The Bear’s Lair: Beanball for bean counter

January 28, 2002 | By Martin Hutchinson

The Enron debacle has allowed the media to declare open season on accountants, working off decades of frustration at the bean-counters’ substantial salaries, uptight lifestyles and poor senses of humor.

I would suggest that accountants are mere victims, if not innocent, and no more guilty than the rest of us. They, too, have been led astray by a misguided control and reward system, poor generational ethics and a hyperventilating bull market in which anything went.

Accounting essentially is a policing system. Its purpose is to provide shareholders with clear, independent information about the stewardship of managers who control shareholders’ assets. Problems inevitably arise when accountants are appointed by the very managers whose performance they are hired to monitor, with shareholders’ roles limited to formal ratification of a choice already made. Before about 1980 this was not an enormous problem. Both managers and shareholders agreed what accountants’ roles should be, and agreed what the limitations of those roles were. Accounting rules were relatively simple, and there was little “financial engineering” to allow managers to hide exposures off balance sheets and away from shareholders’ prying eyes.

The majority of managers got paid in cash and bonuses, so per-share earnings genuinely represented what was left for shareholders after managers were paid. In addition, much shareholder attention was concentrated on dividends, which represented a high proportion of reported earnings. Since dividends were paid in hard cash, there was no possibility of using accounting tricks to disguise their amounts.

Of course there were scams, particularly in periods like the late 1960s when the stock market was ebullient, investors’ defenses were down and “ask-no-questions” equity capital was easy to get.

National Student Marketing, for example, was a company which inflated its results on both sides of the income statement, inventing the amusing concept of “unbilled receivables”—sales for which nobody got around to sending invoices—and on the other side, capitalizing marketing and sales expenses as intangible revenue-generating assets.

But the financial community as a whole frowned on such scams. With inevitable bankruptcies came the caulk that filled loopholes. After the downturn of the early 70s closed many of the loopholes exploited during the late 60s, financial statements became relatively easy to read.

Accountants, too, remained fairly dedicated to their central mission of investor protection.

When, in the late 1970s, company accounts became distorted by double-digit inflation, U.S. accountants agreed fairly quickly on a common-sense definition of what an inflation-adjusted account should look like. For a number of years after 1979, such accounts were prepared in conjunction with ordinary financial statements, albeit in an abbreviated form.

It didn’t have to be that way. In the United Kingdom, accountants were seduced by various industry lobbies into preparing inflation-adjusted accounts which did not reflect the common-sense view of what such accounts should show. Results were correspondingly useless.

Inflation accounting began separating accounting standards from common sense. That led to the Enron debacle, as well as countless others still to be revealed. Inflation-adjusted accounts were hard to understand, as were accounts put out by multi-national companies in an era of rapidly varying foreign exchange rates. Translation rules for foreign exchange movements, unlike those for inflation, no longer followed common-sense precepts.

The invention of derivatives, which gave companies the ability to use hidden hedges against some risks while incurring others also undisclosed, separated the accounts presented to investors still further from common-sense norms. There was also some deterioration in quality resulting from genuine changes in the business environment. That deterioration was poorly handled by the accounting profession.

The pace of corporate restructuring, both internal (plant closedowns, product line realignments and lay-offs) and external (mergers and acquisitions and divestitures) quickened markedly during the 1980s. Conventional accounting allowed considerable flexibility in choosing whether the profits and costs of such matters were “ordinary” or “extraordinary.” Inevitably, managers interpreted matters to their own advantage and company accounts moved ever further away from a common-sense view of a company’s actual profit or loss.

More damaging was the growth in stock options in the early 1990s and the lamentable failure by the accounting profession in 1994-95 to account for them properly. Here management’s interests and those of stockholders directly opposed each other.

The options represented a direct conflict of interest between managers and shareholders. What was more pernicious, the options gave managers a direct pecuniary interest in inflating short-term earnings and boosting the stock price, whatever the economic reality.

From this point on, even items that were neutral between managers and shareholders were potentially the cause of accounting problems, since managers always would be tempted to resolve conflicts in their own short-term interests.

The problem was exacerbated by two additional factors: investors’ increased reliance on Wall Street analysts’ earnings expectations disseminated through the new electronic business media and the decade-long bull stock market and economic boom. Downturns, in both the economy and the stock market, perform an essential cathartic function in exposing fraud, lies and over-optimism. During the 1990s, this function became atrophied, allowing the weeds of deception to grow unchecked.

