"Given the importance of corporate annual reports to the economy . . . one would expect that the figures in these reports would accurately reflect the results of a company's operations and its financial condition. They don't."
Adm. Hyman G. Rickover in testimony before a House Subcommittee
Item: In mid-1974, Texaco reported its first six-months earnings as $3.86 a share. That was a record, and nearly double the six-months profit for the year before. In December, at a time when oil companies were under attack for "obscene profits," Texaco reduced the figure 58 cents. Eight of the other 20 largest oil firms were making similar downward shifts.How was it done? With the stroke of an accountant's pen.
Item: In 1973, Lockheed reported to stockholders that their equilty in the company was $283 million. A year later, an accountant changed that figure to $3 million - a $280 million difference.
Item: In 1974, a defense contractor predicted it would make a $7 million profit from a contract that would take at least five years to complete. Yet an accountant credited the firm with a $10.5 million profit on the contract for 1974 alone.
Feats of magic? Illegal? Not at all. It was just routine work for corporate accountants, the high priests of high finance.
Behind a veil of public inattention, it is accountants who write the story of corporate America. They tell us whether we are richer, or poorer, whether we are zooming ahead or struggling to survive.
"Things like profit, loss and income are not like physical quantities," notes Seymour Fiekowsky, assistant director for business taxation at the Treasury Department.
"If someone told you the flow of the Potomac River was so many million gallons an hour, you could test that. But the analysis of financial transactions is not subject to physical laws. Income is basically a subjective phenomenon."
It is also an important one.
When accountants report a company's profits have risen, the firm's credit rating and stock values stay strong. And conversely, should a company's numbers start to slip, it is a sign to investors and creditors to beware.
Perhaps more importantly, when companies are lumped together, the toatl figures define the country's financial health and are used to set national policies. (KEY OFF)(KEYWORD)re America's capitalists getting the return they deserve? Do the workers deserve a bigger share? Accountants supply the numbers that help us decide. Declining profits for industry can lead to corporate tax breaks, while critics of the oil industry, to use one example, pointed to large profit increases to call for special taxes on "windfall profits."
"I have seen very few people in government who know anything about accounting," notes Fiekowsky, and so, too often, the accountants' figures are accepted as etched in store.
"Accountants are rather modest in disabusing people of this illusion," he adds wryly.
The accounting industry that provides these figures is dominated by eight giant firms, which between them handle over 90 percent of the companies listed on the New York Stock Exchange.
In 1933, the Securities and Exchange Commission was given authority to determine accounting practices, but by a 3-to-2 vote, the SEC decided to forgo that power and rely an standards established in the private sector instead.
As the boom years of the 1960s faded into the recession of the early 1970s, accountants came under increasing fire from investors, government officials, and even other accountants for failing to signal such corporate disasters as the collapse of the Penn Central Railroad and of many conglomerates, the illegal foreign payoffs of Lockheed and the fraud of National Student Marketing Corp.
"The accounting profession itself is confused as to what it is saying [in financial statements]," accounting maverick Abraham Briloff contended, and thus it is no wonder that investors can't understand corporate statements. Briloff, in books and speeches, repeatedly has urged the profession to make reports more consistent and more understandable.
Other accountants, however, believed the problem was not with their profession, but with the public, which didn't understand what accounting was all about. These people saw their mission in limited terms, confined to certifying that a company was keeping its records according to "generally accepted accounting principles" even if the cumulative effect of those practices was to distort the economic reality.
The split remains within the profession today, and accounting is at a crucial crossroad. There is no consensus on what accountants are supposed to do or for whom they are doing it.
They are hired by management, but also owe a loyalty to the company's owners, the stockholders. Creditors and potential investors, though outside the company, rely on accountants' figures.
Accountants also must decide whether their task is simply to certify the work of company accountants or to aggressively shape the way a company reports its finances.
Amid the profession's own debate over these issues, the SEC warned accountants in July that time was running out for them to implement more effective self-regulation against professional misconduct. If "the profession's initiative is not successful, a legislative alternative may well be required," the SEC report concluded.
Rep. John E. Moss (D-Calif.) has introduced legislation to create a mandatory self-regulatory organization for accountants patterned after the National Association of Securities Dealers.
Within the profession, the Financial Accounting Standards Board has taken up where two predecessor groups left off, and is trying to establish clear standards for financial accounting and reporting.
Donald Kirk, chairman of the FASB, explained in a speech last March the problems facing his group.
"Financial accounting standards should assure that financial standards reflect 'economic reality,'" he said. "The problem is, no particular notion of economic reality has been agreed on as a benchmark for financial accounting and reporting decisions.
"The search for economic reality . . . is a dual problem - first, because reality is not easily defined, and secondly, because much of accounting has been designed to mitigate the harshness of reality."
Accounting is not a science. In the attempt to define with numbers the financial status of a company at a given point in time, there is, as even critics agree, room for reasonable people to differ on how to define a company's financial position.
But what has happened is that each of those reasonable alternatives has been accepted as just as good as another, and the entire package of options is called "generally accepted accounting principles," or GAAP. Companies and accountants have almost free rein to choose the alternatives they wish.
Consider, for instance, Texaco and the oil industry in 1974.
For Texaco to compute its profits, it had to subtract the cost of gasoline it sold from the money it took in. But what was the cost of the gasoline sold - the price it paid before the Arab oil embargo or the higher prices it had to pay to replace that gasoline in inventory?
There are four "generally accepted accounting principles" for figuring inventory cost, but most controversy centers around the choice of "first-in, first-out" (FIFO) costing vs. "last-in, first-out" (LIFO). A switch from FIFO to LIFO was behind the drop in Texaco's reported profits for the first six months of 1974.
