The number of U.S. companies embroiled in accounting scandals appears to be endless. WorldCom, Enron, Global Crossing, Tyco, and Adelphia round out a growing list. Bowing to pressure from investors and the public, last month the U.S. Senate Banking Committee approved a reform bill that would establish an independent oversight group to sanction the accounting industry. A similar House measure passed in April. U.S. Securities and Exchange Commission Chairman Harvey L. Pitt has announced tentative plans for an independent Public Accountability Board to discipline companies and executives who rip off investors.
But just as support for accounting reforms gains momentum, Wharton accounting professor Christian Leuz points out that efforts to strengthen accounting rules and oversight may be useful, but in themselves they cannot prevent another Enron. More importantly, he says, the recent incidents of financial chicanery should not be taken as representative of Corporate America in general. Individual investors in U.S. companies, by and large, benefit from strong laws and enforcement that protects their rights. However, no system, even one with effective legal protection for outside shareholders, can prevent some of the most egregious actions from occurring.
Leuz believes that many more firms outside of the U.S. suffer from accounting irregularities. Self-dealing and the misappropriation of profits at the expense of minority shareholders is much more common in other countries due to the weaker legal measures protecting such stockholders. This scenario creates incentives to manipulate financial statements to conceal poor business performance and the private benefits that corporate insiders enjoy.
Leuz offers up convincing evidence for his argument. He, along with co-authors Dhananjay Nanda, a professor at the Fuqua School of Business at Duke University, and Peter Wysocki, a professor at MIT’s Sloan School of Management, tackle the matter head-on in a research paper titled “Investor Protection and Earning Management: An International Comparison.”
The researchers take a critical look at what they term “earnings management” or the masking of a firm’s true performance through accounting choices meant to mislead outsiders. By analyzing data from 31 countries, they show that number fudging appears to be highest in countries with weak investor protection and poor legal enforcement.
Specifically, manipulation appears to be the lowest in places like the U.S., Australia, Ireland, Canada and the U.K., where outside investors have explicit legal rights to vote out misbehaving managers and discipline corporate insiders, and where these laws are enforced. Number manipulation seems to be more common in countries in Continental Europe (Austria, Italy and Germany) and Southeast Asia (South Korea and Taiwan). Not surprisingly, these nations also have the least amount of investor protection.
Leuz and his colleagues used financial statement data from 1990 to 1999 for more than 8,000 publicly traded firms across 31 countries to create a novel summary measure of earnings management activities. They combined four measures of earnings management to capture a wide range of techniques. Specifically, the researchers measured the extent to which insiders use discretion in financial reporting to boost reported earnings and conceal losses, and to what extent they smooth earnings, that is, understate earnings in years of good performance to create reserves for periods of poor future performance.
Overall, the research illustrates the strong link between incentives to conceal private benefit seeking and the quality of financial reporting. Says Leuz: “Much of the public and academic debate tends to focus exclusively on the accounting standards.” Leuz notes that this emphasis misses the important point that managers will still have incentives to misstate financial results if there is poor corporate governance coupled with poor performance. Misleading and fraudulent accounting reports are a symptom of more fundamental governance problems. The emphasis should therefore remain on corporate governance efforts and legal protection of outsiders if the goal is to improve the quality of accounting reports.
While international analysis of accounting isn’t new terrain, this project takes the investigation a step further. Leuz says, “Many researchers have looked at cross-country comparisons and found the accounting numbers to be different and attributed this to differences in the accounting rules. Our approach is to dig deeper and look for differences in corporate governance and the incentives that managers and controlling insiders have.”
Leuz adds, “When you do a cross-country analysis, you discover that the accounting rules tend to be a reflection of more fundamental things within a country, that is, they are chosen to fit the overall legal and institutional system. If the system is designed to protect the outsider, then you are likely to have accounting and disclosure rules in place that will provide the information for outside investors to protect themselves.”
The conclusions that Leuz and his colleagues reached could help restore confidence among skittish U.S. investors. He notes, “Recent stories in the press indicate that some improvements are needed. But we need to be careful to not throw out the baby with the bathwater, which is to some extent what the debate is doing right now. Global Crossing or Enron may have given people the impression that accounting manipulations are far worse in the U.S. than in other countries.” That impression, according to the researchers, is untrue.
Leuz cites the Bank of Credit and Commerce International (BCCI) embezzlement in the early 1990’s, the accounting fraud at Lernout and Hauspie, the Belgian speech recognition software firm, and the current allegations of cash diversions at Korean Daewoo Motors as just three of the many high-profile examples of international accounting shenanigans. Their research suggests that, on average, accounting manipulations and earnings management are far more common in other countries.
But while the problem may be greater overseas, Leuz notes that American legislators and policymakers should not use this as an excuse. Rather, they should push ahead to make changes in the U.S. accounting system and financial marketplace in general. After the bursting of the dot-com bubble and a steady stream of flameouts at companies like WorldCom, Enron and Tyco, U.S. investors cannot be blamed for feeling burned. Restoring their confidence back to health will take time.
