The Changing Role of Accounting

Over the past couple of decades, the role of accounting within a company has changed. Instead of just providing information to insiders and outsiders of a firm, the accounting department began to transition into its own profit center. Instead of simply reporting the quarterly profits of the firm, the accounting department was asked how to increase profits through application of accounting methods . In some areas, the ambiguity in GAAP and the subjectivity of business activities provide for different ways of accounting for the same transaction. Different methods often lead to different levels of reportable profits.

One example is the desire of companies to exhibit a steady and continuous growth in profits. If the profits generated from business activities grow, but at an erratic pace, accountants are asked to smooth out the earnings over time. This is referred to as managing earnings. GE has been accused of using accounting manipulations to manage its earnings. ^[3] In Figure 5-1, notice how steady the growth in GE's earnings has been ” especially since 1995.

Figure 5-1. Annual earnings of General Electric in millions of dollars.

Money magazine wrote in 2000 that GE employs a number of confusing ”but apparently legal ”gimmicks to achieve its consistent growth. For example, GE's financing division, GE Capital, can reduce current earnings for the firm by being pessimistic in its estimates of losses from problem loans. If those loans eventually end up getting repaid, this will increase future profits. The maneuver effectively shifts some earnings into the future. If the firm is in need of more earnings in the present, it can conduct a real estate sale and leaseback. This transaction could work in the following way. GE sells a factory to a group of investors for $100 million, but GE signs a long- term lease with the group so that it still uses the factory. However, since the factory had been depreciated to $50 million, GE could claim the difference as a capital gain and increase pre-tax profits by $50 million. The profit could have been amortized over the life of the lease. This method would not have affected profits. Due to GAAP ambiguities and loopholes, firms can choose methods that benefit them the most.

Both taking reserves for bad loans and the real estate sale/leaseback are perfectly legal. However, the accounting treatment of them assumes that these transactions occur as normal business activities. Some firms use them as accounting gimmicks to manage earnings over time. There are other firms that can be used as an example for managing earnings. For example, IBM has also been accused of using financial steps in the 1990s to create double-digit earnings growth when revenue grew at only 5 percent. ^[4] However, GE holds a special place in the investment industry because it is the only company in the Dow Jones Industrial Average that was an original Dow firm when the index was created more than 100 years ago. If GE is using accounting methods to manage earnings, many other companies are likely to do so as well.

U.S. Vice President Dick Cheney has taken heat over his five-year tenure as CEO of Halliburton Company. ^[5] The SEC investigated Halliburton over accounting practices that occurred during the years when Cheney ran the firm. The issue appears to be why Halliburton accounted for projected overrun reimbursements as revenue while work was still to be completed on projects. By changing its method of booking these revenues in 1998, Halliburton was able to substantially increase revenue. Additionally, the SEC wants to know whether Halliburton adequately disclosed the change and its impact on financial statements. Whether Halliburton or Cheney did anything wrong, we don't know. However, this is just one more instance that illustrates a CEO walking off rich while the shareholders suffer. Cheney pocketed $45 million in compensation over the five years of his tenure while investors have since seen the stock price drop from $54 per share to $13 per share.

The accounting gimmicks that are used can be either simple or quite complex. Indeed, modern consulting by accounting and auditing firms concerns structuring deals that may not have any value in conducting business, but it spins off either profits or losses now that can be reversed in the future to manage earnings.