Texaco had used FIFO, which meant for accounting purposes it was constantly turning over its inventory and using as the cost of each gallon it sold the "oldest" gallon in the inventory. It switched to LIFO, which meant the "oldest" - and usually cheapest - items in inventory were retained, while the company used as the cost of each gallon it sold the "newest" gallon in inventory.
In a time of rising prices, LIFO reduces profits, while conserving less expensive inventory to be used later when it might boost profits.
If Texaco had used its traditional FIFO method of accounting, profits would have jumped from $4.75 a share in 1973 to $6.56 a share in 1974 - a 38 percent increase. Switching to LIFO after the end of the third quarter - and restating profits reported earlier to reflect the accounting change - brought the year-end profit down to $5.84 a share.
That was still a tidy 23 percent rise over the year before, blunting the criticism that might have arisen from reporting a 38 percent increase, and also enabling the company to keep a low-priced inventory reserve which could be used to generate larger than normal profits in future years.
During 1974, nine of the nation's 20 largest oil companies switched from FIFO to LIFO, reducing their reported income by an average of 14 percent.
Changes in accounting methods for major items such as inventory can make enormous differences in a company's financial statements. And so long as it is justifiable, a company can choose any approved accounting method it desires.
Thus Adm. Rickover, a frequent critic of accounting practices used by defense contractors, says GAAP "is just another euphemism for anything goes."
Briloff is even less charitable, suggesting that the better acronym is CRAP, for "cleverly rigged accounting ploys."
A tabulation last year by the Financial Accounting Standards Board found that for 11 accounting transactions there were a total of 36 alternatives and variations.
Criticism of the many alternatives is one reason for establishment of the FASB, and that group has already begun eliminating some of the options.
"Some financial analysts have said that each and every accounting alternative should be eliminated," notes the FASB's Kirk. He explains that these analysts believe "that comparability in financial reporting among companies is so important to investors and creditors that it should be obtained by requiring all enterprises to use the same accounting practises - even if this means forcing an occasional square peg into a round hole."
Other critics, however, believe the alternatives are not necessarily at fault, it is the use that is made of the alternatives.
The problem, says Briloff, is that "the present field rules allow corporate management to pick and choose among the alternatives so the result is not necessarily the result a layman would consider the fairest."
Although public companies ar required to have their financial records approved each year by "an independent auditor," the independence of these outside firms is seriously questioned. A firm that fails to give management the kind of financial report it wants is unlikely to remain the company's auditor very long.
"An auditor might believe the "declining balance' method of figuring depreciation gives the best indication of a company's position, but if the management says use the 'straight line' approach, then 'straight line' is what you go for," explains Briloff. "The auditor might have misgivings, but he will hold his nose and close his eyes."
Companies seek a smooth, steady increase in reported earnings, with few sharp rises and no declines. Big earnings jumps make it harder to repeat the gains in future years, while declines are considered a sign of bad management.
When a drop in profits is inevitable, however, companies often engage in what critics call "big bath accounting," using the occasion to report many smaller losses that either occurred before and were not reported or which will occur in the near future. With the books cleared of these losing items, it is easier to report profits in the future.
Recognizing that only truly independent accountants can prevent companies from playing accounting games, the SEC examined several changes to ensure that independence.
"The most obvious factor which erodes independence - or, at least, its appearance - is that the continued utilization of the auditor's services is largely dependent upon the company's management, the same group toward which the auditor is supposed to be independent," the SEC said in July.
"The ultimate test of independence is the amount of pressure that management can bring to bear on an auditor and the ability of the auditor to withstand that pressure."
The SEC identified two areas for immediate action by the accounting profession.
One is the establishment fo independent audit committees within companies. At the SEC's suggestion, the New York Stock Exchange recently required that its member companies establish an audit committee of independent directors which would buffer the outside accounts from company management.
The SEC said, "Should the profession conclude that an audit committee requirement is beyong its capability, the burden is on it to so demonstrate." The number of companies using audit committees is expected to continue growing, even if the SEC doesn't mandate the practice.
A second area of concern for the SEC is the increasing tendency of accounting firms to provide a range of non-accounting services for clients, such as executive recruitment, performing actuarial service and advising on in-house control systems.
Two problems can arise - the fees for the outside work can become so lucrative that the accountant loses objectivity, and the accounting firm may find itself auditing its own work.
"What happens if an accounting firm advised a client to install a certain inventory control system, and then it turns out that the system is a real bust?" asks Jack Chesson, counsel to the Senate subcommittee on governmental efficiency and the District of Columbia. "The accounting firm is going to be very reluctant to go in and tell management that it doesn't work."
Although accountants exercise wide discretion in approving financial records, they are required to footnote and explain anything that would "mutually" affect a company's reports. The choice of accounting alternatives is generally disclosed, and accountants occasionally give only "qualified" approval if they believe there is doubt about the accuracy of a report.
But the public and even financial experts seldom have the time or expertise to dissect a report for possible hidden flaws. Instead, they rely heavily on the figures as reported, and "record profits" are accepted as record profits even though unaccounted for costs are driving a company near bankruptcy.
"You can argue that the public and investors should be more careful in accepting financial statements at face value; I won't dispute that," says Chesson. "But most investors don't go through every footnote. If you open a report and see the figures, you should be able to rely on them."
Today, investors rely on them only at their own risk. Confused laymen might well heed these words of caution from Rice University professor Robert Sterling:
"[Accounting] concepts are not concerned with real things in the real world."