Ambiguity, ethics, and the bottom line - accounting

Business Horizons, May-June, 1989 by James R. Davis

Another common practice is for a company having a bad year to write off everything possible-to take a "bath." The most infamous period for this practice was the last quarter of 1985, when numerous companies chose to take a "bath" for their poor investments of prior years. Avon shocked many investors when it wrote off $223 million, but it still had to take a backseat to Sohio, where write-offs totaled $1.15 billion. Such activities have been appropriately labeled "Rumpelstiltskin accounting" because they allow management to decide when they want to face the music. This means that the pretax earnings of prior years were probably overstated or, at the very least, unreliable. Most write-offs and writedowns are taken in later fiscal years, thereby creating doubt as to whether any financial reports are accurate.

Write-offs and write-downs on a regular basis, however, are not popular because they make management look as if they are rather careless with shareholder interests. But the fact is that management was careless when they initially made the bad investment. Therein lies the real danger of taking a "bath": it makes wrongdoings appear virtuous and bad judgment appear praiseworthy by glossing over managerial errors.

GAMES MANAGEMENTS PLAY

Note how corporate managements search for ways to rationalize losses as extraordinary, or at least nonrecurring, thereby avoiding their negative effect on the bottom line. As a corollary, the same managements seek to attribute the pluses to the current operating cycle-thereby sweetening the message to shareholders (Briloff 1972, p. 50).

It has been over 15 years since Abraham Briloff made this criticism, and unfortunately it is still true today. The corporate game plan is, of course, to maintain a steadily rising earnings-per-share number that will stimulate demand for shares, raise the stock price, and create a favorable atmosphere for issuing additional equity. Most businesses attempt to report their income as fairly as possible while still meeting the requirements of this game plan, taking advantage of any gaps in reporting standards that would allow management to present even a slightly better picture.

When the stock market is on an upswing, the offensive game plan calls for tactics such as deferral of research and development costs, stretched-out depreciation, and pooling of interests. In essence, companies search for the accounting methods that best suit the game plan. This results in a patchwork of accounting methodology that adheres to particular, and often conflicting, viewpoints while objectivity falls by the wayside, Misrepresentation results. An example is Sears, Roebuck & Co.'s income statement of 1984, Thanks to one-time benefits such as property sales and tax credits, as well as some rather large, somewhat vague "other" categories, Sears reported earnings per share of $4.01. Without these items, however, profits would have been considerably reduced, lowering real earnings to $2.41 per share. Sears' chief financial officer insists that the so-called one-time benefits are actually recurring gains, a claim he would no doubt reverse if the gains were losses, as the above quote by Briloff suggests.