accounting faculty explain what's gone wrong with financial
reporting, and discuss whether recent reforms go far enough.
difference a year makes. In the last 12 months, accountants
have traded their buttoned-down reputation as vigilant gatekeepers
for a rather more sinister persona. Since the accounting scandals
that undermined Enron, WorldCom, Tyco, Arthur Andersen and
other firms, accountants have found themselves suddenly at
the center of billion-dollar criminal investigations unprecedented
Public outcry demanding
reform has reached the ears of the U.S. Congress, resulting
in legislation — the Sarbanes-Oxley Act, the most sweeping
of its kind in 70 years — in an attempt to curb malfeasance.
Some experts, however,
doubt the efficacy of the reform, citing its limited scope
that leaves key problems unsolved, such as loopholes in GAAP,
the Generally Accepted Accounting Principles that govern the
way businesses and auditors report earnings.
reporting scandals have shaken investor confidence in the
market, while decimating the retirement plans of millions.
Estimates of the debacle’s costs to the U.S. economy
run as high as $35 billion, according to a recent Brookings
And now most everybody
wants to blame the accountants.
say Kellogg School accounting faculty, but only to a point.
Professors Lawrence Revsine and Thomas
Lys hardly deny the role accountants played in the financial
crisis. Yet, they insist that the roots of the troubles run
deeper, and implicate many other players — both in the
political and corporate arenas. Even lax individual investors
bear some responsibility for believing the hype without checking
auditor is not your friend. The auditor is supposed to make
sure the numbers are correct and that the company does not
defraud the shareholders,” Lys states, recalling a fact
that somehow became muddled during the financial services
consulting boom that has grown steadily since the 1980s. With
this boom came a host of ethical conflicts as accounting firms
discovered they could make three times as much money advising
clients as they could from auditing their books, and that
providing both services created the best deal of all. Especially
if you didn’t mind that the numbers sometimes bore little
relation to reality.
Gary A. Rosenberg Distinguished Professor of Real Estate Management
and professor of accounting, and Revsine, the John and Norma
Darling Distinguished Professor of Financial Accounting, are
just two of the outstanding scholars on the Kellogg School
Accounting Information and Management faculty. Each has published
extensively and been recognized as an exemplary educator.
Revsine’s highly influential text, Financial Reporting
and Analysis, has recently appeared in a second edition, with
a third edition already in process. The book, used at more
than 150 business schools across the United States, predicted
much of the current accounting landscape, and years ago warned
of the dangers posed by dubious practices such as the off-balance
sheet special purpose entities that led to Enron’s collapse.
World spoke with Revsine and Lys about the scandals and
about what — if anything — can be done to restore
investor confidence in the market and the accounting industry.
That conversation follows.
World: What are some of the elements that contributed
to the crisis in financial reporting this last year?
Revsine: Several things, but the most pernicious part
of the problem involves executive compensation. Executives
were judged by the numbers they put up, by their company’s
performance. There’s a powerful incentive to manipulate
the numbers and persuade the market that the stock is worth
more than it really is, thereby increasing the likelihood
that the CEOs’ options will also earn them more money.
What’s more, these options are not accounted for as
expenses by the company.
Lys: I agree. Culprit No. 1 is stock options. In the
1990s, compensation granted executives in the form of options
reached an unprecedented high. These options create short-term
incentives to manage the stock price. So suddenly, as a CEO,
you not only have an incentive to manage the company, but
also to short-term manage your stock price. This happened
on a gigantic scale. Compensation became the “show.”
But compensation can’t be the show. Compensation is
the sideshow; running the company is the show.
other motivation has management had to manipulate the data,
beyond personal greed?
All sorts of important contracts are tied to the numbers.
Certainly the executive bonus contracts play a role, but so
do lending agreements between firms and financial institutions.
Banks say if your debt-to-equity ratio gets too high, the
loan is immediately due. You saw what Enron was trying to
do with off-balance-sheet debt. The company didn’t want
its loans called or the interest rate stepped up, so they
used the latitude in GAAP to hide liabilities. They exploited
the gaps in GAAP.
sounds as if there’s an institutionalized framework
in place that encourages “creative accounting.”
How has Sarbanes-Oxley alleviated the crisis, and is this
Sarbanes-Oxley has helped somewhat, primarily by limiting
the type of work an auditor can do and thereby minimizing
the egregious conflicts of interest we’ve seen between
accounting firms conducting audits for the same companies
to whom they offer consulting services. But auditors are still
hired by those whose performance is being evaluated. This
is troublesome. What if home teams were permitted to hire
the referees at football games? Would we have impartial officiating?
