Why Accounting Has to Change

From Emory University comes this piece about the structure of accounting and how it leads to various problems in the field.

For decades investors, lenders and other professionals have relied on audited financial statements to ensure that a company's profit, cash position and other metrics are more than simply numbers on a page. But that confidence may have been weakened lately, following a spate of charges filed by the SEC against top-tier companies—including HealthSouth Corp. and Lucent Technologies—alleging improper revenue recognition and other fraud totaling billions of dollars. As more observers ask why outside auditors did not catch the alleged improprieties in a timely manner, professors at Emory University's Goizueta Business School and others who have studied the situation say that a combination of factors—including the very structure of the accounting profession—may be at least partly responsible.

"There's a disconnect when it comes to the behavior of auditors," observes Kathryn Kadous, an associate professor of finance at Goizueta, referring to one of the conclusions arrived at in a paper she co-authored—with S. Jane Kennedy from the University of Washington and Mark E. Peecher from the University of Illinois at Urbana-Champaign—titled The Effect Of Quality Assessment And Directional Goal Commitment On Auditors' Assessments Of Client-Preferred Accounting Methods. "Although in a post-Enron era, many independent auditors say they won't rely solely on management-generated information, our research shows that they are in fact often likely to go along with their client's claims and with management's preferences."

But one thing most people misunderstand is that the goal of an audit isn't to uncover fraud. Most auditors are simply trying to verify complican with GAAP. If they have reason to believe fraud exists, then they are bound to pursue it – but that is a different, more detailed audit process. Most of the time, auditors are just taking samples, not scrutinizing every transaction of a company. To add to the problem, accounting does have gray areas.

The problem is compounded by the fact that management can fine-tune results in numerous ways that may stray into "gray" areas without crossing a definable line into fraud.

"If management wants to pump up earnings for a particular period, it's easy to slow research and development expenses, defer repair and maintenance or even time purchases so bills are incurred a bit later," he explains. "Who can judge the way management runs its business? Achieving precision in a company's numbers is nearly impossible, but at the same time analysts will focus on a penny-per-share difference between estimates and actual figures. It all contributes to the ability to manipulate results."

Kadous also cites these "gray areas" as a concern, noting that in general, auditors are not charged with closely examining the way that management runs its operations.

"To a degree, so-called aggressive accounting is an effect of goal commitment since historically, the role of an auditor did not include comment on 'gray' areas" details Kadous. "But we also have to look at the risk-reward effect of aggressive accounting as it relates to auditors. The reward, of course, is keeping a client, while the risk of detection and punishment is not always that great. Even if financial penalties are imposed, it's often years after the fact, and the auditor who should have caught the fraud may be long gone from the firm. Perhaps regulatory authorities should consider requiring improved monitoring of firms' behavior; and consider how to spur auditors to look at a company's shareholders and the broader market as a client, instead of only seeing the company as a client."

This is why EPS is nearly meaningless to an investor. I don't understand why stocks move so much on an earnings announcement. Any financial number by itself is jibberish because they can all be manipulated. That is why investors must learn to read financial statements to get the total picture.

But back to the original point of the article… does accounting need to change? I think yes. Business continues to change, and while economic value used to be tied up primarily in physical assets, it isn't that way anymore. How much is a marketing meme worth? If successful, it could lead to huge sales gains, but accounting won't often acknowledge that as valuable. I don't have any answers as to what should be done, but I'm definitely on the side that wants to see something changed.