Anaive observer might consider it overkill to scrutinize a company’s financial statements for signs that management is presenting anything less than a candid picture.
After all, extensive regulations compel publicly traded corporations to disclose material events affecting the value of their securities. Even if a company’s management is inclined to finagle, investors have a second line of defense in the form of mandatory annual certification of the financials by highly trained auditors.
These arguments accurately portray how the system is supposed to work for the benefit of the users of financial statements.
As in so many other situations, however, the gap between theory and practice is substantial when it comes to relying on legal mechanisms to protect shareholders and lenders. Up to a point, it is true, fear of the consequences of breaking the law keeps corporate managers in line. Bending the law is another matter, though, in the minds of many executives. If their bonuses depend on presenting results in an unfairly favorable light, they can usually see their way clear to adopting that course.“Getting the job done,” in the corporate world’s success-manual jargon, most definitely includes hard-nosed negotiating with auditors over the limits to which the accounting standards may be stretched. Technically, the board of directors appoints the auditing firm, but management is the point of contact in hashing out the details of presenting financial events for external consumption. A tension necessarily exists between standards of professional excellence (which, it must be acknowledged, matter a great deal to most accountants) and fear of the consequences of losing a client.
At some point, resigning the account becomes a moral imperative, but in the real world, accounting firms must be pushed rather far to reach that point. As a part of the seasoning process leading to a managerial role, accountants become reconciled to certain discontinuities between the bright, white lines drawn in college accounting courses and the fuzzy boundaries for applying the rules.
Consequently, it is common for front-line auditors to balk at an aggressive accounting treatment proposed by a company’s managers, only to be overruled by their senior colleagues.Even if the auditors hold their ground against corporate managers who believe that everything in life is a negotiation, the outcome of the haggling will not necessarily be a fair picture of the company’s financial performance. At the extreme, executives may falsify their results. Fraud is an unambiguous violation of accounting standards, but audits do not invariably catch it. Cost considerations preclude reviewing every transaction or examining every bin to see whether it actually contains the inventory attributed to it. Instead, auditors rely on sampling. If they happen to inspect the wrong items, falsified data will go undetected. Extremely clever scamsters may even succeed in undermining the auditors’ efforts to select their samples at random, a procedure designed to foil concealment of fraud.
New Roman">When challenged on inconsistencies in their numbers, companies sometimes blame error, rather than any intention to mislead the users of financial statements. On April 16, 2001, Computer Associates International preliminarily reported operating earnings of $0.40 a share for the fiscal year ended March 31. On May 4, the software producer put the figure at $0.16. The discrepancy, said management, resulted from a typographical error. According to the company, an employee transcribed a number incorrectly in preparing a news release.1
Investors might have been excused for reacting skeptically. Shortly before the May 4 announcement, Computer Associates’s accounting practices had come under attack in the press. Besides, seasoned followers of the corporate scene realize that companies are not always as forthcoming as investors might reasonably expect. The following examples, drawn from the casino and consumer appliances businesses, illustrate the point.