Unreasonable accounting practices in financial statements

accounting practice

In Buffett’s 1998 shareholder letter (all content in italics in this article is from his 1998 shareholder letter), he mentioned that several U.S. listed companies are common but unreasonable in their financial statements accounting practices.

Manipulation and deception

The role that managements have played in stock-option accounting has hardly been benign: A distressing number of both CEOs and auditors have in recent years bitterly fought FASB’s attempts to replace option fiction with truth and virtually none have spoken out in support of FASB. Its opponents even enlisted Congress in the fight, pushing the case that inflated figures were in the national interest.

Note: For details about employee stock options, please refer to my previous blog article “Pros and cons of employee stock options as compensation”.

         Still, I believe that the behavior of managements has been even worse when it comes to restructurings and merger accounting. Here, many managements purposefully work at manipulating numbers and deceiving investors. And, as Michael Kinsley has said about Washington: “The scandal isn’t in what’s done that’s illegal but rather in what’s legal.”

Moral decline

It was once relatively easy to tell the good guys in accounting from the bad: The late 1960’s, for example, brought on an orgy of what one charlatan dubbed “bold, imaginative accounting” (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America’s most-admired companies then shunned deception.

         In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers — CEOs you would be happy to have as spouses for your children or as trustees under your will — have come to the view that it’s okay to manipulate earnings to satisfy what they believe are Wall Street’s desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

Behavior rationalized

These managers start with the assumption, all too common, that their job at all times is to encourage the highest stock price possible (a premise with which we adamantly disagree). To pump the price, they strive, admirably, for operational excellence. But when operations don’t produce the result hoped for, these CEOs resort to unadmirable accounting stratagems. These either manufacture the desired “earnings” or set the stage for them in the future.

         Rationalizing this behavior, these managers often say that their shareholders will be hurt if their currency for doing deals — that is, their stock — is not fully-priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody’s-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Son of Gresham: Bad accounting drives out good.

One-time loss

 The distortion du jour is the “restructuring charge,” an accounting entry that can, of course, be legitimate but that too often is a device for manipulating earnings. In this bit of legerdemain, a large chunk of costs that should properly be attributed to a number of years is dumped into a single quarter, typically one already fated to disappoint investors.

In some cases, the purpose of the charge is to clean up earnings misrepresentations of the past, and in others it is to prepare the ground for future misrepresentations. In either case, the size and timing of these charges is dictated by the cynical proposition that Wall Street will not mind if earnings fall short by $5 per share in a given quarter, just as long as this deficiency ensures that quarterly earnings in the future will consistently exceed expectations by five cents per share.

         This dump-everything-into-one-quarter behavior suggests a corresponding “bold, imaginative” approach to — golf scores. In his first round of the season, a golfer should ignore his actual performance and simply fill his card with atrocious numbers — double, triple, quadruple bogeys — and then turn in a score of, say, 140. Having established this “reserve,” he should go to the golf shop and tell his pro that he wishes to “restructure” his imperfect swing.

Next, as he takes his new swing onto the course, he should count his good holes, but not the bad ones. These remnants from his old swing should be charged instead to the reserve established earlier. At the end of five rounds, then, his record will be 140, 80, 80, 80, 80 rather than 91, 94, 89, 94, 92. On Wall Street, they will ignore the 140 — which, after all, came from a “discontinued” swing — and will classify our hero as an 80 shooter (and one who never disappoints).

Accomplice structure

For those who prefer to cheat up front, there would be a variant of this strategy. The golfer, playing alone with a cooperative caddy-auditor, should defer the recording of bad holes, take four 80s, accept the plaudits he gets for such athleticism and consistency, and then turn in a fifth card carrying a 140 score. After rectifying his earlier scorekeeping sins with this “big bath,” he may mumble a few apologies but will refrain from returning the sums he has previously collected from comparing scorecards in the clubhouse. (The caddy, need we add, will have acquired a loyal patron.)

         Unfortunately, CEOs who use variations of these scoring schemes in real life tend to become addicted to the games they’re playing — after all, it’s easier to fiddle with the scorecard than to spend hours on the practice tee — and never muster the will to give them up. Their behavior brings to mind Voltaire’s comment on sexual experimentation: “Once a philosopher, twice a pervert.”

Clearly the attitude of disrespect that many executives have today for accurate reporting is a business disgrace. And auditors, as we have already suggested, have done little on the positive side. Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay. (“Whose bread I eat, his song I sing.”)

Provision for losses through M&A

In the acquisition arena, restructuring has been raised to an art form: Managements now frequently use mergers to dishonestly rearrange the value of assets and liabilities in ways that will allow them to both smooth and swell future earnings. Indeed, at deal time, major auditing firms sometimes point out the possibilities for a little accounting magic (or for a lot). Getting this push from the pulpit, first-class people will frequently stoop to third-class tactics. CEOs understandably do not find it easy to reject auditor-blessed strategies that lead to increased future “earnings.”

         An example from the property-casualty insurance industry will illuminate the possibilities. When a p-c company is acquired, the buyer sometimes simultaneously increases its loss reserves, often substantially. This boost may merely reflect the previous inadequacy of reserves — though it is uncanny how often an actuarial “revelation” of this kind coincides with the inking of a deal. In any case, the move sets up the possibility of ‘earnings” flowing into income at some later date, as reserves are released.

A preliminary tally by R. G. Associates, of Baltimore, of special charges taken or announced during 1998 — that is, charges for restructuring, in-process R&D, merger-related items, and write-downs — identified no less than 1,369 of these, totaling $72.1 billion. That is a staggering amount as evidenced by this bit of perspective: The 1997 earnings of the 500 companies in Fortune’s famous list totaled $324 billion.

accounting practice

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