Massaging the numbers

Fajar Hidayat, International Banking & Finance, Birmingham University, United Kingdom, fajarhidayat@lycos.co.uk

The WorldCom scandal, involving the U.S-based global communications provider operating in more than 65 countries, related to the audit finding that the company falsely portrayed itself as a profitable business during 2001 and the first quarter of 2002. WorldCom did so by capitalizing (and deferring) rather than expensing (and immediately recognizing) about US$ 3.9 billion of its leasing network access costs -- which had previously been treated as expenses.

The company transferred these costs to capital accounts in violation of established Generally Accepted Accounting Practices (GAAP).

WorldCom benefited from the transfer because capital costs can be deducted over a longer period of time, while expenses must be immediately subtracted from revenue. Without the transfers the company's reported earning before interest, tax, depreciation and amortization would be reduced to $6.339 billion for 2001 and $1.368 billions for the first quarter of 2002, and would have reported a net loss for 2001 (around $662 million) and the first quarter of 2002 (about $557 million).

The scandal mirrors others, mostly triggered by "creative accounting" -- a process which consists of dealing with several matters of "flexibility" in accounting standards to the presentation of the results of financial events and transactions. This flexibility provides opportunities for manipulation, deception and misrepresentation.

Basically there are five types of creative accounting practices: Recognizing premature or fictitious revenue; aggressive capitalization and extended amortization policies; misreported assets and liabilities; getting creative with the income statement; and problems with cash flow reporting.

The main motive of creative accounting is maintaining the company's market value reflected by its shares price in stock market. Publicly listed companies attempt to stabilize or increase share prices through the growing trends of earnings in profit/loss accounts, strong financial structure in balance sheets and consistent dividend policy.

Today, financial information in accounting reports that shows such performances is an effective tool to maintain and boost the company's market value. The days when a company's accounting reports were simply a record of its business transactions are long dead.

In so doing, companies often tailor their financial results to meet more closely the demands of the stock market. The market prefers companies that show smooth earning growth to those that demonstrate volatile earnings with dramatic rises and falls, however accurate the latter may be.

Companies also have to meet market expectations. The expectations usually are generated by analysts of influencing stockbroking firms who make recommendations for investors to buy, hold or sell the stock based on their forecast of the listed companies' profits. To maintain their market value the companies do not want to shock market expectations. If the market expects that company X assumes to make a pre-tax profit of $25 million, but turns in only $10 million, then market perception and rumors about that company's performance will be bad news.

Selling pressure for the company's stock will be strong. When supply exceeds demand the stock price declines and the company's market value deteriorates.

WorldCom was confronted with such a situation prior to the scandal. Hence, ironically, it is those users of companies' financial reports who perhaps contribute most, directly and indirectly, to creative accounting. It is also those users that will be defrauded by the manipulation.

Creative accounting will lead to fraud if used as a short-term instrument of deception and manipulating figures for a company facing continuing business difficulties. Then investor could be misled into decisions based on information which is neither full nor fair. Banks and other creditors might make false loan disbursement, which would have otherwise been withdrawn.

True, the distinction between creative accounting and fraud is only thinly drawn due to some flexibility in accounting standards. Companies do need to retain some flexibility over their accounting policies.

Nevertheless, any flexibility should be based on proper interpretation of accounting standards. Microsoft does such an interpretation, for example, in matching reported earnings to profit forecasts.

When Microsoft sells software a large part of the profit is deferred to future years to cover potential upgrades and customer support costs. This perfectly respectable and highly conservative accounting policy means that future earnings are easy to predict. On the contrary, the WorldCom accounting scandal is a case where the company intentionally misinterpreted and violated accounting standards, in this case the American GAAP.

Thus companies' accounting policies and practices must contain a large element of realism to prevent misuse of the opportunities available. These are provided to give confidence through a fairer disclosure of results, instead of their distortion.

The nature and level of disclosure requirements have to be emphasized and imposed to minimize manipulations in accounting figures. It means companies have to explain the essential things it has done, and then quantify the financial effects of various accounting treatments. It will make the investors, shareholders and creditors able to gain accurate, reliable, and adequate financial information.

In the U.S., recent pressure for such disclosure is stronger in the aftermath of the earlier Enron accounting scandal. U.S. investors want more accounting disclosure, instead of creative accounting. The demand for full disclosure of financial data now grows greater.

Investors are pressing several corporations to put up more detailed numbers more frequently. These include Cisco Systems, Amazon and AOL -- all high-technology stars who have struggled over the past 18 months against massive decline in consumer demand and stock price. Investors want to see the sum of the parts as the whole truth, and nothing but the truth.

Stronger pressure comes from the Securities and Exchange Commision (SEC) as a government-backed up watchdog and enforcement agency that supervises the U.S. capital market. SEC's Enforcement Division does nothing but address accounting fraud. Intending to make accounting fraud a major goal of the commission, the SEC is working actively with the heads of major accounting firms to have them crack down on their clients in terms of how they are reporting their accounts.

The number of accounting fraud cases investigated by the SEC jumped by 41 percent, from 79 cases in 1998 to 112 cases in 2001, resulting in millions to billions of U.S. dollars in fines to settle the charges. In 1999, Cendant Corp. agreed to pay shareholders $2.83 billion to settle a suit alleging accounting irregularities in its merger with CUC International Corp.

In November 2001 Waste Management paid $457 million in fines to settle charges of violating securities laws in its 1998 merger with USA Waste Services and its 1999 financial statements. In May 2002 Sunbeam Corp. was forced to restate financial results for 1996 and 1997. The company later filed for bankruptcy.

The lesson: Creative accounting only solves problems in the short term. It cannot make bad things look good in perpetuity without leading to fraud. Creative accounting has its limits: Proper interpretation of accounting standards. Once the border is crossed, the losses eventually will be much greater than the advantages.