TCS Daily


Scandals of Accounting

By Duane D. Freese - March 30, 2006 12:00 AM

There are financial accounting scandals, and then there are financial scandals created by accounting.

Financial accounting scandals are typified by the kind of fraud that bilked investors of assets in the 1990s. From Enron to WorldCom, companies cooked their books, hiding losses and risks from investors while making money for the owners of the enterprises themselves.

Some of those schemers got away with it, others are off to jail. All of it amounted to business ethics gone downhill with damaging effects for the nation and the economy.

But in their wake, there are now brewing scandals created by financial accounting that also may cost investors money. Except these scandals are the very accounting rules and financial reporting reforms aimed at correcting the financial accounting scandals of the past, such as the Sarbanes Oxley Act of 2002 and the Financial Accounting Systems Board's Statement 133 of 1998.

The intentions of these acts and accounting rules are good. They are trying to make sure every company follows the same recipe of accounting, auditing and reporting of things that go into their financial statements -- the statements that investors, including many institutional investors and pension funds, rely upon to decide where to put their money.

But the benefits protecting investors from fraud must outweigh the economic costs to business of complying with rules. After all, if the costs outweigh the benefits it's the investors -- and the American economy - that suffers the losses. And right now, there's evidence the reforms have gone too far.

Take SOX, as Sarbanes Oxley is called. When passed, the Securities and Exchange Commission estimated it would take about five man hours per company to implement. But E. O'Brien Murray of the Free Enterprise Fund quotes Financial Executives International as now estimating compliance at total $4.36 million per company. Instead of five hours, companies will have to spend some 26,000 hours implementing the rules.

Raymond Stapell, managing partner of the Harris Beach law firm in Buffalo, told MSNBC: "It is staggering to try to comply (with SOX). The companies end up spending more on that than product development. Companies are trying to comply, and it is making them noncompetitive in their product line."

Indeed, as The Wall Street Journal quoted a General Motors accounting officer back in 2004: "The real cost isn't the incremental dollars, it is having people that should be focused on the business focused instead on complying with the details of the rules."

A University of Rochester study put the lost opportunity and other economic costs at $1.4 trillion. Even liberal New York Attorney General Eliot Spitzer recognizes that is no good thing.

What goes for SOX goes, on a smaller scale, for SFAS 133.

Its laudable aim was to get the accounting right for financial derivatives, devices such as futures and options contracts, interest rate and exchange swaps that were developed in the 1980s to help business better manage risks from the fluctuations in exchange and interest rates and commodities prices.

A study from George Allayannis and James Weston in 2001, "The Use of Foreign Currency Derivatives and Firm Market Value" in the Review of Financial Studies showed that derivatives help firms add substantial value to their operations, encouraging them to engage in productive activities they otherwise would avoid.

But as with any good thing, some people put them to questionable uses -- as speculative instruments to double up gains, leverage capital or hide profits and losses so as to give investors a false impression of smooth earnings growth. Their misuse was key to the financial debacles of Orange County in 1993, Long-Term Capital Management in 1998 and Enron in 2001.

The Financial Accounting Standards Board (FASB) recognized that risks of such speculative uses would be hidden if derivatives were allowed to be kept off the books until their positions were closed, as they were in the 1980s and 1990s, which is why it issued SFAS 133 in 1998 with an initial implementation in 2001.

But there's forever been a problem with the rule. Reconciling the market value of future contracts on a daily basis -- marking to market -- as required by FSAS 133 for most derivatives, Alex J. Pollock of the American Enterprise Institute has pointed out, accounts for "only one side of what are in fact two-sided positions." By assigning hedges to specific assets and liabilities, the rule misses the real risk of the relationship between assets and liabilities. And in doing so, it neglects the macro hedging businesses do for "combined balance sheet risks."

The rule -- at 201 pages in its initial offering and with more than 150 pages of amendments since -- is too complicated, leading to dizzying financial flow charts to weed out speculative risks for instruments most businesses used to insure themselves (and their investors) against serious losses.

Furthermore, the rules requirements for reporting of fair value positions with every financial statement creates an appearance of earnings volatility without there being any, leading companies to take or consider actions that end up on the front pages as "accounting scandals."

Consider the "accounting scandals" at Freddie Mac and Fannie Mae, the two private congressionally chartered government sponsored enterprises that create a national market for mortgages.

Both companies have fired top executives, changed their accounting firms, conducted internal investigations, accepted external examination and had to restate their earnings since Freddie Mac first re-examined its books back in 2002, leading to a forced reexamination at Fannie Mae a year later.

