After directors of Rite Aid Corp. ousted the chief executive last week and announced that earnings going back to 1997 would be "restated" to wipe out $500 million in pretax profits, one stock analyst said it might take some time before investors get a true picture of the drugstore chain's finances.
Rite Aid's announcement raised an important question for investors: If the public has yet to see a true picture, what good were the two years' worth of audited financial statements that the company issued earlier?
There's been no suggestion that the Rite Aid write-down resulted from any impropriety by its auditor, KPMG LLP, which declined to comment, citing client confidentiality.
However, regulators have been troubled for some time about the quality of corporate financial statements. And investors should be, too.
In recent years, companies such as Waste Management Inc., Cendant Corp. and Sunbeam Corp. have disclosed that the picture painted by their earlier financial statements was not accurate.
More than a year ago, Securities and Exchange Commission Chairman Arthur Levitt Jr. called attention to what he dubbed a "numbers game" in which companies manipulate accounting data to produce desired results.
These results range from "making one's numbers"--meeting Wall Street projections--to smoothing out quarterly results to produce a steady run of increases.
"This process has evolved over the years into what can best be characterized as a game among market participants," Levitt said in a speech last year.
Many investors agree.
Richard P. Howard, manager of the T. Rowe Price Capital Appreciation Fund, said there is immense pressure on company managers to match or outperform market expectations.
"Top managers are almost more managers of their stock than they are managers of their own companies," he said.
But if outside auditors are doing their jobs and making sure that the numbers presented to the public present a true picture of the company within the rules of generally accepted accounting principles, how can companies play games with their books?
The answer, in the view of some experts, is that auditors don't do their jobs properly.
In most cases when a fraud is exposed or when a company makes a large restatement of its earnings, it is management that has done something wrong, but "I would consider it also an audit failure," said Howard Schilit, a former American University professor who now runs the Center for Financial Research and Analysis Inc., a Rockville firm that analyzes corporate financial statements and has issued several prescient warnings about companies about to tumble.
Schilit said accounting problems typically arise when a previously healthy company starts having business problems.
"The starting point is always the same--a business that is starting to struggle. At that point, management has two choices--come clean and get hammered" in the stock market, as happened to Unisys Corp. earlier this month, or "don't play fair."
Those that don't are a minority, but they "are the ones that become the giant accounting frauds," said Schilit, who has been dubbed "the accounting sleuth."
Outright fraud, of course, can be difficult to detect if management is clever enough, and especially if it is able to enlist vendors and customers in the scheme.
For example, said Alan Anderson of the American Institute of Certified Public Accountants, auditors are supposed to verify that a company's receivables exist and are likely to be paid. In the aftermath of some frauds, auditors' records contained letters from customers verifying the receivables and saying they intended to pay--when in fact the sales were bogus.
SEC officials noted that the agency brings about 500 enforcement cases a year, of which about 100 involve financial or reporting fraud, a rate of about one-half of 1 percent of public companies.
Far more common is what is called aggressive accounting, experts say. Auditing, though it requires a great deal of number crunching and tire kicking, also typically involves many judgment calls, and those calls leave room for pressure by management, critics say.
This pressure can be effective because of the internal dynamics of the accounting firm. In many firms, consulting has become the major income source, while the auditing market is very competitive and prices are down. Thus, audit partners may be struggling to keep revenue up and reluctant to risk losing an engagement by angering management.
"The auditor is being paid by the person they are evaluating," noted Stephen Loeb, professor of accounting at the University of Maryland, and partners in accounting firms "don't have tenure."
The judgments involved cover a wide range of subjects. Recently controversy has arisen over some Internet companies' practice of bartering advertising on their sites for advertising on the other firms' sites. The companies are assigning value to these transactions and booking it as revenue. Plainly such transactions do have value, but how much? That is where judgment can come into play.
At the same time, "there is no requirement presently in the law for the auditors to discuss with the [company] board of directors the 'quality' of the financial accounting being reported by the enterprise," said Walter P. Schuetze, chief accountant of the SEC's enforcement division.
The SEC has proposed a new rule that would bring board members, particularly the board's audit committee, directly into the loop, Schuetze said. It would require that "the auditor discuss with the board the accounting policies, the estimates and judgments that are being made by the enterprise, [and] how these fall on the spectrum between aggressive and conservative," he said.
T. Rowe Price's Howard said also that many accountants' way of looking at companies is out of sync with modern markets, which focus on a company's earning rather than its asset value.
"One of the problems that accountants have is that they're still working on the theory that the balance sheet [the statement of assets and liabilities] is sacrosanct. So they err on the side of writing down assets. They think that they're being conservative, but that's wrong," he said.
Writing down assets--reducing their value on the company's books--actually results in aggressive statements of profit, he said. For example, if you write down the value of a plant, you take a one-time hit, but in future years the depreciation that would be assigned to the plant, and that would be subtracted from earnings, is reduced or gone, so earnings are higher. And as equity is reduced, the same amount of income produces higher return on equity.
The SEC's Schuetze said he thinks the new rule bringing directors into the process will go far to\ward eliminating overly aggressive accounting.
"Once boards of directors and audit committees become more involved in understanding the financial affairs of an enterprise, corporate governance will improve and possibly improve by a quantum stride. It is after all the directors who everybody looks to," Schuetze said.
In the meantime, what are investors to do?
Among the numbers, Howard and Schilit both pointed to cash flow as a useful item that is less subject to interpretation than net profit.
Schilit, in a report on Rite Aid a year ago, noted that cash flow from operations had gone from a strong positive to a large negative between 1997 and 1998, and was trailing net profit.
Howard also said it is important to try to understand the company, its place in the economy and how it "generates value" so that you have a context against which to read the numbers you see.
If stock analysis "was just looking at three numbers and making a decision, then any bozo could day trade and make money," he said.