Over the next few years, a vast series of class-action lawsuits likely will have a profound effect on the accounting profession. After all, the partners of Arthur Andersen are jointly and severally responsible for the firm’s liabilities, so no such partner is likely to remain untouched by the tsunami of litigation we can expect.

Nevertheless, redistributing the income of accounting partnerships to class action lawyers will provide no long-term benefit to investors or to the U.S. economy. While the lawsuits will produce changes in accounting principles and practices, it is unlikely that those changes will be in the direction of greater clarity.

Modest structural change is the solution. The requirement that public companies should have an audit by independent accountants was a product of the securities regulation of the 1930s. Its spirit, that the share buyer needs accurate information to make an informed decision, needs to be more closely followed. If auditors are appointed by managers, then their role is compromised at the first hurdle.

Regulation is not the answer. The Securities and Exchange Commission balked at its attempt to remove the conflict of interest involved in accountants acting as consultants (whose removal is a necessary but by no means sufficient condition for accountant objectivity.) As for legislation, the chance of that being done right is minimal, as is demonstrated by the sanctimonious Sen. Joseph Lieberman, D-Conn., moral scourge of the Enron Republicans, having been a leader in the attempt to prevent the proper accounting of management stock options in 1994-5.

Instead, the Securities Exchange Commission or Congress should impose two requirements:

  • First, all bids to a company to become its auditor for a given year must be referred by managers to the annual shareholders meeting and put to a vote. Detailed terms of the bid and qualifications of the bidder should be made available to all on the company’s Web site. This removes the cost and timing problem that would have prevented this requirement from being imposed in the past.

In this way, each company’s annual general meeting would not simply be given the managers’ choice of auditors, to ratify or reject altogether, but would have all available bids from which to choose. This would rapidly open up the accounting profession beyond the Big 5.

It also would lead accountants to focus their work on providing accurate information to shareholders rather than on satisfying the needs of company management. As in the mutual fund area, rating services would rapidly spring up to grade accountants independently on the quality of their work, both in terms of audit thoroughness and of reporting conservatism.

  • Second, the Financial Accounting Standards board, the body that sets accounting principles, should have a governing body elected by shareholders of publicly listed companies, pro rata to their shareholdings. If that proves to be impracticable, a governing body could be elected by a small number of shareholder representative institutions such as the American Association of Individual Investors, the National Association of Pension Funds, etc., again roughly pro rata to those groups’ shareholdings in American public companies.

These measures would at least align the interests of the accounting profession more closely with those of the true users of its services. But it is unlikely such measures will fully solve the accounting problem.

At least not in this generation. If you believe William Strauss and Neil Howe, in their path-breaking 1990 book “Generations,” each generation of Americans has a unique character with unique strengths and weaknesses.

The baby boomer generation, those born between 1943 and 1961, are especially prone to self-regard and especially dismissive of traditional restrictions on conduct. Brought up in the age of Benjamin Spock permissiveness and influenced in their high school years by the wide dissemination of Heisenberg’s 1925 Uncertainty Principle (that the position and velocity of an object are intrinsically unknowable) as well as by all the avant-garde uncertainties of the modernist and post-modernist artistic movements, the baby boomer generation inevitably tends to believe deep down that there is no such thing as objective truth, that “is” can have several meanings, and that short-term gratification should be pursued at all costs. President Clinton did not cause this trend, he was merely symptomatic of it.

To this extent, accounting is simply reflecting society as a whole. Its standards began to slip after 1980, as the baby boomers moved up through the corporate and accounting practice hierarchy. It reached its nadir in the late 1990s, as the baby boomers’ influence over the U.S. economic system became overwhelming.

If Strauss and Howe are correct, then true reform must wait. It will wait not only for the “Generation X” (born 1962–81) contingent, a bunch of cynical nihilists, but the generation after that, the “Millennials,” who in the normal historical cycle will restore traditional civic and moral values. A side effect of “Millennials” in the work market will make company accounts once more a true reflection of what is actually happening.

Regrettably, the “Millennials,” born in and after 1982, will not reach positions of corporate or accounting partnership influence until 2017 or so.