The restatements have been huge: $5 billion in upward revisions for Freddie and nearly $11 billion for Fannie, and Fannie is still working to get its accounting right.

At the base of both firms' restatements is the accounting for derivatives. Both companies use derivatives extensively to hedge against interest risk in the portfolios of mortgages that they buy, which now total $1.3 trillion. Those portfolios are bought with bonds issued to foreign investors who otherwise might not invest in the U.S. mortgage market through the GSEs' other standard product, securities backed by mortgages that the GSEs bundle and securitize for a fee.

As Eileen Fahey and colleagues noted in a special report for Fisk Research, held-to-maturity mortgages and mortgage securities aren't eligible for simple hedge accounting for interest rate risk which results in the most pronounced appearance of earnings volatility in "pure-play mortgage companies," such as Fannie Mae and Freddie Mac.

Pollack, generally a critic of the GSEs, points out, "FAS 133 Led Fannie Mae and Freddie Mac Astray":

"It appears that one source of Freddie's accounting problems was its management's conviction that FAS 133 so distorted the operating results that it made sense to structure shell transactions to adjust them. That did not make sense after all, as truncated careers attest, but did the effects of FAS 133 on Freddie's financial statements represent reality or accounting artifice?"

Pollack asks:

"Is the 47 percent after-tax return on equity now reported by Freddie in its restatement for 2002 believable? ... Granting that Freddie's mortgage book is economically well hedged, what can the 30-percentage-point drop from the re-stated 47 percent ROE in 2002 to the reported 17 percent ROE in 2003 mean? ...With the effects of FAS 133, are investors in Freddie's debt and equity better informed or just baffled?"

As the recently released Rudman report, under former Senator Warren Rudman, makes clear, the problems at Fannie may have been more extensive than at Freddie. There was a real accounting scandal there, with bookkeeping gimmickry that hid costs in 1998 so profits and earnings looked about $200 million better, giving some executives bigger bonuses. Further, as Pollack pointed out, the deficiencies in Fannie's accounting led to real losses of $11 billion, not just accounting and timing errors.

Still, SFAS 133 isn't helping make things clearer for investors of what's right and what's wrong.

Critics of the GSEs, including some in the Bush administration, are using the accounting problems to claim a systemic risk to the nation's financial system from the GSEs' mortgage portfolios.

AEI scholar Peter Wallison, an advocate of GSE privatization, has even said that Freddie's restatement led former Federal Reserve Chief Alan Greenspan to suddenly urge limits on the portfolios to protect against any systemic risk.

But Stephen Blumenthal of the Office of Federal Housing Enterprise Oversight, who was responsible for uncovering problems at Freddie, points out this is simply wrong. Freddie and Fannie's financial problems were the result of accounting and management impropriety, he pointed out last fall, not risk management. He said, "their credit risk management has been exceptional and their actual experience with interest rate risk should satisfy even the most critical."

Strengthening his point that the problem is with the accounting not the risk management is a wave of restatements now coming out of other businesses.

SOX has had a domino effect as the SEC has forced companies to re-examine their hedge accounting. These companies include some big banks that have been among those pressing for the toughest reform of Fannie and Freddie because they see the GSEs supporting their regional bank competitors. And like Fannie and Freddie, they are discovering they are going to have to refigure their books to comply.

Bank of America is looking at a $345 million restatement; all of it is due to bookkeeping rules, none of it has to do with actual economic performance, it says. The Federal Home Loan Banks of Atlanta, Chicago, Pittsburgh, Des Moines, Dallas, Topeka and Seattle, among others, all are restating thanks to FSAS 133. So are mortgage lenders such as Saxon Capital and thrift institutions such as WSFS Financial Corporation of Delaware.

Indeed, dozens, and possibly hundreds, of honest businesses will be restating their earnings, thanks to SFAS 133. And if Fannie's experience with hiring hundreds of accountants and paying out more than $140 million is any experience, those firms will spend hundreds of millions of dollars fixing not a problem with their operations but a problem in bookkeeping rules.

But as with SOX, the worst of it is that these companies may be detoured by the cost of the accounting from engaging in productive activities or take on more risk by not using derivatives, thus reducing their shareholder value.

Duane Freese is Deputy Editor of TCSDaily.com.

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7 Comments

For the Author. Article misses big picture and error reduces credibility- from a CPA
I'm a CPA and "Big 4" escapee there's much that I find of dubious value in the current reporting architecture, some of which you touch on here, however you miss way to much by obsessing on FAS 133 and SOX.

