Accounting at a Crossroad

By Eugene H. Flegm

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DECEMBER 2005 - The accounting profession, broadly defined to include both private and public CPAs, has been going through a terrible time. At the start of this century, top-management frauds at major corporations, including Enron, WorldCom, Parmalat, Tyco, HealthSouth, Qwest, and Global Crossing, resulted in the loss of pensions and jobs for thousands of employees; the dissolution of a major public accounting firm; the discovery of widespread manipulation of mutual fund accounts for personal gain or privileged customers; and the fining (by New York State Attorney General Eliot Spitzer) of 10 major investment banks $1.4 billion for their part in hyping high-tech stocks during the infamous stock market bubble of the late 1990s, the collapse of which resulted in the loss of billions.

Frank Partnoy, a professor at the University of San Diego School of Law, tells the story in his book Infectious Greed: How Deceit and Risk Corrupted the Financial Markets (Henry Holt & Company, 2003) of the financial shenanigans of the l980s and l990s—beginning with the speculation in currency options; the $3.6 billion bailout of Long-Term Capital Management in 1998; and culminating with the collapses of Enron, Global Crossing, and WorldCom. Partnoy describes a culture of greed that reached epidemic proportions before it crashed, the root cause of which I believe to be the decline in ethical behavior in our society. Moreover, accounting standards setters introduced into this climate changes in the measurement base that facilitated mismanagement of earnings by unscrupulous executives. This was exacerbated by the CPA profession’s focus on fees instead of audits. Some observers have also pointed to the general lack of ethics in MBA programs during this period. Dennis Gioia, a professor of organizational behavior in the department of management and organization of Pennsylvania State University, referenced this in a speech to the Academy of Management in 2002, noting that the call of stock price on Wall Street is very strong and quite seductive. He concluded that, “We are training and turning out a very skilled group of people from our programs. But we shouldn’t be surprised if some cynical observers conclude that we are also turning out some very skilled criminals.”

Congress contributed to the problem by underfunding regulatory agencies, principally the SEC, thus preventing it from having the people to dig into problem areas in the manner of the bank investigations performed by Eliot Spitzer (see “The Investigation,” by John Cassady, The New Yorker, April 7, 2003). Furthermore, many corporate boards and audit committees performed their duties perfunctorily at best. Finally, this environment existed in the short-term speculative culture of the stock market. All of this, plus the movement to a fair-value measurement base, has resulted in the profession’s finding itself at a point in time when the very existence of the independent public accounting sector of the profession is in doubt.

Ethics in the Real World

Everyone likes to work and live with people that have a positive attitude. In medicine, sports, business, and just living, it is better to have a positive outlook. Doctors will tell you that if you think your illness is hopeless, there is a good chance it is. In sports, great stories are made by teams that looked beaten, but a coach rallied and changed the players’ attitudes and made them winners. It is true also in business and life that if you think you will fail, you probably will. One’s attitude, however, must be tempered by facts, and certainly a Pollyanna view is to be avoided.

Earning a living involves basic conflicts that we must recognize when we look at how we can forestall repeats of the egregious frauds we’ve experienced recently. Every organization, be it a Boy Scout troop, sports team, social club, business, and certainly a military unit, strives for a bonding, a feeling of the Three Musketeers: “All for one and one for all.” That bonding is sought by every organizational leader, and although it is generally a good thing, it can be, and was, abused—badly—in the recent financial frauds.

Carrie Johnson wrote of this in a March 20, 2005, Washington Post column. She noted that the sheer number of subordinates facing criminal charges belies the myth that a small group of devious executives carried out these recent frauds. She noted that it seemed apparent that many workers in these companies vowed loyalty not to ethical practices or even to the company, but to charismatic leaders who came to personify their businesses. Why do basically honest people keep their mouths shut during a fraud? Why do they obey instructions they know are wrong? Because since the time they were in kindergarten they had been told, “Don’t be a tattletale.” They learn to “go along to get along.” And there is the bonding: the loyalty to one’s family, team, group, employer, and country.

