The latest announcement came from Qwest, which said Sunday that it had improperly accounted for $1.1 billion in transactions over the past three years. Meanwhile, federal investigators continue to dig into questionable dealings between Merrill Lynch and Enron. And this comes on the heels of other astounding announcements from companies like Xerox (which said it would restate five years of financial results to reclassify billions in revenues) and, most notably, WorldCom, which recently fessed up to a whopping $3.8 billion in accounting errors before filing for Chapter 11 bankruptcy protection. While accounting errors and restatements are nothing new, the amount of money involved in the recent revelations could feed a small nation—or bankrupt a Fortune 100 company. And that begs the question: How does a company make a mistake of such magnitude and how could it go unnoticed for so long? NEWSWEEK’s Jennifer Barrett spoke with American Accounting Association President G. Peter Wilson, an accounting professor at Boston College.
G. Peter Wilson: That was a case of revenue recognition [when to count a financial transaction as revenue]. The problem is, in many contractual relationships, the company makes a deal today that has long-term consequences and the issue is, when should they recognize the revenue? There are lots of guidelines but it’s still not so easy to know. It’s conceivable that under advice from auditors at the time [Arthur Andersen], Qwest decided to go with the revenue-recognition policy they went with. But with hindsight—or even if they’d had a different auditor at the time—the revenue-recognition policy would have been viewed as too aggressive [meaning the company was routinely counting revenue on its earnings statements that it had yet to receive]. Revenue recognition can be extremely challenging. There was a bulletin that came out from the SEC and went into effect [in December 1999] that was about 100 pages long trying to explain all the situations where revenue recognition could be difficult and trying to give guidance. You can find a lot of gray areas and, without guidance, folks took some pretty aggressive stands.
It was an issue of expenses with WorldCom. If you go out and buy a building, you recognize it as an asset, capitalize the cost, then depreciate the asset over time. One of the most controversial issues in accounting is when a company incurs a cost—that is, a large cash outflow today—should the company make it an asset and depreciate it over time, or should the company expense it right away? With a building, there’s no controversy [it’s depreciated]. With maintenance costs, you expense it right away. But in other areas, it takes a lot of judgment. Still, one ought to be transparent about how these judgments are being made. There was an issue in the WorldCom case as to just how transparent they were being.
It’s conceivable an auditor knows about the policy that was being followed by its client and they come to judgment together. For example, in the Global Crossing case, Arthur Andersen actually submitted a white paper to the SEC around the revenue-recognition issues surrounding Global Crossing and asked the SEC to pass judgment. My recollection is that the SEC sat on it for awhile, probably perplexed. In that case, there was nothing hidden but it was a new situation and Arthur Andersen was trying to get the blessing from the SEC. When I learned about that, though, it was really shocking to me because basically it says the SEC had at least some prior knowledge [of what was happening at Global Crossing, which has since been charged with deceptive accounting].
It’s a matter of intent. To be fraudulent is to intentionally mislead. You have to prove intent. It can usually be established by evidence of insider trading. You can also find examples of it if you see misstated records.
I’m not a fraud expert–there are actually people who specialize in forensic accounting–but literally, there are lots of examples in which a company says ‘Our policy is X’ and then, in fact, they do Y and Y is really different than X, and it would have to be to misrepresent.
Well, there is this other gray area where you can change your accounting policy but you don’t announce it.
Strictly speaking, no. But it’s one of those areas where the SEC didn’t take strong stands for quite awhile. GAAP means “generally accepted accounting principles”— not rules. So it gets kind of problematic in terms of trying to go after someone in court. You have a hard time making the legal case.
No. Arthur Andersen was obviously taking some pretty aggressive stands on revenue recognition back then—that doesn’t mean they were illegal but they were certainly aggressive. And the Enron story broke in December 2001. Anything that happened before December 2001 is not surprising given what we now know. It’s when you start seeing restatements of 2002 numbers, that’s scary. We haven’t seen many of those, except with WorldCom in first quarter 2002. That’s really scary if, for no other reason. you have to wonder what the hell they were thinking to do that kind of accounting after what we’d all been through.
Do you think we’re going to see many more revelations before the Aug. 14 deadline for CEOs to certify financial statements at more than 800 of the country’s largest companies? Should we expect big changes now in terms of what is “generally accepted”?
If we go looking for problems that took place between 1999 and 2001, we’re guaranteed to find them. You’re going to see a lot of restatements for two reasons. GAAP refers to what is ‘generally accepted’ and whatever was generally accepted in 1999 through 2001 isn’t going to be generally accepted in 2002, and that is really important. When you hear companies say they expect managers to restate the numbers because they are going to be more ‘conservative’ what they are really saying is that, in that spectrum of judgment, they would rather be safe than sorry right now. Otherwise, they were just wrong. They cut down the cherry tree and now they’re coming forward and taking the hit for it. That’s what everyone thinks all these restatements are going to be, but that’s only one story. I suspect there are some of those, but just a few. There are quite a few in which the restatements will be a result of GAAP changing.
I think it is almost irresponsible to say ‘fraud’ until you get in there and looks at the data and sees what the decisions were—the kind of detail we now have on Enron. It’s a 99 percent chance it was fraud with Enron. But we have very little evidence on Qwest at this point. It’s too early to make that kind of a call.
Every investor should be a healthy skeptic, though not cynical. Throw up a red flag, but don’t just assume the worst. There are always two valid hypotheses when looking at the superficial level. That’s great if you begin to examine it a bit more. My advice is to differentiate restatements of numbers from 2001 and before from the current year because I really do believe that managers are going to restate previous numbers just to be more conservative.You have to connect the numbers to the business and you have to understand how the numbers were generated and what is happening with the business. Short of that, you need a really good reporter to do that for you.
