Accountants Can’t Keep Up With Financial Complexity

When Timothy S. Lucas began his career as a rule maker for the accounting industry, there were 33 rules and the nation’s accounting standards fit on 342 pages.

Lucas, now the research chief at the Financial Accounting Standards Board, has watched an explosion in rule making and complexity. The board is up to rule 144 and has 12,000 pages of standards, pronouncements and bulletins.

The exponential growth in accounting rules--giving the nation’s bean counters an assignment equal to reading Leo Tolstoy’s “War and Peace” 17 times, has saddled U.S. businesses with audit costs that can run into tens of millions of dollars.

Despite the growing range and sophistication of the rules, they have failed to keep up with the evolution of the U.S. economy and with changes in the financial structure of American business, experts say. In addition, the pressure on corporations to report consistent and predictable profit growth has exacerbated the distortions in accounting.

Auditors face simultaneous risks of losing lucrative clients if they reject their books and lawsuits by investors if they approve suspect deals. Even major players within the industry said this has given rise to a culture in which auditors avoid examining the substance of financial transactions to determine whether they are reported accurately. Instead, they engage in a process known as “check off” auditing in which they make sure no regulation prohibits a transaction.

“The tendency is that the more complex the standards are, the more time you spend making sure you are technically in compliance,” Lucas said. “In some cases, the objective of financial reporting is lost.”

This complexity often makes it impossible for the average investor, and occasionally even Wall Street analysts, to figure out what’s going on at a company. And when companies provide information, the disclosures often are couched in legal and technical terms that only finance experts can decipher.

For example, in an annual report to the Securities and Exchange Commission, Inktomi Corp., a Foster City, Calif.-based technology company, said:

“In June 2000, we entered into a synthetic lease agreement for the land and facilities of our corporate headquarters. Immediately prior to the closing, the agreement was assigned to a third-party lessor under the terms of a lease finance structure. In accordance with this agreement, we have created and will maintain a cash collateral account that limits the liquidity of approximately $119.6 million of our cash.”

What that means is that the $472 million in shareholder equity listed on the balance sheet several pages later in the report actually could be closer to $350 million in some circumstances.

And that’s a relatively simple deal, worlds away from the Enron Corp.-created construct in which it would establish a venture and then book the current value of potential future revenue from the business, even in instances where it turned out the venture was a money loser.

Recently bankrupt telecommunications company Global Crossing Ltd. used a controversial accounting method for trades and leases of transmission space on fiber-optic networks to bolster measures of revenue and cash.

Global Crossing would purchase a long-term contract for fiber-optic space on a network and book the price as a capital expense to be spread over a number of years. It then would resell the space and count the entire sales prices as revenue for the quarter, according to a former financial executive at the company.

“Every time a smart CFO or investment banker wants to do something, they look through the rule book and say, ‘this isn’t here,’ so they design a transaction that is not covered and then ask the accountants, ‘where does it say I can’t do it,’” said Roman Weil, a University of Chicago accounting professor.

Companies are supposed to follow what is known as generally accepted accounting principles, or GAAP. Issued by the accounting board, the rules have been developed over the last century by the accounting profession, business and regulators. Its intent is to create a set of bookkeeping and financial reporting standards that can be used to make a reasonable and fair representation of a company’s financial position.

Businesses prepare the books according to these guidelines. The auditor’s job is to determine whether the accounting principles were applied correctly and the resulting report fairly states the company’s finances.

These standards were born in an age when the U.S. economy was beginning to churn out mountains of manufactured goods.

Accounting allowed the company to document transactions that reflected the flow of money to suppliers, the cost of labor and the sale of the product for a profit.

The accounting principles, even with all the new rules, fail to address the development of what many call the information or intellectual economy.

Determining the value of intellectual assets, such as software engineers, or intangible assets, such as a proposed venture to deliver an Internet product, is very different from calculating the profit on a shipment of doorknobs.

The nation’s system of financial reporting has become so complicated that many in the industry are asking whether it should be scrapped for a new one.

“We’ve evolved into a postindustrial economy with a business climate that is infinitely more complex than before, when most of our accounting standards and securities regulations were formulated,” Stephen G. Butler, chairman of accounting firm KPMG, said in a recent speech to energy executives. “In this context, generally accepted accounting principles don’t do a very good job of describing any modern company.”

Robert Kaplan, a Harvard Business School professor, says much of the complexity in the financial reporting system dates to the model of valuing stock options devised three decades ago by economists Fischer Black and Myron Scholes.

The pricing model, which won the authors the Nobel Memorial Prize for economics in 1997, gave rise to a new class of financial vehicle called derivatives, which allow businesses to hedge all sorts of risks.

And the price model coincided with an explosion in computing power that allowed clever finance executives to develop and track thousands of new types of transactions.

Determining and reporting the value of derivatives has become one of the stickiest issues in accounting.

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Derivatives Can Be Useful, Deceptive Tools

Enron dealt in derivatives that ranged from energy products to telecommunications services to even what amounts to bets on weather patterns.

Though Enron has shown that these tools can be used to manipulate company profit figures, they also have legitimate purposes, allowing a business to hedge, or protect itself from some sort of risk.

“Much of this is so complex that people who have been trained in a much simpler economic model just don’t understand it well,” Kaplan said. “That includes auditors, board members and even the regulators. This is not simple arithmetic.”