Another major factor is fear of the loss of a chance for a promotion or even fear of the loss of one’s job. I know personally the extreme difficulty of being the lone naysayer on the “team,” because I was a professional “black hat,” a nickname given me by a chairman who noticed that whenever the then–current CFO had bad news in the form of an unfavorable variance from forecast earnings, he would bring me along to discuss the results with the chairman, while I was not asked to accompany the CFO to deliver good news. The chairman quickly picked up on this pattern, hence his comment: “Uh oh, it’s bad news: You brought the man in the black hat along.”

The preceding also illustrates another flaw in our society’s behavior. As noted earlier, optimistic coworkers are preferable to pessimistic ones. Many CEOs prefer to surround themselves with people who not only think the way they do but who support their proposals rather than criticize them. The best CEOs, however, recognize the need for a “no-man” rather than only “yes-men.” If Richard Nixon had had one trusted “no-man” staffer who would have put the kibosh on the Watergate break-in plan, he would have served out his second term.

Being a “black hat” is often less pleasant, however. Consider the case of David Graham, a 20-year veteran of the FDA. As profiled in Fortune (January 24, 2005), he blew the whistle on Merck’s Vioxx in the summer of 2004. Graham went on to give explosive testimony before a Senate committee in November 2004, criticizing the FDA’s drug-safety oversight procedures. He told Fortune: “It’s been the roughest six months of my career. The sense I get is that I’m an enemy, a traitor.” Sadly, this has been the usual experience for whistleblowers who are revealed. Similarly interesting to note is the reaction in June 2005 to the disclosure that high-ranking FBI official Mark Felt was the most famous whistleblower of all time, “Deep Throat.”

Achieving success in the “greed is good” culture that has pervaded business for the past 30 years is another major factor in the behavior of employees. Charles Prince, who became CEO of the troubled Citigroup corporation in October 2003, was interviewed for a Fortune article (November 29, 2004). Commenting on the problems Citigroup had experienced in the past year, which resulted in $8 billion in charges related to questionable practices and the dismissal of three officers, he said, “I never thought that you had to say to people, ‘We want to grow aggressively—but don’t forget not to break the law.’” (The AP reported in June 2005 that Citigroup paid $2 billion to settle the class-action suits filed by Enron investors for its role in helping Enron orchestrate the fraud that led to Enron’s collapse. This was in addition to the $2.58 billion that Citigroup paid to WorldCom investors for the same reason in 2004. Nine other banks—JPMorgan Chase, Barclays, Credit Suisse First Boston, Merrill Lynch, Toronto Dominion Bank, Royal Bank of Canada, Deutsche Bank, and Royal Bank of Scotland—were also named in the suit and have settlements pending.) Recently, the Economist echoed Professor Gioia’s comments when it cited an article by Sumantra Ghoshal in which he argued that many of the “worst excesses of recent management practices have their roots in a set of ideas that have emerged from business-school academics over the last 30 years” (February 19, 2005).

Public accounting became infected also. Professor Arthur Wyatt spoke of this problem in his speech at the 2003 American Accounting Association’s annual meeting: “Just as greed appears to have been the driving force at many of the companies that have failed … greed became a force to contend with in the accounting firms.” [See The CPA Journal, “Accountants’ Responsibilities and Morality (Accounting Professionalism: A Fundamental Problem and the Quest for Fundamental Solutions),” March 2004.] The same factors that influence employees also influence the public accountant. The goal of every new hire by a public accounting firm is to “make partner.” That desire is fine so long as it is pursued in an ethical and professional manner. Argumentative clients can make this very difficult, however. Much of the pressure to please the client stems from the action of the Federal Trade Commission in the late 1970s, when it decided that public accounting was a commodity and that accountants should be allowed to advertise and compete—it has been all downhill since then.

