Accounting: No Voodoo, Just the Facts

Wednesday, March 29, 2006
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There are a legion of stories of the demise of accounting in corporate America running around out there–loose and undaunted, and perhaps somewhat exaggerated. As one corporate accounting bungle after another makes its way to the top of the headlines, they report on them as if detailing out a home brewing recipe. Accounting snafus are not always as simple as their layman’s understanding would have it. One thing that laymen–including economists and business journalists and wannabee critics–don’t understand is accounting. Unless, of course, they’ve had prior experience. For only accountants who have actually done accounting essentially understand accounting.

Quite recently, GM again announced an earnings restatement, and the eager press, all-too-anxious to jump on the “oh no, another restatement!” bandwagon, do so without ever understanding what a restatement really is. I read several stories that told the layman nothing about what is actually happening.

A restatement is a revision of a previous financial statement. It is an acknowledgement of error in the recording of accounting transactions, whether the transactions are misrepresentative because of fraud or error.

One decent write-up comes from the business page of the International Herald Tribune.

There was a time when General Motors was seen as the paragon of financial quality. Its bonds were rated triple-A, and it was known for the most conservative accounting. Let other companies use liberal accounting rules to make results look better. GM did not need such things.

The announcement late Thursday that General Motors would revise profit figures for every year of this decade, and would have to restate the 2005 earnings it had already reported, shows how far the icon has fallen. Less than a year after it lost its investment-grade bond rating, its bonds are viewed as middling even among junk bonds.

“You have to question what controls are in place,” said Charles Mulford, an accounting professor at Georgia Tech. “When companies like GM are profitable, there is not a need to engage in aggressive accounting,” he added. “What we are seeing now is a pattern of very aggressive accounting that took them well beyond the limits of generally accepted accounting principles.”

GM, among its myriad problems, is having issues with some supplier discounts that it took before they were earned, leaving them with deferred credits instead of that which they claimed as having been earned; reductions to income that were instead taken as a reduction to shareholders’ equity; and misrepresentation of cash flows, where perhaps some positive cash flow in the “investing” category may have showed up as “operating” cash flows, making the company look more healthy cash-wise.

What’s the reason for this? Is it all purely in error? Of course, the bulk of such problems are due to the fact that publicly-held companies are living quarter-to-quarter in an effort to keep the eyes on Wall Street in their favor, and to keep the executive bonus programs on the radar map–programs that are oftentimes the result of regulatory/tax avoidance and/or minimization. Should quarterly earnings not keep pace with analysts’ expectations or within executive bonus boundaries, disaster looms, and corporate heads get fired. The expectations and mindset inherent with short-term thinking is such that time preferences are severely distorted, turning the tables from long-term stabilization and growth for steady earnings power to short-term profit grabs and/or calculated financial statements that brandish exactly what the execs want others to see. Creative accounting, as some call it.

Another issue in the workplace is the awful state of education and thus the lack of skillsets in corporate finance. MBAs and not CPAs are dominating the finance environment. Some companies that have been subjected to restatements have taken a stance on training and skills, and are retaining CPAs with proven track records–and only CPAs–at the top corporate levels to do the tough accounting work and research.

Corporate politics also play a role, as premium jobs are given to non-threatening kinsmen, political favorites, long-term hangers-on, and those who are known to attach their lips to the behinds of others so skillfully that surgical removal becomes necessary. It’s all a part of the human experience, and it is what it is. But now, with accounting snafus hanging out to dry like stained undergarments on a neighbor’s clothesline, it’s time for the profession to put its house in order before accountants become less trusted than, God forbid, lawyers.

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