Credible Accounting Is the New Essential
The current rage on Wall Street over accounting and the quality of corporate earnings is a little like a hangover victim swearing never to touch another drop. Big investors have known for years that company accounts have been mildly or even seriously fictional. And yet that made little difference in their investment decisions.
But clear and credible accounting is making a difference now, in the wake of Enron’s collapse amid disclosures of hidden debts and overstated profit.
Investors this week dumped stocks of companies deemed guilty of obscure accounting or understating liabilities in their financial reports.
And those investor reactions already are forcing changes in corporate reporting and in the accounting profession. Some of these changes:
* Companies will have to end or severely limit their use of off-balance-sheet partnerships that hold debt or assets away from their reports to shareholders and the Securities and Exchange Commission. Enron had used such partnerships extensively to make its financial situation look better than it actually was.
* Accounting firms will get new regulation, and they will have to separate auditing of company books from other services to clients, such as management and information technology consulting.
* Companies generally will have to bolster their credibility by fully explaining all profits and losses, assets and liabilities. They will have to stop using loosely defined “operating income” in presentations to investment analysts, who themselves are coming in for fresh scrutiny by the SEC.
The rising trend is regulation of financial reporting. The Financial Accounting Standards Board, the corporate world’s rule-making body, said Thursday that it planned to change the rule on special partnerships of the kind that allowed Enron to effectively place debt off its balance sheet. The board is working with the SEC to tighten rules on disclosure of debts and contingent liabilities.
That reform is part of a general coming-clean by companies that saw their stocks clobbered this week. The stock of Williams Cos., a natural gas pipeline and producing firm, fell an additional 2% on Thursday to $17.68 a share. It is down 27% from Tuesday, when the company told shareholders of a potential $2-billion liability from debts it had guaranteed for a subsidiary last year but failed to tell investors about previously.
Cendant Corp., owner of Avis rental cars and Days Inn hotels, said Thursday that it was putting on its Web site information about off-balance-sheet ventures previously undisclosed to shareholders. Investors this week had driven Cendant stock down 10% before the announcement. They promptly sent it back up 6% to $17.48 a share.
Accounting firms were eager to burnish their images. Samuel DiPiazza Jr., chief executive of PricewaterhouseCoopers, the largest accountancy firm, said he welcomed regulation of his industry by an oversight committee that will be set after a suggestion from SEC Chairman Harvey L. Pitt.
DiPiazza was not merely being diplomatic in welcoming regulation. Accountants, who are being criticized these days, say the corporate customer frequently has as much to do with poor accounting as the auditor. A national, government-sanctioned oversight body could strengthen the auditor’s hand in disputes with company managements.
An expert watchdog of corporate accounting, Howard Schilit of the Center for Financial Research & Analysis in Rockville, Md., says, “Firmness and strength in the accounting firms’ head offices is necessary to clean up these trends in corporate reporting.”
DiPiazza also announced that his firm would spin off its consulting division as a separate company to dispel the appearance of a conflict of interest.
“We believe the perception of conflict of interest is something we must deal with,” DiPiazza said.
Doubts about the quality of corporate earnings are not new. But the 1990s boom made matters worse, says Srinivas Thiruvadanthai, a researcher at the Jerome Levy Economists Institute at Bard College outside New York City.
The institute, founded in the 1930s by an economist who believed that corporate profits drove the U.S. economy, issued a study last fall estimating that U.S. company earnings have been overstated by 20% in recent years and by more than 10% for decades. The study received attention from the institute’s investment company clients, Thiruvadanthai says, but not because the findings were new.
“We told our investment clients about overstated earnings for years. They told us in past years that even if they paid attention, stocks of the companies kept going up. But now it is different since Enron.”
One abuse the Levy study focused on was the increased use by companies of “operating earnings” as a guide for investment analysts. Firms would instruct investment markets to judge them by earnings before many costs such as interest, taxes, depreciation and amortization, or EBITDA. That would help stock market valuations, the study reported.
“But then firms would come back later with write-offs because of greater depreciation or other business events and cast doubt on the whole earnings picture.”
While the bull market was raging, such subtleties of accounting were mere technicalities to investors. But with stock prices and the economy struggling and Enron casting shadows of doubt on all corporate behavior, clear and credible accounting has become the new essential for any company looking for support from investors.
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James Flanigan can be reached at jim.flanigan@latimes.com.