What to Do

Recognizing from the preceding that underlying human traits can and do cause major frauds, what can be done to control, if not prevent, fraud from recurring?

First, recognize that while we want to control all fraud, top-management fraud deserves our primary focus because that fraud can and has brought down companies. The Sarbanes-Oxley Act (SOA) is a major step toward controlling fraud through fear of imprisonment and or fines. Establishing the Public Company Accounting Oversight Board (PCAOB) was another step in such control as it replaced the AICPA and self-regulation for public accountants. Both are after the fact, however, and therefore give no relief in the actual performance of corporate accountants’ or auditors’ duties. Edward Deming, the brilliant quality-control engineer who was scorned in the United States in the 1950s and went to Japan, where his message was taken to heart, commented on quality at a meeting at General Motors many years ago: “Americans plan to keep the production lines running and then inspect quality after the fact.”

To build quality into products, we should do a far better job of teaching ethical behavior. That is more easily said than done, however, especially considering how strongly embedded “Greed is good” has become. James Copeland, retired CEO of Deloitte & Touche, wrote in the March 2005 Accounting Horizons about the myriad factors that may have caused our ethical crisis: the decline in religious faith; the impact of the breakdown of the family structure; the rise of a drug culture; the deterioration of our education system; the impact of the entertainment and Internet society, where anything goes; and government itself. Commenting on the pressure on corporate accountants and auditors from aggressive senior management, he said: “Ethical decisions can have negative repercussions, but integrity and character come with a price tag. If they were free, everybody would have them. But today, we are discovering that the cost of integrity and character is cheap compared to the cost of not having them.”

While we should be attempting to change our culture, more must done. Two areas that must be strengthened are solving theory applications that are in contention, and eliminating the high degree of subjectivity involved in the application of fair-value statements such as FASB Interpretation 133. The SEC has long had a process for reviewing difficult accounting questions, but its use has been generally limited to proxy filings. This writer believes that SOA should be amended to establish a legal review authority to require significant accounting disputes be brought to the SEC for settlement. Penalties should be provided, and senior management should be made aware of such rules and penalties. This would give the auditor a process to resolve a dispute with the client and provide something of a heat shield. (It would also provide the same protection for the corporate accountant as well.) In addition, SOA should be amended to specifically require companies to establish a whistleblower procedure, historically a reliable method of finding fraud. (SOA currently provides for protection of whistleblowers in section 806.) Given anonymity, people will tell of abusive practices, but such calls must be validated, because they can also be motivated by vengeance or malice, with no basis in fact.

The Fair-Value Controversy

Another area of concern is FASB’s move to fair value as the measurement base. Although both SOA and the PCAOB ignored this issue, it has the potential (as Enron demonstrated) to have fatal consequences when misused by unscrupulous managers.

The Securities Exchange Act of 1934 established the Securities and Exchange Commission and mandated that the SEC set accounting standards. (Only five such “standards” existed at that time.) Carmen Blough, the first SEC chief accountant, wanted the AICPA to take action on standards setting, but after two years of waiting, he lost patience and told the Institute that if it did not move at once, then he would. The AICPA formed the Committee of Accounting Procedure forthwith, and in 1938 the SEC delegated its authority to the AICPA by a 3–2 vote. (This was probably not permitted under the 1934 act, but it has gone unchallenged.) Over the next 35 years, the AICPA and academics wrestled over standards setting. In 1959, they decided that they needed some sort of general theory, a constitution as the basis for setting standards rather than the ad hoc approach used up to then. (In 1940, W.A. Paton and A.C. Littleton published An Introduction to Corporate Accounting Standards, which, while still the most widely used exposition on the subject, has never gained formal recognition.) When the Accounting Principles Board was formed, professors Robert Sprouse and Maurice Moonitz were asked to prepare a constitution, and “Accounting Research Study 3, A Tentative Set of Broad Accounting Principles for Business Enterprises,” was produced. The project was viewed as too radical, however, and was never completed.

