I cannot possibly cover the entire set of issues raised and all the
parties involved in this crisis in financial reporting. What I will
do instead is skip lightly around the territory, trying to touch upon
some prime morsels for our early evening consumption.
What do you call them?
A difficulty one faces very early in preparing remarks about the
crisis in financial reporting is what to call the problems of Enron,
WorldCom, Global Crossings, Homestore, Qwest, Xerox, Tyco, Adelphia,
and - let me just stop there. You might have noticed that I have already
used several descriptors: failures, fiascos, and debacles. I started
with debacle, as it is commonly used to describe Enron. Perhaps
because I have an undergraduate degree in accounting, I am often somewhat
cautious in my use of particular words, so I looked it up. According
to my online source,(1)
a debacle is "a sudden, disastrous collapse, downfall, or defeat;
a rout." The second definition of debacle is my favorite: "a
total, often ludicrous failure." A fiasco is "a
complete failure."
A failure is simply "a cessation of proper functioning or performance."
Whether the failures of financial reporting in Enron, WorldCom, etc.,
were "complete" as is required to label them fiascos, or
"sudden, disastrous collapses" as is required to label them
debacles, it seems there is little question that they were at least
failures. Clearly, there was a "cessation of proper functioning"
of at least one, and often more, of the components of the process
of financial reporting. But which one or ones failed? How did they
fail, and why did they fail?
Management
One component that seems to me to have ceased its proper functioning
in all of these failures is management. Call me old-fashioned, but
I thought the management of a public company has a fiduciary duty
to its shareholders. As I recall from my undergraduate class in business
law, a fiduciary duty is a pretty high standard. To be sure about
this (I got a B in business law), I again went to the dictionary.
What I found was revealing. A fiduciary is "one, such
as an agent of a principal or a company director, that stands in a
special relation of trust, confidence, or responsibility in certain
obligations to others."
There are two aspects of management's role in financial reporting
that I would like to focus on tonight. First, even before the recent
SEC requirement that executives "sign off" on their firms'
accounting, there has long been a statement of management responsibility
in financial reports. That statement said that the financial reports
were the responsibility of the company's management -- not its accountants,
or even its auditors -- its management. Enron's Form 10-K
for its fiscal year ended December 31, 2000 was signed by, among others,
Jeffrey K. Skilling, president and chief executive officer of Enron.
So my first point is that management bears the ultimate responsibility
for financial reports, and if those reports contain material errors
or omissions or are otherwise misleading, management must bear the
responsibility.
My second point is a bit more subtle. I recall Mr. Skilling, in his
testimony before Congress, defending himself by saying something like,
"I am not an accountant." Robert Friese, Attorney for Peter
Tafeen, former Homestore vice president for business development ,
said in defense of his client, "Mr. Tafeen was a businessman,
not an accountant."(2)
Mr. Skilling presided over the creation of, or perhaps was the architect
of, some of the numerous special purpose entities that Enron is alleged
to have used to cover its losses and hide its debts. Mr. Tafeen is
the Homestore vice president accused of inflating revenues using improper
"round-trip" transactions.
The "I am not an accountant" defense is based on the undoubtedly
truthful proposition that no one can know all the details of the generally
accepted accounting principles used by a large, complex business.
I resort to a similar defense when asked for tax advice by relatives
or acquaintances. "I am not a tax accountant," I say. I
go on to explain that I hire a CPA to do my taxes.
It is true that I sign my tax returns and I am ultimately responsible
for them. But reporting to the government for the purpose of determining
your tax bill and reporting to your shareholders are different things.
There is widespread acknowledgement that the tax laws form a set of
rules within which we are expected to do everything legal to minimize
our tax payments. Reports to your shareholders are supposed to provide
a basic progress report on your management stewardship.
Let me try this another way. One of the basic distinctions in accounting
is between income and capital transactions. We are interested in income
because we are interested in whether an entity produced value. The
basic idea of income is that it is an increase in the net assets of
an entity from sources other than ownership transactions with its
shareholders.
The purpose of a for-profit corporation is to earn income so that
its shareholders can earn a return on their investment. Surely, anyone
who is in charge of a for-profit organization has to know whether
the transactions he or she is creating are adding value for shareholders
or consuming shareholders' investments. "I am not an accountant"
is no defense for failing to understand whether you have created value
for shareholders.
Economic concepts and accounting conventions
Understanding whether value has been created goes beyond generally
accepted accounting principles. We all know that accounting income
measurement is imperfect when it comes to capturing additions to shareholder
value. But I think it is useful to dig a little deeper into the imperfections.
