Is value reporting for real?

Review of Business, Spring, 2003 by Teresa M. Cortese-Danile, Irene N. McCarthy

The Accounting profession is undergoing very trying times. The actions of a few have transformed it from one of the most highly respected professions to one that is now far less valued. The authors recount recent events which have served to discredit the profession. They examine current legislative reaction to these events, and provide an analysis of what can be done to regain Accounting's status.

Introduction

The rash of recent accounting-related indiscretions has left the profession tarnished. Not long ago, the accounting profession was among the most admired. What must accountants do to regain the trust they once enjoyed? The mistakes of the past must not be repeated. Indeed, fundamental changes are needed. The Government will certainly be an intervening factor, and its influence is now inevitable.

Some would say that misleading practices contributed to the hyper growth of the stock market during the 1990's. (1) What actually happened is that the grand expectations of the stock market put great pressure on management to continuously outperform from year to year. Companies routinely presented analysts with 15% growth annually. "Making the numbers" depended on it. With such a mindset, it's no wonder that management was compelled to manipulate the numbers. There is tremendous pressure to find creative ways to inflate revenue when a salary bonus depends on making or exceeding a number. Consequently, the auditor invariably gets swept in the wave of reporting mayhem. Unequivocally, management is the first line of defense against fraud. A strong system of internal control serves to minimize fraud. However, no system of internal control, no matter how strong, will guard against fraud in the event of collusion. Indeed, when management engages in misconception and deceit, it makes the financial information repor ted that much less reliable. Accountants have been under a great deal of pressure to placate the client and find ways to work with existing rules to the client's advantage.

Many questionable transactions have surfaced in the recent past The SEC recently led an inquiry into Global Crossing and Qwest Communications International Inc. for swapping fiber optic capacity to increase revenue. A probe into Lucent Technologies examined the role that vendor financing played in its sales. There was also an examination of three Internet firms that booked revenue from wire transfers among themselves which were supposedly payments for services. Lawyers familiar with the transactions say that in at least some cases, there were no services rendered at all. (2)

Enron and its Associates Used Questionable Accounting Practices

Clearly, there have been cases where management knowingly deceived the auditors. Then there seem to be other instances where the accounting treatment envelope was pushed just a bit too far. In the case of Enron, David B. Duncan, the former Andersen partner in charge of the Enron audit who was the government's chief witness in the trial against Arthur Andersen, stood behind the decisions that resulted in the widespread use of off-balance sheet financing in the reporting of certain partnership transactions. (3) Certainly he carried out the breadth of the related accounting pronouncements to the extent allowable. Off-balance sheet financing is a technique generally used by companies entering into a joint venture whereby both invest in a project Monies borrowed to get the venture up and running appear on the newly formed entity's books. This is a strategy sanctioned by accounting pronouncements so long as proper disclosures are made.

Mr. Duncan, however, appeared to have been duped by a situation where management went above and beyond what was allowable. He testified that he had been deceived by Enron officials on at least two matters. The first of these was the company's use of what investigators have called a "side agreement" in the establishment of a partnership known as Chewco. If that agreement had been known to auditors, the accounting treatment of the partnership would have changed, according to Mr. Duncan. The result would have been a dramatic difference in the picture presented by Enron's reported financial statements. Mother situation involved a partnership called Southampton Place. A group of Enron insiders, including its former CFO, Andrew S. Fastow, used it to turn a profit of millions of dollars through an investment in a transaction involving the company. None of those executives were authorized by the company to make the investment, according to a report of the special committee of Enron's Board, and Mr. Duncan testified t hat he and Andersen were never told about it. (4)

Enron was not alone. Its saga was amazingly intertwined with Global Crossing. According to executives and traders involved in the transaction, these two companies used a complex deal brokered by a third party, Reliant Resources, to sidestep accounting rules. Their March 2001 transaction was designed to help Global Crossing disguise a $17 million loan from Enron and allow each company to book revenue. The transaction helped camouflage what was essentially an exchange of long-term services. It started out as a 1998 deal to swap fiber optic circuits and services in a non-cash transaction. The companies planned to renegotiate the deal in late 2000 in order to disguise a loan and help each side book a third quarter profit Under the deal, Enron would prepay Global Crossing about $17 million for long term access to a fiber optic network. Global Crossing would, in turn, purchase network services from Enron for about the same value but make monthly payments over about 8 years. A former Enron executive said that Global Crossing wanted cash EBIDA (earnings before interest, taxes, depreciation and amortization), which is a measure of cash flow, and Wall Street was looking for that at that time. In order for the two companies to book profits on the deal, they would need to make the swap appear to be two separate deals with an independent party, and not a loan. Em-on would sell to the broker, which would then sell to Global Crossing, and then Global Crossing would sell back other services to the broker and then on to Em-on. This kind of "sleaving" was done all the time. When the deal was completed, the loan was not expected to appear on Global Crossing's balance sheet since it had been structured as part of a fiber optic transaction. In order to pay Reliant for its role in brokering the deal, Em-on began engaging in numerous losing broadband trades with Reliant One trader involved in the deal said the end result was earnings for Global Crossing. It was earnings management, and that is what the brokers were selling--earnings ma nagement According to a former Em-on executive, the goal was to try to show profit and revenue growth since everyone was on the "Wall Street treadmill" over-reporting their numbers. (5)