You don't address many of the worst problems associated with reporting practices. Too be fair, nobody is writing about those problems. First is the sheer volume of paper coming from FASB. Individual statements are coming out at a dizzying volume, often for the sole purpose of making US accounting more like the rest of the world-not because of any compelling developments that allow or require transactions to better reflect economic reality. It begs the questions, whose interest does FASB serve and are they, by regularly annihilating their own pronouncements with amendments and restatements admitting they've been wrong a lot?

Even where international congruence is not the big motivator, FASB is obsessing over trivial things. Consider this months new statement, 156 which relates to mortgage "service rights"-it amends FASB 140, issued in 2000, which amended FASB 125, which was issued in 1996. Worse, as statements have been issued with greater frequency, (often used to be less than 20 pages in length) they have now ballooned to be well over 100 pages on a regular basis.

As for the SOX issue-If you want to really want to reform auditing, stop having auditors appointed by the company bigwigs-because I personally witnessed how standards can be tortured to accomodate the wishes of management for a clean opinion. That might take away some power and prestige from partners but too bad, they're bean counters, not cancer researchers.

However, before you delve into the arcana of the most technically difficult issues in accounting, you need to get the basics right-FASB is an acronym for Financial Accounting STANDARDS Board, not Financial Accounting SYSTEMS Board.

One other thing..
General Motors accounting officer back in 2004: "The real cost isn't the incremental dollars, it is having people that should be focused on the business focused instead on complying with the details of the rules."

GM isn't the place to get credible accounting advice-outside of the possibility of a bankruptcy and issues related to pension funding, they just announced a multibillion dollar restatement.

Who Profits From SOX and FAS 133
Follow The Money: SOX and FAS 133 Enrich Insiders and Accounting Firms

“The intentions of these acts and accounting rules are good. They are trying to make sure every company follows the same recipe of accounting, auditing and reporting of things that go into their financial statements -- the statements that investors, including many institutional investors and pension funds, rely upon to decide where to put their money.”

“Take SOX, as Sarbanes Oxley is called. When passed, the Securities and Exchange Commission estimated it would take about five man hours per company to implement. But E. O'Brien Murray of the Free Enterprise Fund quotes Financial Executives International as now estimating compliance at total $4.36 million per company. Instead of five hours, companies will have to spend some 26,000 hours implementing the rules.”

Do you suppose in passing SOX many in Congress and other insiders made sure their portfolios included the stock of selected big accounting firms?

“Indeed, dozens, and possibly hundreds, of honest businesses will be restating their earnings, thanks to SFAS 133. And if Fannie's experience with hiring hundreds of accountants and paying out more than $140 million is any experience, those firms will spend hundreds of millions of dollars fixing not a problem with their operations but a problem in bookkeeping rules.”

And were those same people in Congress who passed SOX, whose portfolios included accounting stocks, working in concert with the FASB in its promulgation of FAS 133. Is the basic purpose of FASB the generation of more work for CPA firms. Did the same thing happen here benefiting accounting firms and insiders as happened with the passage of Medicare Part D benefiting insiders and health insurance and pharmaceutical firms.


More Errors
And were those same people in Congress who passed SOX, whose portfolios included accounting stocks, working in concert with the FASB in its promulgation of FAS 133. Is the basic purpose of FASB the generation of more work for CPA firms. Did the same thing happen here benefiting accounting firms and insiders as happened with the passage of Medicare Part D benefiting insiders and health insurance and pharmaceutical firms.

While pointing out the potential for the regulatory reflex in Congress to be something thats often ted by something other than sage public policy, the above paragraph is wrong on a couple counts.

First, there are no "accounting stocks", accounting firm ownership is restricted, with some exceptions to CPA's. The big firms are almost all LLP's, other firms might be professional corporations or straight partnerships.

Secondly, FASB is not in bed with Congress-some of the mighty mouths in Congress objected to the requirement to expense stock options-but FASB did indeed implement that requirement. Roundly booed by Jim Glassman and other TCS authors-it was the proper thing to do and their dire predictions have not yet come to pass.






I stand corrected.
I stand corrected. But if I didn’t make false assumptions, my thinking would still be clouded by ignorance. Thanks.

Hand stuck in cookie jar
Oh boo-hoo, they tricked out there accounting "system" for the officers private benefit, now its costing them millions to make it correct. So what? "Oh look at me, I'm so clever, I can fool the share holders for another quarter with fancy pants hedging schemes." Another thing, whats the big deal about stability, if you have a long view it comes out in the wash. Short term thinging is what its all about. I think the Fannie thing they claimed they were "smoothing" earnings when the reality was more that they were manuvering to get that years bonus.

XYZZ1-What the hell are you talking about?
Is this supposed to be a response to something on this board or just an incoherent soliliquy?

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