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Accounting and Profits

2002-05-15

According to the Economist, General Electric's shares have fallen sharply in recent months because investors have concluded that much of corporate America has been fiddling its accounts, and General Electric is a prime suspect. Since the collapse of Enron, many companies with “accounting issues”--especially those that manipulated their accounts to smooth their earnings--have seen their stock prices fall sharply. As the Economist writes: "Investors used to reward firms that showed steady profit growth because they disliked volatility. Now they think smooth means fake, and are demanding the truth."In the first three quarters of 2001 the 100 biggest Nasdaq firms reported pro-forma earnings of $20 billion. For the same period, they reported losses under America's Generally Accepted Accounting Principles (GAAP) of $82 billion.
It all depends

Over the years, accounting-standard-setters responded to these changes in the business environment at different speeds and in somewhat different ways. America's GAAP, produced by the Financial Accounting Standards Board (FASB), tends to involve minutely detailed rules, spelling out precisely how a specific item is to be treated. By contrast, Britain's Accounting Standards Board, and latterly the International Accounting Standards Board, have tended to set out broader principles, leaving it to the accountants to work out how these apply to a particular item.

America's approach has fostered “a technical, legal mindset that is sometimes more concerned with the form rather than the substance of what is reported”, in the words of Joseph Berardino, until recently boss of Andersen, Enron's auditor until it went bust. America's litigious environment reinforces this emphasis on playing by the rule book and not questioning whether the rules actually provide useful information.

In Britain, some accountants feel that their country's broader, less pedantic approach would have prevented an Enron-like disaster. They also point out that Britain has much tougher rules than America to limit the creation of off-balance-sheet special-purpose entities. But Sir David Tweedie, chairman of the International Accounting Standards Board and former head of Britain's Accounting Standards Board, is sceptical. “History is full of people who said ‘it couldn't happen here' and came to regret it,” he says about Enron. “I do not plan to repeat that mistake.”

For all their differences, accounting rules everywhere have become much more complex as rule-makers have responded to changes within firms and have tried to close loopholes. Martin Whitman of Third Avenue Funds, a veteran investor, agrees that today's accounting is complex. But he blames this on the desire of accounting-standards-setters to meet the needs of the average investor—who tends to be obsessed with getting one “true” number, such as quarterly profits or cashflow per share from normal operations. Enron catered for that obsession, writing in its annual report that it was “laser-focused on earnings-per-share growth”. This Mr Whitman regards as folly: “GAAP can never produce a statement of true earnings.” He wants accounting to pursue a simpler goal, full disclosure, by providing plenty of useful information—“not truth”—so that trained analysts can judge the financial health of a firm for themselves. Deciding what the numbers in the accounts mean should be up to the users, not those who prepare them.

According to Mr Whitman, even with today's complexity, company accounts will tell seasoned analysts most of what they need to know. This may have been true even of Enron, if only people had cared to look. In a recent article, “Did Enron's Investors Fool Themselves?”, Chris Higson of London Business School argues that the information in the firm's published accounts should have set warning bells ringing long before the share price started falling. In particular, its operating return on capital and its return on equity declined sharply during 1996-2000, falling below the economic cost of capital. In other words, the publicly available data showed that the company was operating at a loss, says Mr Higson.

Jack Ciesielski of the Analyst's Accounting Observer, a suddenly much-followed journal, agrees. He sees “a crisis on the user side of accounting too. There is a ton of good disclosure out there that nobody is getting excited about.” Disclosure in Enron's books was incomplete, but there were plenty of footnotes that should have given analysts “a knot in the stomach”.
Hidden meanings

Back in the 1950s, companies prided themselves on the conservatism of their accounting. What changed their mind? One factor was the rise of inflation, which widened the gap between a company's book value on its balance sheet and its market value. Companies could book a profit simply by selling an asset at the higher current price and pocketing the difference over what they had paid for it. A second factor was the emergence of new sorts of assets and liabilities, says Baruch Lev, an accounting professor at New York University's Stern School. A third was the evolution of the modern firm and the blurring of corporate boundaries. Joint ventures, leasing and special-purpose entities all made it harder to determine whether a particular activity should be consolidated into a company's accounts.

