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		The Shadow Side of Accounting In corporate America, hitting pay dirt can be filthy business. By Michael Cottrill Consider how many times you’ve read recently about self-serving CEOs, managed earnings, or corporate immorality. Descriptions of financial mismanagement pepper today’s business news. And the effect has been palpable. Investors’ current lack of confidence in the marketplace can be linked to revelations of less-than-reliable financial reporting, which have seriously undercut corporate credibility. Is this kind of fraud a new problem? History suggests not. Those surveying even the past four decades might quickly point to Equity Funding, Penn Square Bank, Michael Milken, Ivan Boesky, Barry Minkow, and Charles Keating. Yet the proportions and scale of the latest accounting scandals are genuinely alarming. Corporate financial reporting—the language of business—rests on the generally accepted principles of fair presentation, adequate disclosure, and rejection of misleading information. The aim: to report revenues truly earned and expenses actually incurred, leading to profit or loss. This is the tried-and-true “top-down” approach to determining results. The latest crop of scandals, however, betrays a loss of this perspective. Companies overstate revenues or understate expenses (or both) to achieve goals. This practice, often referred to as “backing in,” may more aptly be called a “bottom-up” approach. Companies start with projected or expected profits, then, by manipulating revenues and expenses, work backwards to hit a targeted bottom line. Four years ago, to help the future leaders of corporate America develop their fraud awareness, I created a course called “Fraud: The Dark Side of Business.” In the original course overview, I described fraud as “the crime of choice in modern economies. It pays better than street crime. The physical dangers are minor. The risk of detection is not great. Punishments, such as fines or jail time, are usually not very serious.” Not much has changed since then, though the physical dangers have increased somewhat, and from an unlikely quarter: Last year, organized crime bribed, extorted, and physically threatened Wall Street brokers to recruit them into a “pump and dump” scheme. Brokers were told to manufacture hot tips to drive up (“pump”) the price of stocks, then sell (“dump”) them at the inflated prices. And “do the crime, do hard time” attitudes are deepening. The Sarbanes-Oxley Act of 2002 has established a new Public Company Accounting Oversight Board, which operates under the Securities and Exchange Commission (SEC). The board will oversee and investigate public companies’ audits and auditors, and sanction both firms and individuals whenever it finds that laws, regulations, or rules have been violated. Those found guilty of records destruction, securities fraud, or failure to report fraudulent activity could face substantial fines or jail time. Even so, fraud remains a seductive crime, easy to perpetrate and difficult to detect. Often the only boundaries are the limits of the fraudster’s own imagination. Today the fraud course, though it covers many kinds of business activities, keeps step with the headlines by giving careful attention to the topic of fraudulent financial reporting, or fraud intentionally committed by management through materially misleading financial statements, harming both investors and creditors. Note the three key concepts contained here. “Intentionally committed.” There is no such thing as accidental fraud. Any fraudulent act is an intentional act to deceive. “Committed by management.” Fraudulent financial reporting almost always occurs with managers’ knowledge and consent. Even when that’s not the case, all financial statements are management’s responsibility “Materially misleading.” Accounting is not a precise science, and companies often take advantage of guideline loopholes to argue that certain methods fall within common business practices and are therefore acceptable. But a legal practice is not necessarily an ethical one. What does aggressive accounting look like? Howard Schilit outlines some common techniques in his book Financial Shenanigans, issued in a new edition this year: Premature revenue recognition. Often referred to as “front loading” or “early booking,” this is when companies report revenues in periods earlier than the ones in which the revenues are actually earned, giving the impression of higher earnings. This year, after Xerox “accelerated” its recognition of equipment-leasing revenue, the SEC levied a $10 million penalty, the largest in history, against the company. Fictitious revenue. Recognizing legitimate revenues too soon is fraudulent; reporting revenues that will likely never be earned takes the dishonesty to a higher level. One method of fictionalizing revenue is “channel stuffing,” shipping merchandise to distributors who can return any items not sold to customers. Recently, JNI Corporation, which produces computer components, admitted to using this technique, prompting a $501,000 restatement of its 2001 revenues. Improper deferral of revenue. Companies occasionally set up “cookie jar” reserves, which, when times are good, allow them to postpone the recognition of revenues; then in leaner later periods, they’re able to draw from the reserves. Often labeled “income smoothing,” this approach to financial planning is misleading unless it’s adequately disclosed. Microsoft used the technique from 1994 through 1998, without disclosing it adequately in their interim reports. Improper deferral of expenses. Some companies seem to forget the significant distinction between “revenue expenditures” and “capital expenditures.” The former is a current-period expense, reducing profit. The latter is an asset, benefiting current and future periods, affecting current and future profits as the asset’s cost is depreciated. WorldCom committed one of the largest-ever cases of corporate fraud by improperly treating more than $7 billion of revenue expenditures as capital expenditures. ($7 billion!) Premature expense recognition. Instead of deferring revenue, companies may cosmetically improve future-period performance by shifting upcoming expenses into the current year. Known as “big bath” accounting, it’s designed to make management look better in the future, since analysts often look beyond the one-time loss to focus on the future earnings. Large charges related to restructuring can be an indicator of this practice. Inadequate disclosures. As mentioned earlier, fair and clear presentations and adequate disclosures are fundamental to accounting. Yet practices that fall far short of this bar have become “generally acceptable.” Enron failed to disclose substantial debt by parking it in various undisclosed partnership interests, referred to as “special-purpose entities.” This was considered acceptable—and therein lies the problem. The “how” of financial-statement fraud is fairly easily described. The “why” is more difficult to capture. Obviously, the causes are as various as the men and women and corporations involved. But one factor trumps them all: When a company offers incentives for boosting sales and profits, its financial statement becomes its managers’ report card, the basis for performance evaluation—and the perfect vehicle for cashing in. A compensation structure that emphasizes the bottom line encourages “creative” accounting policies. External audit failures only exacerbate the problem. To stem financial improprieties, auditors must be competent, honest, and objective; they must understand complex accounting methods in a rapidly changing business environment; and they must strive to find and report material misstatements made through error or fraud. As consulting fees outpace audit fees, though, auditors have allowed their objectivity to dull. In the absence of good self-regulation by the accounting industry, independent oversight has become necessary. So the establishment of the SEC’s accounting oversight board is a step in the right direction. As are other measures aimed at restoring faith in the marketplace: requiring chief financial officers to attest to the accuracy of their financial statements, for instance, and prosecuting unethical corporate officials, imposing prison sentences or fines, as appropriate. But these proactive steps will have to be applied with rigorous consistency, to every American company and manager. If they’re not, investor reassurance and confidence will be a long time in coming around. Michael Cottrill is a lecturer in the College of Business Administration’s accounting group.