In fact, I think it is useful to go all the way back to the beginning.
What do financial reports do? They use economic concepts and
accounting conventions to accumulate and report financial information.
They do so in a rich institutional context. The economic concepts
contain our aspirations - what we are trying to measure. Economic concepts
guide our structuring and presentation of data. Take the balance sheet,
for example. We want to portray the entity's wealth at a point in time.
We frame the presentation in terms of listing its assets, then subtracting
its liabilities. Assets, liabilities, and equities are all economic
concepts. This fact is underscored by the recognition that our familiar
tool: Assets = Liabilities + Equities is in fact an identity.
It holds by definition. When teaching, I usually rewrite the fundamental
accounting identity as: Assets - Liabilities = Equities. This highlights
the fact that the accounting identity is really a definition of equity
as the difference between assets and liabilities.
The first step in applying this identity is to decide the entity
to which it refers. Whose assets and liabilities and equities are
we talking about? Mine? IBM's? Enron's? Chewco's?
The identity itself does not help us make this decision. The decision
about what entity is the focus of the identity's application is a
matter of convention. This is where generally accepted accounting
principles (GAAP) come in. GAAP are required if we are to apply economic
concepts to any practical situation.
The identity also does not help us decide where to draw the line
on what to include in it. What exactly are we going to count as assets
and what are we going to count as liabilities? For example, one balance
sheet that always balances is to define assets to always be equal
to zero and liabilities to be equal to zero. By definition, equity
will then be zero:
0 - 0 = 0
I could be perhaps even a step cleverer. I could define assets as
always equaling five and liabilities as always equaling three. By
definition, equity will be two:
5 - 3 = 2
While these definitions preserve the accounting identity (i.e., the
balance sheet balances), they are not very useful. GAAP come into
play here by providing recognition criteria that guide our
determination of when to count something. For assets, these criteria
begin by looking at whether an item has a future benefit that is owned
or controlled by the entity and that arose from a past transaction
or event. For liabilities, they begin by looking at whether an item
entails an obligation to make a probable future sacrifice of resources
by an entity as the result of a past transaction or event.
The economic concept of income is another example. Income (loss)
is the increase (decrease) in net assets arising from sources other
than raising resources from or returning them to owners. The first
step in determining whether to recognize income is to determine whether
net assets have increased or decreased. Therefore, the calculation
of income is tied to the recognition criteria for assets and liabilities.
A simple example
Now we are ready to examine a straightforward example that illustrates
some of the defects of accounting in capturing increases in shareholder
wealth. Suppose ABC Co. owns a building that originally cost $6 million
and on which it had recorded accumulated depreciation of $4 million.
So the book value of the building is $2 million. Now suppose ABC Co.
sells the building for $3 million.
From the point of view of the accounting records, the transaction
is clear. $3 million was received for an asset with a book value of
$2 million. Therefore, net assets have increased by $1 million, and
we will record a Gain on Sale of Building for $1 million.
But here is the key question: Did the sale of the building for $3
million actually increase the wealth of ABC's shareholders? Suppose
we discover that the building was really worth $10 million, and that
the chief financial officer of the company arranged to have it sold
to his wife for $3 million. Then this transaction actually was a theft
of shareholders' wealth, not an increment to it. The defect in the
accounting here is its failure to record the opportunity cost of selling
the building.
On the other hand, suppose $3 million was a fair price for the building.
Why did ABC's accounts report a gain? They did so because the book
value of the building was out-of-line with its market value at the
instant of the transaction. Many aspects of accounting have been pointed
to as causing this, from our beginning with historical cost, to our
algorithmic depreciation methods, to our failing to "mark-to-market"
for all assets. The bottom line is that the amount of the gain is
as much a correction of the book value as it is a signal that value
has been created for shareholders.
I do not think there is much confusion about this among senior executives,
or even freshly minted business school graduates. Nor do I think that
this simple example illustrates some basic flaw in the way we keep
accounts. We start out recording an asset at its cost because the
cost is the best estimate of value we have. As long as some firms
have economic assets that are not readily tradable in markets with
lots of buyers and sellers, complete mark-to-market adjustment will
not be available. Accounting methods for making adjustments, such
as depreciation algorithms and LIFO/FIFO inventory methods, will be
required.
As long as adjustment processes are imperfect, there are bound to
be times when differences arise between economic and book values.
The accounts will reflect "gains" and "losses"
when these differences are closed in a transaction, but these do not
translate directly into increases or decreases in shareholders' wealth.