And the accounting gets more complicated with use, Weil said.

Typically, a company must report changes in the value of a derivative on its income statement. But if the company says it is holding the contract with the intent to sell it in the future, it doesn’t have to show those changes in valuation.

“A big pharmaceutical company has a legitimate need for a currency hedge because of its operations in Germany, but now comes 23 other CFOs who have designed a bunch of hokey transactions to get around the rules, and that in turn requires more rules,” Weil said.

Compounding the complexity is the decline of auditing from a principle-based discipline to a check- list process.

“Some of this has turned into ‘check the box’ rather than looking at the substance of transactions,” said Mark Bagaason, managing partner for accounting firm Grant Thornton’s practice in Southern California. Grant Thornton officials said auditors must reject the type of rule-book approach Weil described.

Yet if an accounting method is not prohibited by the standards, auditors are loath to make a stink, Weil said. They don’t want to lose the client.

Sometimes, the accountants then go to the rule makers--the FASB, the Emerging Issues Task Force or the SEC and ask for a rule. But in these instances, the auditors are looking to protect themselves.

“Auditors, in a rational pursuit of a full purse, want unambiguous rules to stand behind when, inevitably, the trial lawyers sue them for accountant judgments and estimates, made in good faith, that turn out to miss the target,” Weil said in congressional testimony this month.

It is a seemingly endless cycle, Weil told The Times. “We spend a lot of time writing detailed rules, and the CFOs and investment bankers spend a lot of time to get around the rule book.”

The gaps in the accounting principles have become a matter of course work at the nation’s business schools.

A device called a “synthetic lease” takes up five printed pages of a handout posted on the Internet for Business Administration 280, a real estate investment analysis class taught by Nancy Wallace at the Walter A. Haas School of Business at UC Berkeley.

The goal of such a lease, Wallace teaches, is to “keep reported earnings high and balance-sheet assets low since small boosts to earnings can have a significant impact on the stock price.”

In addition, students are told, “For GAAP reporting, the financing is reported as an operating lease, yet the firm retains control and tax benefits of ownership.”

It is the financial equivalent of having your cake and eating it too.

Wallace’s course teaches specific ways this type of lease structure works well for technology companies, retailers and manufacturers. The benefits range from helping to keep stock prices high, adding stores “off balance sheet” and burnishing debt-to-equity ratios.

Enron used this type of financial structure to finance one of the towers at its Houston headquarters. Similar lease structures have been used by companies as different as Inktomi and Krispy Kreme Doughnut Corp.

Weil said the accounting treatments for the special purpose entities, or ventures, that figured in the Enron collapse grew from the synthetic lease rules.

But other long-term trends, such as the way companies pay executives, the volatile nature of Wall Street and the stock market’s addiction to quarterly profits, also have contributed to the complexity as financial managers look for ways to emphasize a company’s growth and profit.

The stock market’s recent jitters about the quality of accounting at publicly traded companies is an ironic reaction to a system Wall Street helped create.

Starting in the late 1980s and accelerating through the boom years of the last decade, chief executives and Wall Street developed a symbiotic relationship in which each was rewarded by projecting and hitting financial targets--generally profits and revenues.

Analysts won praise for predicting the growth of a business. Shareholders saw the value of their holdings increase. And the executives, who held huge numbers of options to purchase shares in the company at low prices, earned millions of dollars by exercising their stock options, selling shares at high prices and pocketing the difference.

Companies suffered swift punishment when they failed Wall Street, often losing a third of their market value within minutes of issuing a statement that they would not achieve the growth estimates expected by analysts. A long-term change in the way executives are paid added to this pressure cooker.

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Aligning Corporate Performance With Pay

Starting in the 1980s, corporate-governance activists complained about the lack of a direct relationship between executive pay and the financial performance of a company. Their objections contributed to a shift in executive compensation practices intended to better align executive pay with the financial and stock performance of the companies.

In 1995, 41% of a typical chief executive’s total pay was in the form of a conventional salary, or cash. The CEO collected slightly more--42%--in long-term incentives, primarily stock options. The remainder of the pay came from short-term incentives such as bonuses, according to statistics compiled by Clark/Bardes Consulting in Marlborough, Mass.

By last year, chief executives were collecting 65% of their pay in long-term incentives, the Clark/Bardes report said. Salary plunged to 18% and bonuses remained steady at 17%.

Moreover, the size of the pie nearly tripled. The median CEO pay package was just over $1 million in 1995. That grew to $2.85 million in 2001. Long-term incentive payments jumped by more than 425%, to $1.85 million from $433 million.

One consequence of this trend was to create a financial incentive for managers to meet the expectations of Wall Street quarter after quarter, said Graef Crystal, a Las Vegas-based compensation expert.

Aggressive and complex accounting became one of the prime tools of meeting those expectations, Crystal said.

A simple accounting change could help reverse this trend, according to accounting and compensation experts. Unlike a salary paid in cash, companies don’t have to account for stock options as an expense, said Brett Trueman, an accounting professor at UC Berkeley.

Crystal believes that if companies had to subtract the value of stock options from their profits, they would be much more circumspect about using them as a form of pay. And that could reduce the emphasis on short-term financial measures.

Previous efforts to make such a change have failed, but Sens. Carl Levin (D-Mich.) and John McCain (R-Ariz.) recently introduced legislation that would change the accounting methods for stock options.