Accounting in the U.S. and Europe: Arrogance, Angst and Ideas for ReformPublished: October 23, 2002 in Knowledge@Wharton
Following the business scandals of the past year, the initial focus of reform has been on accounting and auditing practices. But going forward, reform will branch out beyond technical rule-making to confront deeper notions about corporate governance in the United States and abroad, according to participants in a panel entitled “What Rules, Who Enforces? Accounting Standards and Auditing Practice.”
Referring to Enron and the other companies that dominated business headlines in the past year, John Paul MacDuffie, co-director of the Reginald H. Jones Center, noted that “each new revelation had a cumulative effect. It became harder to attribute the events to a few renegade accountants or rogue CEOs. We’re seeing a systemic set of phenomena.”
While “it is tempting to apply a quick fix,” he said, such an approach is “typically short-sighted.” Change can come through new laws or regulations, but firms and other gatekeepers, such as institutional investors, also need to take a proactive stance with their own initiatives. These initiatives, MacDuffie suggested, might include a new emphasis on ethical behavior in business education and within firms. Tougher new accounting and auditing rules can go only so far if they are applied in a context of corruption.
The major scandals have been limited to U.S. companies, he added, but the changes in accounting and audit rules they generate will affect other companies as well. “Our American rules will become global rules, for better or worse.”
MacDuffie recognized concerns that efforts at reform may go too far and create new unforeseen problems. “Some of you may feel there is a risk in tampering with a system with so many recognizable virtues. Yet even the purest markets depend on certain core beliefs and institutional mechanisms that uphold them.” The recent corporate scandals have damaged faith in those beliefs, he added. “Repairing the damage will take creativity, common sense, goodwill and patience.”
Too Much Transparency?
Franklin Allen, co-director of the Financial Institutions Center, told conference participants that the scandals have consumed the financial industry, even at a time when the economy is extremely fragile. “Corporate governance is the most pressing issue facing the financial industry at the moment.”
But Allen warned that some of the debate over reform has made assumptions that may not necessarily hold true. “One thing that is taken for granted is that transparency is a good thing. In many circumstances, that’s true. But in some other plausible ones, it’s not.”
For example, he said that if a publicly traded company releases information more frequently, sometimes the information will convey positive developments, other times the news will be negative. Each release will send the share price up or down, creating volatility and risk for shareholders who may have to sell into a down period.
Less frequent announcements will give a company’s good and bad days more time to average out. General Electric, for example, has been criticized for managing its earnings by cushioning bad periods with gains socked away during good times. But that led to a steady climb in earnings and a fairly accurate view of the company over time. Investors paid a premium for that certainty, said Allen.
He also questioned the assumption that highly compensated executives should be watched over by independent outside directors. Instead, he pointed to Toyota Motor Co., which is considered to be one of the world’s best-run companies. He said Toyota executives are paid far less than their American counterparts – the equivalent of hundreds of thousands of dollars instead of millions – and the company’s huge, 60-member board includes only one outsider.
A third notion Allen questioned was that companies facing a takeover perform better. He again pointed to Toyota, which sits comfortably behind many barriers to change in control, yet continues to outperform in share price. “So my view is we need to have a very careful debate about all the issues,” he said. “The fact that we have rushed in the public sphere to pass all these laws in the past few months means we have done things too quickly.”
Accountant: A Firm’s ‘Good Conscience’
Gunther Gebhardt, a professor at Johann Wolfgang Goethe University in Frankfurt am Main, Germany, opened the conference’s first panel titled “What Rules, Who Enforces? Accounting Standards and Auditing Practice” by pointing out that the United States does not have a monopoly on scandal. “Of course they will happen in Europe as well,” since the same incentives and institutional structures exist there that allowed scandals to occur in the U.S., he said.
Gebhardt cited one important aspect of reform which has not been addressed in the United States: “There has been a lot of discussion about auditing and accounting rules, but what I think is important is the role of the accountants within the companies.” In European business tradition, especially in Germany, the chief accountant acts as a firm’s “good conscience,” Gebhardt said. Traditionally, when management wanted to do a transaction it needed to justify the plan to the chief accountant. “Nowadays it appears the burden has shifted. Management comes up with the transaction it wants to have done and it is up to the accountant to [make the rules fit] the execution of the transaction.”
Gebhardt also pointed out that even in a large multinational firm, very few people are involved in accounting policy, typically only the chief financial officer and chief accountant. Accounting plays very little role in the promotion of most managers and therefore generates little interest or concern.
He said that while the U.S. scandals have drawn attention to the role of auditors, the internal accountants should not be ignored because they are the ones who prepare statements for the auditors. “The auditor only gets access to what management allows. We should think more about the incentives for company accountants, or the disincentives, for them to take risks in preparing statements.”
Germany, like the United States, is reevaluating its accounting and auditing standards in conjunction with the International Accounting Standards Board, according to Gebhardt. But he said business is likely to lobby to prevent rules that might tie its hands. Those who would benefit from change, including employees and investors, are less inclined to lobby for their interests. “They do not have the same incentives and they are not efficiently organized,” he said.