For example, several years ago after interest rates had gone up sharply,
some companies retired their debt early and borrowed to do it. The
only thing this accomplished, except for enhancing the wealth of investment
bankers, was the reflection of a "gain" on the income statement.
The questionable nature of this gain is why gains on early retirement
of debt must be reported as extraordinary items on income statements.
Now I want to reconsider the "I am not an accountant" defense.
Is this really an admission that the effect on accounting income was
the criterion by which decisions were made? We got rid of that notion
in financial accounting research a long time ago when the functional
fixation hypothesis for equity markets was debunked. It seems to me
that the "I am not an accountant" defense is really a claim
of the functional fixation of management.
It does not seem credible to me that sophisticated people could confuse
the aspirations of accounting measurements and the practical results
of its conventions and techniques. There is a lot of evidence for
this claim. In the 1970s when many companies were switching from FIFO
to LIFO to economize on taxes, there were a great many people able
to explain why such a shift would add to shareholder wealth, even
though reported net income was going to be lower. For a more recent
example, every day it seems that some management is explaining that
income was low because of non-cash charges, and that shareholders
have not really lost as much as what is reported on the income statement.
It seems that no one has much trouble explaining why some charges
and losses are not so bad for shareholders. But for some reason, it
appears tougher to identify when gains have not really enhanced shareholders'
wealth.
Standards setters
We could go on talking about management all night, but let us move
on to talk about standards setters. I believe standards setters are
the products of their environment. This is particularly true with
the FASB because of its elaborate due process requirements. If the
rules are too detailed, it is because some interested party has a
desire for the details. If there are loopholes in the rules, it is
often because some interested party has the clout to keep them open.
In preparing my remarks, I read several of the previous Saxe Lectures.
Robert Swieringa discussed his term on the FASB in one of the 1996
lectures. A quote from his lecture illustrates my point:
"Another very frustrating standard was Statement
123 on stock-based compensation. …The development of other standards
has reflected political behavior. However, the focus of the stock-based
compensation project increasingly was on Washington as the project
progressed. People decided to go around the Board's due process."
(3)
You can tell that I am sympathetic to the plight of the standards
setters. I would like to highlight some of the difficulties they face
by going through a particular case that might be currently of interest:
special purpose entities.
Special purpose entities
Suppose Risky Corp is in the business of speculating on gold futures.
It wants to build for its own use an office building that costs $100,
and it wants to arrange financing to do so. One thing Risky Corp might
do is to approach Big Bank and ask for a loan.
In deciding on an appropriate interest rate, Big Bank must consider
the uncertainties involved in Risky Corp's business. Big Bank is likely
to seek a relatively steep interest rate from Risky Corp because speculating
in gold futures is a risky business.
Risky Corp would like to borrow money from Big Bank in a way that
shields Big Bank's loan from Risky Corp's general business risk. Shielding
the loan from Risky Corp's general business risk should allow Risky
Corp to get a lower interest rate on its loan. After all, Risky Corp
simply wants to construct and use an office building. It is not borrowing
the money to use in its speculation.
see larger image
One way Risky Corp could shield the loan from its general business
risk is to set up a special purpose entity, say Office Corp. Office
Corp would borrow the money from Big Bank, construct the office building,
and rent it to Risky Corp. A straightforward arrangement would be
to make Office Corp a wholly owned subsidiary of Risky Corp. As a
consequence, Risky Corp and Office Corp would be consolidated for
financial reporting purposes. The office building and the loan would
show up on the consolidated balance sheet. Depreciation on the office
building and the interest payments to Big Bank would be reflected
in the income statement.
see larger image
Now the real fun starts. If Office Corp was a completely separate
corporation from Risky Corp, Office Corp would not be consolidated
into Risky Corp. Neither the loan from Big Bank or the office building
would show up on Risky Corp's balance sheet. Risky Corp would show
rent payments on its income statement, but not depreciation on the
office building or interest payments to Big Bank.
see larger image
To establish Office Corp as a separate corporation, Risky Corp needs
to make sure that it does not own too much of Office Corp's stock.
Risky Corp needs to find some outside investors that will own Office
Corp. Of course, the holders of Office Corp equity will require a
return on their investment, but if the reduction in interest is very
large, Office Corp's shareholders can be paid some dividends and everyone
will win as a result: Risky Corp gets its office building, and finances
it more cheaply than it could have without setting up the special
purpose entity. Big Bank is happy because it has lowered the risk
on its loan. Office Corp's shareholders get a return on their investment.
