Fear of All Sums

Fear of All Sums

Investors do not trust the financial statements of public companies. The restatements of large, well-known firms (like WorldCom and Xerox) come right on the heels of the collapse of hundreds of Internet- related firms. The average investor who reads the annual reports could not have predicted these events. These accounting issues may be too complex for the average investor to find. Yet, the letters from the auditors in these reports do not speak of the possible trouble ahead. Surely the auditors understand the financial health of a firm. Investors have also relied on financial analysts to interpret financial statements and comment on the financial health and prospects of a firm. Analysts have also failed the investor (see Chapter 8). Investors need to reestablish faith in the financial statement of a firm in order to restore their confidence in public companies and the stock market.

This will be difficult in the near- term . The collapse of Arthur Andersen has forced many companies to switch auditors from Arthur Andersen to one of the other accounting firms. Consider the motivation of the new auditing firm. Since it must certify that the financial statements it audits are fair, it has an incentive to find any problems with past accounting while it can still blame the previous auditor. Thus, the change from Arthur Andersen to a new auditor may foster many more restatements. Indeed, the pace of earnings restatement seems to be dramatically picking up. A study by the Huron Consulting Group reports that 116 firms restated in 1997. This number has grown to 233 in 2000 and 270 in 2001. [14] As the public focus on accounting increased in 2002, so did the number of restatements and their magnitude. While the 233 firms in 2000 represent less than 3 percent of all listed firms, the 503 restatements in 2000 and 2001 together represent nearly 7 percent of all firms. With many more firms restating in 2002, investors could easily be looking at a minimum of 10 percent or 15 percent of their firms restating over the three-year period.

We want to point out that if aggressive (or even fraudulent) practices occur in 10 percent of the exchange-listed firms, that leaves 90 percent of the firms that did the right thing. It is too bad that the 10 percent will affect the investing industry and the financial environment so much for the 90 percent. It is too bad that the few problems have shaken investor trust so much. However, a typical investor's perspective is that the risk caused by this 10 percent is considerable.

The risk might be growing. Because of the public outrage and the political rush to make changes, it is likely that GAAP will be changed so that firms must disclose " off-balance " sheet transactions with subsidiaries, partnerships, and "special purpose entities." Auditors seemed to have lost the emphasis on "economic substance" for the emphasis on "form." This will probably change. Changes will also be made to close loopholes that foster some of the accounting gimmicks. These changes will make many companies look less profitable than before. As they miss earnings targets and expectations, their stock prices could decline further.

An International Perspective

The bankruptcy of major companies and the ensuing media attention and political rhetoric make it seem like the U.S. system of accounting has been a total failure. However, this is simply not true. Compared to the accounting systems used internationally, the United States is quite tough. Characteristics of a high-quality system would have many shareholder rights and strong protection of those rights. This protection comes from strong laws that are enforced and accounting standards that have little ambiguity.

In comparison with the environment in other countries, the United States already has tough laws and a high degree of enforcement. In a recent study of 31 countries , three accounting researchers found that the United States has the best legal environment to discourage earnings manipulations and smoothing. [15] Australia, Ireland, Canada, and the United Kingdom also have good investor protection and enforcement histories. Earnings manipulations are more common in Austria, Italy, Germany, South Korea, and Taiwan. While investors currently lack confidence in the financial numbers reported by U.S. firms, the numbers of some foreign firms could be of lower quality. The scandals in some U.S. firms parallel some recent international scandals. International examples of scandal include embezzlement at the Bank of Credit and Commerce International and at Polly Peck, accounting fraud at Lernout and Hauspie, cash diversions at Daewoo Motors, and numerous shenanigans in Robert Maxwell's firms.

There is work being done to create a high-quality set of international accounting standards. The International Accounting Standards Committee (IASC) was founded in June 1973 by the accounting bodies of ten countries. Effective April 1, 2001, the International Accounting Standards Board (IASB) assumed accounting standard-setting responsibilities from its predecessor body, the IASC. This board is developing a single set of global accounting standards that are high quality, understandable, and enforceable, and that require transparent and comparable information in general-purpose financial statements. In addition, the board wants to encourage convergence in accounting standards of individual countries around the world.