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More than three years after its original publication, a bestselling book on creative accounting arrives in paperback this month.
The Financial Numbers Game: Detecting Creative Accounting Practices by Charles Mulford and Eugene Comiskey, was first published in January 2002, just as the Enron scandal began to unfold. The book concentrates on how companies use earnings management to manipulate financial reports and create an altered impression of business performance.*
SmartPros asked the authors to revisit this topic in the post-Sarbanes-Oxley Act era.
Charles Mulford is Invesco Chair and Professor of Accounting. Eugene Comiskey is Callaway Chair and Professor of Accounting in the DuPree College of Management at the Georgia Institute of Technology in Atlanta, Georgia.
SmartPros: Many financial professionals see SOX as a necessary evil -- and studies continually show that they believe the new requirements go overboard. Cost is a major complaint. What's your take on the Act?
A: The costs quite clearly are a much smaller percentage of profits, sales, or shareholders' equity for large versus small firms. While both large and small firms are affected, the burden is far greater on smaller public firms. Large firms have more internal expertise and far greater capacity to absorb the costs. If one takes a careful look at the litany of devices used by firms to manage earnings (outlined in the book at great length), especially those that led to SEC actions, it is not at all clear that the features of SOX will have a substantial effect. We do remain hopeful, however, that by improving internal controls, increasing the penalties for malfeasance and encouraging auditors to be more diligent, we will see some benefits.
SmartPros: In the first edition of The Financial Numbers Game in 2002, you printed the results of a financial professional survey. In that survey financial professionals did not necessarily consider earnings management manipulative. What would you expect if that survey was conducted today?
A: It is likely that the threshold for considering an action to be beyond what is permissible under GAAP (generally accepted accounting principles) will be much lower - more earnings management moves will now be considered improper. A case in point is "real actions." Real actions involve taking operational business steps to alter (improve) results. For example, special end-of-quarter incentives might be offered to encourage purchases from customers. The survey in the book finds survey respondents quite uniformly classifying such actions as not inconsistent with GAAP. However, recent SEC actions have been taken for the "channel stuffing" actions taken by a number of firms (Coca-Cola and Bristol-Myers Squibb). We recently mentioned this to a group of experienced businessmen and women and they were quite shocked. They said that in various ways all of their firms did it!
SmartPros: Does SOX effectively close the creative accounting loopholes you talk about in The Financial Numbers Game? Are there new loopholes post-SOX?
A: Few of the regulatory actions close creative accounting loopholes. There will continue to be incentives to make numbers by accelerating revenues recognition and delaying expense recognition. These actions were wrong before and they remain improper. With sufficient incentives, firms manipulated results before and there is no reason to believe that SOX will prevent these actions in the future. Firms may simply be even more creative. Also, recent court actions send quite mixed signals concerning the likelihood of suffering any significant consequences for accounting misbehavior. This does not help.
SmartPros: The collapse of Arthur Andersen came after your book published. How has the accounting firm's role changed?
A: Firms have every reason to be much more conservative in their auditing activities. One could reasonable expect audit fees to increase as more time is invested in the conduct of audits. However, audit firms in general may be able to reduce some of this cost increase in view of the new income associated with work on the review of internal controls.
SmartPros: What words of wisdom do you impart to accounting students who are entering this profession in the 21st century?
A: They should expect to make a very significant ongoing investment in the maintenance of their technical accounting skills. Moreover, many will discover that their accounting education has shortchanged them because it has not made sufficient demands on them to build their technical skills and because this education has not been sufficiently integrated with the practice side of accounting and financial analysis.
SmartPros: If readers were to take away just one thing from your book, what would that be?
A: A very significant amount of technical accounting skill (more that is found in even experienced users of financial information) is necessary to perform competent financial analysis. Moreover, good financial analysis must be supported by a very sound understanding of the business or businesses being analyzed.
* C. Mulford and E. Comiskey. Financial Warnings (New York: John Wiley & Sons, 1996) p. 360.
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