So Risky Corp needs to find some outside equity holders to own Office
Corp. How much of a problem is that? Office Corp does not need equity
because it is going to borrow all the money to construct the office
building from Big Bank. It will have the building as collateral and
its lease with Risky Corp as a source of money from which it will
repay the loan. Therefore, Office Corp needs only a miniscule amount
of equity.
It seems a bit extreme to try to set up Office Corp with no equity
at all. But Risky Corp has incentives to make the amount of equity
as small as possible. You might imagine this dialogue between Risky
Corp's executives and its accountants. "How about $0.01 of equity
for Office Corp? Not enough to keep Office Corp from being consolidated
into Risky Corp? How about $0.02? Still not enough? Ok, you tell me,
how much equity is enough?"
Accountants and standards setters have only two choices. First, they
can refuse to answer the question of how much equity is enough. Second,
they can pick a number. Pre-Enron, that number was $3, now I believe
it is $10.
Refusing to answer does not seem feasible. After all, you would just
get this dialogue: "Let's go another way. How about $100 of equity?
That will do it? Then how about $99? That's ok, too? Then how about
$98?"
My point is that accounting standards setters have to answer the
question of how much equity is enough for a special purpose entity.
The answer will very likely be some level of equity, or at best a
rule for determining a cut-off level of equity. Once there is a cut-off
level or a rule for determining one, transactions' engineers will
take only a few days to learn how to bend, shave, and otherwise maneuver
around to get the results they want.
If the special purpose entity situation stopped here, it might not
create too many problems. But I have left out an important piece.
Suppose, in an attempt to further lower the interest rate on the loan
from Big Bank, Risky Corp offers to guarantee Office Corp's debt.
The guarantee might have a large or a small chance of coming into
play. It might get really difficult to tell whether Risky Corp has
much of a likelihood of having an obligation to Big Bank that we would
feel should be recorded as a liability on Risky Corp's books.
In the case of Enron, there were two more pieces. Enron set up special
purposes entities to hold all kinds of assets, not just buildings
it was constructing for its own use. Apparently, some of these "assets"
were Enron's own stock. Further, once a special purpose entity is
not consolidated into its creator, the creator can book revenues from
transactions with the special purpose entity.
Classification problems and principles-based standards
The difficulty presented by special purpose entities goes all the
way back to the first judgment we have to make in applying the accounting
identity: To what entity is the identity to be applied? Special purpose
entities complicate this judgment. In accountant-speak, they make
more difficult the choice of the proper level of consolidation.
This illustrates a basic difficulty faced by any accounting system.
It is hard to construct an understandable accounting system in which
Office Corp could be half-in and half-out of the proper consolidated
entity for Risky Corp. Just as it is hard to construct an understandable
accounting system where a particular financial instrument is half
debt and half equity. We make a useful accounting system by classifying
thousands of transactions and events into a finite set of bins and
aggregating them. An accounting system with fuzzy categories is not
likely to be as easily understood and useful as one with clearly defined
categories, whether the categories of interest are the entities, assets,
liabilities, equities, revenues, expenses, or extraordinary items.
If we are going to have categories, there have to be some rules for
determining what goes in them. Those rules could be either explicit
or implicit, and they could be either uniform or varied. Our approach
now is to try to make uniform, explicit rules. The proposal for principles-based
accounting would leave the rules implicit and subject them to varied
interpretation on a case-by-case basis. Without a substantial change
in current institutional arrangements in which management is responsible
for financial reports and auditors express an opinion on them, some
combination of management and auditors would have to make the decisions
about how to apply principles-based standards. Two issues arise here.
One is that their decisions are likely to vary across otherwise similar
circumstances. Second is that the demand for detailed rules and guidance(4)
in our current standards came from auditors and managers. I simply
do not understand how refusing to give guidance will work without
radical changes in the relations between clients and auditors and
in auditors' legal liability.
The accounting profession
I would be remiss in discussing the crisis in financial reporting
if I omitted the accounting profession. In the current environment,
I do not think the public will be keen on a proposed solution that
gives auditors more leeway in determining what goes into financial
reports. In a word, the credibility of the profession is shot. Executives
are the only ones with a worse problem, probably because auditors
have not as yet been implicated in some of their fiascos, such as
getting caught trying to evade sales taxes and insider trading.
There is only cold comfort, however, in the refuge of "misery
loves company." The profession must find proactive ways to recoup
its status. An important first step, I believe, was taken last September
4 by Barry Melancon, president and CEO of the AICPA, when he publicly
acknowledged the profession's role in creating some of its own problems.(5)
He outlined some steps the profession is taking to rebuild its image.
But it is a big job that will require an extended, concerted effort.
