THE FLAWS IN THE REASONING

As the preceding deviations from GAAP demonstrate, neither fear of anti­fraud statutes nor enlightened self-interest invariably deters corporations from cooking the books.

To begin with, corporations can push the numbers fairly far out of joint before they run afoul of GAAP, much less open themselves to prosecution for fraud. When major financial reporting violations come to light, as in most other kinds of white-collar crime, the real scandal involves what is not forbidden. In practice, generally accepted accounting principles counte­nance a lot of measurement that is decidedly inaccurate, at least over the short run.

For example, corporations routinely and unabashedly smooth their earnings. That is, they create the illusion that their profits rise at a consis­tent rate from year to year. Corporations engage in this behavior, with the blessing of their auditors, because the appearance of smooth growth re­ceives a higher price-earnings multiple from stock market investors than the jagged reality underlying the numbers.

Suppose that, in the last few weeks of a quarter, earnings threaten to fall short of the programmed year-over-year increase. The corporation sim­ply “borrows” sales (and associated profits) from the next quarter by offer­ing customers special discounts to place orders earlier than they had planned. W⅛^er-than-trendline growth, too, is a problem for the earnings- smoother. A sudden jump in profits, followed by a return to a more ordi­nary rate of growth, produces volatility, which is regarded as an evil to be avoided at all costs.

These are not tactics employed exclusively by fly-by-night companies. Blue chip corporations openly acknowledge that they have little choice but to smooth their earnings, given Wall Street’s allergy to surprises. Officials of General Electric have indicated that when a division is in danger of failing to meet its annual earnings goal, it is accepted procedure to make an acqui­sition in the waning days of the reporting period. According to an executive in the company’s financial services business, he and his colleagues hunt for acquisitions at such times, saying, “Gee, does somebody else have some in­come? Is there some other deal we can make?”¹³ The freshly acquired unit’s profits for the full quarter can be incorporated into GE’s, helping to ensure the steady growth so prized by investors.

Why do auditors not forbid such gimmicks? They hardly seem consis­tent with the ostensible purpose of financial reporting, namely, the accurate portrayal of a corporation’s earnings. The explanation is that sound princi­ples of accounting theory represent only one ingredient in the stew from which financial reporting standards emerge.

Along with accounting professionals, the issuers and users of financial statements also have representation on the Financial Accounting Standards Board (FASB), the rule-making body that operates under authority dele­gated by the Securities and Exchange Commission. When FASB identifies an area in need of a new standard, its professional staff typically defines the theoretical issues in a matter of a few months. Issuance of the new standard may take several years, however, as the corporate issuers of financial state­ments pursue their objectives on a decidedly less abstract plane.

From time to time, highly charged issues such as executive stock op­tions and mergers lead to fairly testy confrontations between FASB and the corporate world.

There is another reason that enlightened self-interest does not invariably drive corporations toward candid financial reporting. The corporate executives who lead the battles against FASB have their own agenda. Just like the in­vestors who buy their corporations’ stock, managers seek to maximize their wealth. If producing bona fide economic profits advances that objective, it is rational for a chief executive officer (CEO) to try to do so. In some cases, though, the CEO can achieve greater personal gain by taking advantage of the compensation system through financial reporting gimmicks.

Suppose, for example, the CEO’s year-end bonus is based on growth in earnings per share. Assume also that for financial reporting purposes, the corporation’s depreciation schedules assume an average life of eight years for fixed assets. By arbitrarily amending that assumption to nine years (and obtaining the auditors’ consent to the change), the corporation can lower its annual depreciation expense. This is strictly an accounting change; the ac­tual cost of replacing equipment worn down through use does not decline. Neither does the corporation’s tax deduction for depreciation expense rise nor, as a consequence, does cash flow¹⁴ (see Chapter 4). Investors recognize that bona fide profits (see Chapter 5) have not increased, so the corpora­tion’s stock price does not change in response to the new accounting policy. What does increase is the CEO’s bonus, as a function of the artificially con­trived boost in earnings per share.

This example explains why a corporation may alter its accounting prac­tices, making it harder for investors to track its performance, even though the shareholders’ enlightened self-interest favors straightforward, transpar­ent financial reporting.

The logical solution for corporations, it would seem, is to align the in­terests of management and shareholders. Instead of calculating executive bonuses on the basis of earnings per share, the board should reward senior management for increasing shareholders’ wealth by causing the stock price to rise. Such an arrangement gives the CEO no incentive to inflate reported earnings through gimmicks that transparently produce no increase in bona fide profits and therefore no rise in the share price.

Following the logic through, financial reporting ought to have moved closer to the ideal of accurate representation of corporate performance as companies have increasingly linked executive comp ensation to stock price appreciation. In reality, though, no such trend is discernible. If anything, the preceding examples of Mercury Finance, MicroStrategy, and Lernout & Hauspie suggest that corporations are becoming more creative and more aggressive in their financial reporting.

Aligning management and shareholder interests, it turns out, has a dark side. Corporate executives can no longer increase their bonuses through fi­nancial reporting tricks that are readily detectable by investors. Instead, they must devise better-hidden gambits that fool the market and artificially elevate the stock price. Financial statement analysts must work harder than ever to spot corporations’ subterfuges.