By 1972, pressure built up again for a better approach. The AICPA formed two committees. One, named the Trueblood Committee after its chairman, then–managing partner of Touche, Ross & Co. Robert M. Trueblood, produced the Objective of Financial Statements. The other, named the Wheat Committee after its chairman, SEC commissioner Francis Wheat, was to determine how accounting standards should be established. FASB was the result of its report, “Establishing Financial Accounting Standards.”

In 1976, FASB issued a revolutionary document, the Discussion Memorandum on the Conceptual Framework for Accounting. It proposed turning the accounting world upside down. Although the income statement and the matching concept had been the primary focus of financial reporting since the Paton and Littleton monograph in l940, FASB changed that focus to the balance sheet. The basis for this proposal was the Trueblood Report’s reference to an economic concept of income. The report stated, “Accounting measurements of earnings (income) should recognize the notion of economic better-offness, but should be directed specifically to the enterprise’s success in using cash to generate maximum cash.” However, as Eldon Hendrickson pointed out in his Accounting Theory (3rd ed., 1977), there is a contradiction in this goal, because, “The former goal is the concept of capital maintenance and the latter goal is another form of the profit maximization concept or measurement of efficiency.” Because measuring capital maintenance is difficult, if not impossible, the pragmatic accountant focuses on profit maximization.

Two future chairmen of General Motors, Thomas A. Murphy and Roger B. Smith, were involved in the preceding. Murphy was a member of the founding board of trustees of the Financial Accounting Foundation. Smith was a member of the Wheat Committee. Murphy had been comptroller when I joined GM in 1967. When FASB issued the conceptual framework in 1976, Murphy, then an executive vice president, asked me to “get into this in depth.” I drafted the GM response to the exposure draft, which included a strong defense of the historic cost measurement base as well as references to the Paton and Littleton monograph. The draft was routed to and approved by Frederic G. Donner (retired chairman of GM) and Andrew Barr, then–SEC chief accountant and a good friend of Donner.

For 17 years, I represented GM on the Committee on Corporate Reporting of what is now Financial Executives International, working with the committee to persuade FASB not to pursue an economic view of income. Professor Gary Previts and I worked with the AAA, conducting seminars with accounting professors and corporate controllers for 10 years, attempting to demonstrate how accounting was used in business. I have done this from the perspective of an auditor who wants data that is auditable and from the perspective of a corporate officer preparing data used to judge divisional performances as well as the overall corporate performance. Much of what some of us in business have done has been to no avail. We are, as one professor declared, the “foxes in the henhouse”; or as a former FASB member told me, “I don’t believe you have any business even being involved at all; you are who we are trying to control.” Unfortunately, from what I have witnessed these past three years, FASB is doing a poor job of controlling anyone.

Through its standards, FASB gave the individuals behind at least four major frauds—Enron, Qwest, Global Crossing, and Parmalat—the tools to defraud their stockholders. FASB was a part of the problem when it should be part of the solution. Derivatives are extremely complicated to evaluate under the best circumstances, but when such assets are required to be written up to a presumed “market value,” or 30-year executory contracts are required to be discounted to present value, abuse is almost inevitable. When PCAOB board member Charles D. Niemeier spoke at the AICPA Annual SEC and PCAOB Conference in December 2004, he said: “The most disturbing aspect of Enron and similar scandals was not that what was done was wrong, but that what was done was right. Enron did not ignore the rules and regulations, but instead took them and used them to achieve results that were never intended.”

Mariner Energy, an oil and gas offshore-exploration company in which Enron held a controlling interest, was required by FASB rules to apply fair-value accounting to its oil reserves, and it did. In October 2003, the SEC charged Mariner’s former chief accounting officer (CAO) with fraud (Litigation Release No. 18403). The charge states in part: “Enron, through Colwell [the CAO] and others, fraudulently inflated the value of its largest private merchant asset, Mariner Energy, Inc. … In the fourth quarter of 2000, Enron needed an additional $100 million of earnings to achieve budget targets. … To meet this need, Colwell and others fraudulently increased the recorded value of Mariner by approximately $100 million.” Business Week (February l5, 2002) reported that the Enron Risk Assessment & Control Group began offering valuation ranges of from $80 to $350 million to Enron during that period, which seemed to indicate, “Take your pick. What do you need?”