The growing use of derivatives and off-balance-sheet financing and the rising importance of intangible assets such as brands and goodwill have all posed challenges to traditional accounting, none of which has been resolved entirely satisfactorily. And serious distortions have been introduced because share options awarded to employees, clearly an employment cost, are not charged against profits. In America, the Fed reckons that this has caused profits to be overstated by an average of 2.5 percentage points a year over the past five years.

There has also been a growing trend to take huge write-offs, and then announce pro-forma profits that supposedly reflect the firm's normal business activities. AOL Time Warner recently wrote off $60 billion related to acquisitions it overpaid for. JDS Uniphase has written off $51 billion in goodwill and intangibles.

How should accounting systems be reformed? Robert Merton thinks that something like banks' value-at-risk measures would be useful alongside current Generally Accepted Accounting Principles. In his view, VAR is “a damn sight better than what we have now in the corporate sector.” But perhaps more important is to give managers an incentive to report numbers giving an accurate account of their companies' finances. If only markets rewarded companies that provided transparent and full accounts.

However, in the world in which we live in, the accounting system appears to have broken down massively starting in 1998. Corporate profits as reported in the National Income and Product Accounts peaked at the end of 1997. Corporate profits as reported by the firms themselves kept growing for three more years, peaking at 50% higher than their value at the true NIPA earnings peak of late 1997.


Source: Economist


Previous Handouts

2002-05-08: Unemployment and Productivity: First Quarter, 2002
2002-05-01: Industrial Production Release...
2002-04-24: Productivity Discrepancies
2002-04-17: The Course of the Recession and What It Tells Us About the New Economy
2002-04-10: Productivity Growth
2002-04-03: SPRING VACATION
2002-03-27: America's Rebound from Recession
2002-03-20: World Economic Forecasts
2002-03-13: Population Growth (Chapter 5: Growth Facts)
2002-03-06: Capacity Utilization (Chapter 2: Economic Data)
2002-02-27: U.S. Household Incomes (Chapter 2: Economic Data; Chapter 5: Growth Facts)
2002-02-20: Unemployment in the 1990s (Chapter 2: Economic Data)
2002-02-06: U.S. Monetary Policy (Chapter 13: Stabilization Policy)
2002-01-28: GDP in 2000 and 2001 (Chapter 13: Stabilization Policy. Chapter 2: Economic Data)
2002-01-21: The Course of the U.S. Recession (Chapter 13: Stabilization Policy)
2002-01-07: Argentina's Crisis (Chapter 15: Exchange Rate Regimes)
2001-12-10: The U.S. Recession (Chapter 2: Principal Macroeconomic Variables)
2001-12-03: The Overvalued Euro (Chapter 3: Exchange Rates; Chapter 15: Exchange Rate Regimes)
2001-11-26: Net Exports, the Exchange Rate, and an IS-Led Boom (Chapter 11: Balance of Payments; Chapter 15: Exchange Rate Regimes)
2001-11-19: The European Central Bank and Its Monetary Policy (Chapter 13: Stabilization Policy)
2001-11-12: Central Banks Worldwide Cut Interest Rates Again (Chapter 13: Stabilization Policy)
2001-11-05: Effects of the Collapse in Spending on Durables (Chapter 9: Income-Expenditure and the Multiplier.)
2001-10-28: What Kind of Stimulus (Chapter 13: Stabilization Policy. Chapter 9: Income-Expenditure and the Multiplier.)
2001-10-21: Federal Reserve Reaction to the Terror Attack on the World Trade Center (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)
2001-10-14: Why a Stimulus Package Might Be Desireable (Chapter 13: Stabilization Policy. Chapter 10: The IS Curve.)


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