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Cover by numbers

Kellogg accounting faculty explain what's gone wrong with financial reporting, and discuss whether recent reforms go far enough.

By Matt Golosinski


What a 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 in scope.

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.

The financial 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 Institute study.

And now most everybody wants to blame the accountants.

Prof. Lawrence Revsine  
Prof. Lawrence Revsine  

Fair enough, 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 the math.

“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,” 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.

  Prof. Thomas Lys

Lys, the 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.

Kellogg 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.

Kellogg World: What are some of the elements that contributed to the crisis in financial reporting this last year?

Lawrence 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.

Thomas 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.

What other motivation has management had to manipulate the data, beyond personal greed?

LR: 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.

It sounds as if there’s an institutionalized framework in place that encourages “creative accounting.” How has Sarbanes-Oxley alleviated the crisis, and is this legislation sufficient?

LR: 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.

TL: 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.

Should the boards of directors have played a more constructive role, perhaps mitigating the scandals?

TL: 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.”

Clearly this is a complex problem left untouched by the Sarbanes-Oxley reform. What else has not been fixed by Sarbanes-Oxley?

LR: 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 extent.

So this reform could be interpreted as a stopgap measure to appease the public and key constituents, without entirely putting out the fire.

LR: 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.

TL: 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.

A reasonable person would assume that giving options away is, in fact,an expense and should be accounted as such.

TL: 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?

Why hasn’t anyone addressed this point? It seems a glaring lapse in logic.

TL: 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.

How has Kellogg responded to the accounting crisis? Has the curriculum here changed as a result of Enron-gate?

LR: 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.

So 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 malfeasance?

TL: 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.

LR: 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.

©2002 Kellogg School of Management, Northwestern University