One of the difficulties the profession faces is that it has been
the focus of criticism for some time now. Judge Stanley Sporkin, in
the Saxe Lecture on September 22, 1993, had this to say:
"During the recent past, however, the profession
has not always lived up to its duties and responsibilities. …Because
of the growing list of substandard audits, the profession is slowly
losing its credibility…. We have seen too many recent instances
of flawed accounting reports that simply have been chalked up to
the overworked explanation that a certain amount of poor financial
reporting is inevitable." (6)
Judge Sporkin also quoted Abraham Briloff, who at the time was the
Emanuel Saxe Distinguished Professor Emeritus:
"We are not confronted with a liability crisis.
We are instead confronted with an identity crisis. We don't know
for what, to whom, and the when of our responsibility."
These criticisms have a new sting in light of the Andersen failure.
I had long been fond of Andersen. It was the firm that gave me summer
jobs when it knew I was going on to graduate school to become a professor.
I held, and still hold, in very high esteem two of my former undergraduate
professors, Elba (Bud) Baskin and G. Michael Crooch, who left academia
to work for Andersen. Through Mike Crooch, I came to know a little
about Andersen's Professional Standards Group. It always struck me
as a collection of the very best of the profession's highly talented,
hard-working, and honest members.
Revelations that the advice of the Professional Standards Group was
overruled in the Enron audit shocked me. I was further shocked by
Andersen's lack of, or failure to deploy quickly, an emergency response
team. I can only imagine that if GE caught wind of a major problem
involving accounting in one of its divisions, a "SWAT" team
would be dispatched immediately and those suspected would find their
keys no longer fit the locks to their offices. They would certainly
not be given access to documents that they could commence shredding.
I expect the new Public Company Accounting Oversight Board will assure
that the remaining Big Four have procedures in place to prevent such
things from happening in the future. I would like to see the Big Four
act now to fortify their emergency response procedures. I would like
to see them do it in a very public way, and I would like to see them
do it on their own, without waiting for the Public Company Accounting
Oversight Board to require it. This is very likely to be especially
important at a time when Andersen's former clients have been dispersed
to other firms.
I am confident that each of the Big Four are taking and have taken
steps to minimize the likelihood that it will be the next Andersen.
But their efforts have not received much attention from the financial
press or the world at large. I hope the profession steps up its efforts
to rebuild its image by proactively taking and publicizing strong
action. Because you cannot build credibility by being forced into
it, I believe the profession needs to respond ahead of requirements
that the Public Company Accounting Oversight Board is likely to impose.
Conclusion
If I have done nothing else in this lecture, I feel I have fulfilled
my promise in the introduction to skip lightly around the territory
of the crisis in financial reporting. I have touched on the role of
management, economic concepts and accounting conventions, the difficulties
faced by standards setters, and the accounting profession's credibility
problems. I left boards of directors and government regulators for
another day.
Whatever comes out of this crisis, and I do believe it is a crisis,
perhaps it has caused us to think a little more deeply about financial
reporting - about what makes it work, how valuable and important a
trustworthy system is, what its strengths and weaknesses are, and
how we may help fashion a culture that relies on its strengths without
taking advantage of its weaknesses. I believe that the system of financial
reporting has tremendous strengths that we often take for granted
and, unfortunately, have too often not defended rigorously enough,
both in academic circles and in practice.
Footnotes
(1) All dictionary
definition in this lecture are from The American Heritage Dictionary
of the English Language, 4th Edition, HoughtonMifflin Company,
2000, as reflected on Dictionary.com in October, 2002.
(2) Kirkpatrick, David
D., "From 'Piranha' At Homestore To Key Role In U.S. Inquiry,"
The New York Times, Friday, September 27, 2002, pages C1
and C3
(3) Robert Swieringa,
"FASB in My Rear View Mirror," The Saxe Lectures in
Accounting, April 22, 1996. Available at http://newman.baruch.cuny.edu/digital/saxe/saxe_1996/swieringa_96.htm
(4) Katherine Schipper
aptly laid out the issue of guidance in applying standards in a speech
before the American Accounting Association in Augst 2002.
(5) Barry Melancon,
"A New Accounting Culture," speech before the Yale School
of Management at the Yale Club of New York, September 4, 2002. Video
available online at http://www.aicpa.org/video/New
Culture/.
(6) Stanley Sporkin,
"The Time Has Come: A Call to the Accounting Profession to Join
the Fight Against Financial Fraud," The Saxe Lectures in
Accounting, September 22, 1993. Available at http://newman.baruch.cuny.edu/digital/saxe/saxe_1993/sporkin_93.htm