In Germany, academics have often played a role in lobbying on behalf of investors or others who might benefit from changes in accounting or audit procedures. However, currently this is not a popular field. “The development of accounting theory is not happening in the university, but in the back offices of the standard-setters, where there is excellent staff. But critical reflection on accounting rules should be given more weight in the academic world,” Gebhardt suggested.
Taking Exception to the Rules
According to James J. Leisenring, a member of the International Accounting Standards Board and its liaison to the United States, many of the same issues that have been discussed in the United States, such as whether to expense stock options, are now springing up in Europe. He also noted an ongoing debate over whether the U.S. rules-based accounting system or European principles-based accounting is superior.
The major critique of the American system is that it is too complex, he said. But that complexity has been created by businesses seeking exceptions to existing rules. And while some companies may publicly praise the European principles-based system, they too would want to be able to make exceptions if such actions would benefit them.
Another reason for the complexity of the U.S. system is an attitude by U.S. companies that Leisenring summed up as: Tell me where it says I can’t do what I want to do. “Unfortunately this is something the United States is exporting to the rest of the world.”
The Enron scandal, he added, with its roots in special purpose entities, has analysts looking at international accounting standards related to consolidation and control. Other important issues include revenue recognition and accounting for stock options. Leisenring is also interested in an “important gimmick ... called an operating lease. The focus on special purpose entities and leasing are the issues of the next five years.”
Europe is now gearing up for the debate over whether to expense stock options, he noted, adding that during similar discussions in the United States he often jokingly asked business executives: “If these things are free, then give them to me. Now the discussion is moving to the IASB; I bet I don’t get any more this time around.”
On either side of the Atlantic there will still be pressure from business to mold accounting and auditing practice to its advantage, Leisenring predicted. “We’ll hear the same disingenuous arguments, only it will now be worldwide and in more languages.” The same politicians who “interfered with and intimidated my colleagues at FASB have been born again over Enron,” he added. “I bet after the election, they will turn again on FASB once the PAC money starts to come in.”
Leisenring cautioned that efforts to move the accounting system to include more non-financial or so-called performance measures may be another way for companies to improve results in the same way some used pro forma earnings in company press releases at the height of the market euphoria.
In his opinion, FASB was unfairly criticized over the use of pro-forma earnings. That criticism should have been pointed at the SEC which regulates financial disclosure: “FASB cannot suspend the First Amendment. To those who believed the sell-side analysts that pro forma earnings were a much better measure of the entity than earnings, you richly deserve to have lost what you lost on your investments,” he said. “I never have known a company to announce pro forma earnings that were smaller than their earnings.”
Beefing Up Sarbanes-Oxley
Robert G. Eccles, founder and president of Advisory Capital Partners, Inc. and a senior fellow at PricewaterhouseCoopers, offered the audience four ideas that could add more heft to the hastily drafted Sarbanes-Oxley Act. “It was done incredibly quickly,” he said. “The decision to pass that legislation happened more quickly than the federalization of airport security and that was truly a matter of life and death.” He warned the new law may have unexpected consequences: “The biggest danger is to say we’re done.”
Eccles’ first proposal would be to establish global accounting standards. The world now has global product markets and should also have global capital markets, he said. “Investors being able to easily compare the performance of companies in an industry regardless of where they are headquartered would be a good thing.”
Eccles expects continued convergence between IASB and U.S. Generally Accepted Accounting Principles (GAAP). He noted European and U.S. companies account for 75% of the world’s market capitalization so their domination of global accounting standards is “a done deal.” He said the two systems are likely to compromise between the European concept of principles-based accounting – which gives companies more latitude to account for complicated transactions – and the rules-based system used in the United States.
Those in favor of a principles-based system argue that modern financial transactions have become so complicated that a detailed, rules-based system like GAAP is too difficult and costly to implement. Furthermore, because the rules-based system is so complicated, businesses can meet the literal requirements of the rules but ignore the intent and spirit of the standards.
On the other hand, the argument against European-style principles-based accounting is that it gives companies too much freedom to interpret their own accounting. FASB has published a proposal on principles-based accounting and will hold a roundtable discussion on it in December.
Second, Eccles suggested accounting standards include non-financial measures that might be meaningful to investors. He said these measures would be different for each industry. For example, in banks customer retention is crucial; in pharmaceutical firms, research and development spending is key. Eccles cited a trend toward voluntary disclosure of this information, but without industry standards it could be misused the same way that some companies misled investors with pro-forma earnings. These performance measures, he said, could evolve for each industry with input from companies in the field, trade associations and investors.
Third, Eccles addressed auditing. The Sarbanes-Oxley Act, he predicted, will sharply limit accounting firms’ ability to use auditing services as a loss leader to reap more lucrative consulting work. “I think that’s going to have profound implications on the economics of auditing. We’re going to have to pay for it.”
Finally, Eccles predicted that technology will play a role in bringing greater transparency to financial reporting. He pointed to a pilot program underway by Microsoft, PricewaterhouseCoopers and Nasdaq, using Extensible Business Reporting Language (XBRL), that will standardize financial reporting data and make it available for investors on a website hosted by Nasdaq. The pilot project includes financial data for five years from 21 companies.
“It’s a technology of staggering proportions,” said Eccles. “It won’t keep fraud from happening, but the ease with which this information can be manipulated will make it easier to identify where problematic decisions were made.”