The problems with such valuations began with the conceptual framework. The Trueblood Committee dealt not only with an economist’s view of the world but with a utopian one as well. The committee never considered that a certain percentage of people are dishonest, are unethical, and sometimes get into positions to take advantage of the honest people in the world. Moreover, it chose to ignore the responsibility of any standards setter to reduce, not increase, the subjectivity of accounting. And, most important, it changed the basic emphasis of financial reporting from a report to absentee owners attesting to managements’ (agents) successful stewardship and accountability, to a report to potential investors reflecting the company’s potential (assuming that this could be expressed in dollars).

Surprisingly, no regulatory body, including Congress or the SEC, has criticized FASB for its part in enabling frauds. The broad-reaching SOA is silent on the actions of FASB. The PCAOB is properly focused on public accounting, but action on the use of value-based “measurements” as well would be appropriate.

Former FASB chairman Dennis R. Beresford has written of the increasing complexity of accounting standards, citing the August 2004 report of the PCAOB on its initial reviews of the Big Four (The CPA Journal, December 2004). He noted that all four firms had missed the fact that some clients had misapplied EITF Issue 95-22, which deals with the balance-sheet classification of borrowings under revolving lines of credit. He noted KPMG’s response: “Three knowledgeable informed bodies—the firm, the PCAOB, and the SEC—had reached three different conclusions on the proper accounting,” and pointed out that today companies are subject to quadruple jeopardy because there are at least four levels of possible second-guessing: 1) the external auditors; 2) the SEC; 3) the PCAOB; and 4) a law firm for a plaintiff. Regarding this last point, remember that under SAS 99 the auditor is now more responsible for the detection of fraud.

Beresford’s comments regarding fair-value accounting are particularly interesting. Although he continued to defend fair-value accounting in some cases, he expressed concerns about its wide use, citing FASB Interpretation 45 in particular. This standard, covering guarantees, states that a fair value must be recorded even when the company does not expect to have to make good on a guarantee. He opines:

I have three major concerns about such pervasive use of fair value accounting. First, in many cases determining fair value in any kind of objective way will be difficult if not impossible. Second, the resulting accounting will produce answers that won’t benefit users of financial statements. Third, those answers will be very difficult to explain to business managers, with the result that accounting will be further discredited in their minds. The approach that FASB is using for what I would call operating liabilities is particularly troubling. Take, for example, a company that owns and operates a facility that has some asbestos contamination. The facility is safe and can be operated indefinitely, but if the company wanted to sell the property it would have to remediate that contamination. The company has no plans to sell the property. But FASB’s exposure draft on conditional asset retirement obligations calls for the company to estimate and record a fair value liability.

Beresford goes on to question FASB’s plans to revise revenue recognition, basing it on fair value: “This may well make revenue accounting even more complicated than the detailed rules that we are least used to working with.” He concludes that, “Fair value definitely makes sense in certain instances, but FASB seems intent on extending the notion beyond the boundaries of common sense.” In response to Beresford, I personally believe the use of fair-value estimates is appropriate only in the application of the rule “lower of cost or market” and in mergers involving stock rather than cash when appraisals of assets have to be made—and even those are often not accurate.

It is my belief that FASB pursues the fair-value measurement base out of hubris. Twenty-five years ago, one FASB board member responded to a question about FASB’s role in business by saying, “Our role is to defend free enterprise and preserve the capital markets of our country.” FASB may still believe it is doing that, and although one would hope the frauds of the past few years would give it pause, the defenders of fair value repeatedly argue it is more relevant than old historical costs. I would argue that no data can be relevant if it is not reliable, and the reliability of historic costs is far more valuable than the accumulation of statistical probabilities offered in fair-value accounting.

