increasing part of total assets. Looking at 5,300 publicly traded companies, Multex.com, a research concern, found that their intangible assets have grown to about 9% of total assets, from about 4% five years ago.


Companies and their accountants can decide how to value an intangible asset, and how that value changes from quarter to quarter. While there are tests to determine the change in value, in practice it is difficult for outside investors to understand how the figures were arrived at or to challenge the changes, which can affect earnings.


Further complicating matters for investors, many companies have taken to providing pro forma earnings that, among other things, often show profits and losses without these changes in intangible values. The result has been virtually a new accounting system without any set rules, in which companies have been free to show their performance any way they deem fit.


Finally, add to the equation the increasing importance of a rising stock price, and investors face an unprecedented incentive on the part of companies to obfuscate. No longer is a higher stock price simply desirable, it is often essential, because stocks have become a vital way for companies to run their businesses. The growing use of stock options as a way of compensating employees means managers need higher stock prices to retain talent. The use of stock to make acquisitions and to guarantee the debt of off-the-books partnerships means, as with Enron, that the entire partnership edifice can come crashing down with the fall of the underlying stock that props up the system.


And the growing use of the stock market as a place for companies to raise capital means a high stock price can be the difference between failure and success.


Hence, companies have an incentive to use aggressive -- but, under the rules, acceptable -- accounting to boost their reported earnings and prop up their stock price. In the worst-case scenario, that means some companies put out misleading financial accounts. "The argument that honesty is the best policy does not work in such markets, since firms would not be around in the future to reap the benefits of their honesty," wrote Harvard University professors Andre Shleifer and Gene D'Avolio, along with Efi Gildor of Gildor Trading, in a research paper last year.


Write to Steve Liesman at steve.liesman@wsj.com





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