Hardly. Why should we expect a different outcome when the
audit “referees” are hired by the firm playing
the game? Sarbanes-Oxley hasn’t fixed this.
Auditors have had an incentive to “give away the audit”
to make sure they can sell their consulting services, because
that’s where the money is. But the auditor is not your
friend. The auditor is supposed to make sure the numbers are
correct and that the company does not defraud the shareholders.
the boards of directors have played a more constructive role,
perhaps mitigating the scandals?
The real gatekeeper is not the auditor, it’s the board
of directors. The board must ensure that management has satisfied
its duties. The auditor should report to the board. The shocking
part in what has happened is not just the failure of the audit,
but the failure of the boards to fulfill their fiduciary responsibility.
Everyone’s pointing at the auditors, but frankly the
auditors are a small cog in the gearbox. These are board failures.
The auditors contributed, but the boards failed to protect
the auditor from management. A good board must take the auditor
aside and say, “Be tough. If management fires you, we
will fire them.”
this is a complex problem left untouched by the Sarbanes-Oxley
reform. What else has not been fixed by Sarbanes-Oxley?
Congress doesn’t make accounting standards, so the loopholes
in GAAP remain. There are numerous opportunities to manipulate
the numbers. Furthermore, stock options still aren’t
treated as expenses, and the auditors are still hired by the
companies they’re supposedly scrutinizing, as I mentioned
earlier. So the crisis has been solved only to a very small
this reform could be interpreted as a stopgap measure to appease
the public and key constituents, without entirely putting
out the fire.
Exactly. Appeasement is a wonderful word to describe this
kind of reform. Sarbanes-Oxley did say that there should be
a study to examine the feasibility of mandatory rotation of
audit firms. A feasibility study. That’s a classic illustration
of a ploy to take the heat off the auditors while everyone
drags their heels.
The reform fails to remedy an important point: the accounting
trick associated with accounting for stock options. Currently,
if you give me options your earnings are not down. You pay
me cash, and your earnings go down. As a company you’re
concerned about earnings; you give me more options to keep
me happy and make your earnings look good on paper. It’s
a vicious cycle.
reasonable person would assume that giving options away is,
in fact,an expense and should be accounted as such.
A dollar is a dollar. You give me a dollar in furniture, your
earnings should be down by a dollar. Give me a dollar in cash,
your earnings should be down by a dollar. Why does it matter
whether you compensate me with a desk or cash?
hasn’t anyone addressed this point? It seems a glaring
lapse in logic.
Several years ago the proposal was put forth to count options
as expenses, but there was political pressure turned on the
Financial Accounting Standards Board to discourage pursuit
of this course of action. Essentially, Congress screwed up
and helped create incredibly powerful incentives to compensate
CEOs with options.
has Kellogg responded to the accounting crisis? Has the curriculum
here changed as a result of Enron-gate?
Kellogg has always set the bar for our students a lot higher
than it would be for an auditor. We’ve done this for
years, so what’s happened in the accounting world has
affected our curriculum less than it has other schools because
we always focused on incentives, managers’ exploitation
of latitude in GAAP, and auditors’ conflicts of interest.
Our students have always been enthusiastically engaged with
these issues. They don’t need a pep talk to be convinced
that this is important stuff. Our courses are way ahead of
the curve here.
the Kellogg students are doing great, but what about those
people sitting in the boardroom now? Can they be given better
tools to assess the numbers and intervene when they suspect
This crisis has been the worst thing to happen to the audit
profession, and it’s the best thing to happen to accounting
academia. Suddenly people understand how important it is to
understand the process by which the numbers are created. Dean
Emeritus Don Jacobs and I have developed an Executive Education
program to train directors, called Strategies for Improving
Directors’ Effectiveness. Our idea is to bring this
information to the gatekeepers.
Kellogg’s MBA and Allen Center Executive Education courses
have long provided a forensic accounting focus. For example,
the Credit Analysis, Equity Valuation and Financial Reporting
exec ed course that I direct was started 21 years ago. We
train people to fulfill their roles as directors, investors
and management leaders. What frustrates me in these scandals,
though, is the generally mechanical way many schools have
taught accounting. Accounting educators are a big part of
the problem, and there’s a lot of programs that are
just awful. And there are a lot of investors who think themselves
sophisticated because on Friday nights they tune into some
investment program on TV with a cast of people who are there
simply to generate clients. That’s silliness. Investors
should stop listening to sales pitches.