FASB does not recognize that the greatest risk any company faces is strategic risk. A notable example is Sony: In 2000, Sony’s stock price hit $140; today it is around $40. The company failed to recognize the changes in the electronics business: digital music-players (the popularity of the iPod overtook Sony’s long-time dominance of the field with its Walkman), and television (Sony missed the shift to flat-screen television).

Avoiding More and Bigger Frauds

Much is written about the need to provide investors with financial data that reflects the value of the company. While accounting is vital to the successful management of a company, many nonfinancial drivers in addition to strategic risk are only indirectly reflected in earnings, including market share; product quality and design; speed to market; innovation; talented employees; leadership; and ethics. If the move to fair value continues, we will not only see more and bigger frauds, but we will soon have three sets of books: one based on historic cost and used to control and evaluate employees and management and to report on their stewardship; a second to meet the requirements of the IRS; and a third to prepare fair value–based financial statements for regulatory agencies.

The move to a third set of books is well under way. In May 2005, the AICPA Council endorsed a dedicated effort to explore changes to GAAP for private companies. The AICPA task force report on this project notes that only 17,000 of the nation’s 4.9 million corporations are registered with the SEC, thus raising the question of whether all of those private companies are being well served by the GAAP being formulated by FASB. Obviously if FASB’s goal is serving the investment community, it is not considering private companies. Ordinarily one would think that GAAP should be the same for everyone. However, the emphasis of the stock market on the short term is a very disruptive force in financial reporting. As public company managers are pressured to predict earnings and then to “hit those targets or else,” an unhealthy business climate is the result.

The news service Knight Ridder carried an interesting story in January 2005 in this regard about ING Direct Bank, a Dutch-owned lender operating in the United States. Noting its steady growth since it opened in 2000, its CEO, Arkadi Kuhlmann, said that although the bank is publicly traded, with its European investor base, it is protected from activist U.S. investors in search of a quick profit.

SOA sets some significant rules to prevent or at least limit the vast management frauds we have seen and to preserve an independent public accounting profession. Section 404 has awakened everyone to the hazards of unethical and illegal behavior. Although not enough was done to ensure strong boards of directors, SOA strengthened the audit committee of the board. I would have liked to have seen as much attention paid to requiring a truly independent compensation committee. The internal control environment is spelled out quite well in the Committee of Sponsoring Organizations (COSO) report on internal control, and SOA will give it teeth. I also would have preferred that every publicly owned company be required to set up a whistleblower hotline. And of course every company should have an internal auditor who reports to the audit committee as well as to the CEO.

I submit that FASB has outlived its usefulness and that the SEC, adequately funded, should exercise its 1934 mandate and take full control of accounting standards. Furthermore, the SEC should also reaffirm the use of historic cost as the measurement base, and the basic need for the attestation by an independent public accountant as to the stewardship of management. This would reduce the subjectivity of accounting and aid in presenting auditable data. In addition, I believe we should provide the heat shield that I outlined for the public accountant and for the corporate accountant, recognizing that we are dealing with human beings who can (and will) be pressured and tempted to manipulate accounting data. If, instead, we continue the march to fair value, the result will be more major frauds and probably the end of an independent public accounting profession.

Accountants’ goal should not be to serve short-term speculators but instead to serve the stewardship interests of the long-term owner and to stop top-management fraud.

Eugene H. Flegm, CPA, CFE, was the general auditor for General Motors Corp. before his retirement.

Editor’s note: Dennis R. Beresford’s December 2004 article (“Can We Go Back to the Good Old Days?”), referenced herein, won The CPA Journal’s 2004 Max Block Distinguished Article Award for Best Article in the Area of Informed Comment and is available online at

All photos courtesy of the Accounting Hall of Fame and Daniel L. Jensen, Deloitte & Touche Professor Emeritus of Accounting at Ohio State University.





















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