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the auditing industry. However, in the wake of the Enron bankruptcy, many firms have volun-
tarily decided to no longer hire their auditors as consultants, and this practice may be banned
by new legislation. Moreover, big auditors such as KMPG, Ernst & Young, Pricewaterhouse-
Coopers, and Deloitte Touche Tohmatsu either have spun off their consulting practices as
independent firms or have announced their intention to separate the audit and consulting
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

Deciphering the Black Box: Many Accounting Practices,
Not Just Enron™s, Are Hard to Penetrate
Why has corporate accounting become so difficult
Just 30 years ago, the rules governing corporate ac-
to understand? In large part because corporations, and
counting filled only two volumes and could fit in a brief-
what they do, have become more complex. The ac-
case. Since then, the standards have multiplied so
counting system initially was designed to measure the
rapidly that it takes a bookcase shelf”a long one”to
profit and loss of a manufacturing company. Figuring
hold all the volumes.
out the cost of producing a hammer or an automobile,
As the collapse of Enron has made painfully clear,
and the revenue from selling them, was relatively easy.
the complexity of corporate accounting has grown
But determining the same figures for a service, or for a
exponentially. What were once simple and objective
product like computer software, can involve a lot more
concepts, like sales and earnings, in many cases have
variables open to interpretation.
become complicated and subjective. Add the fact that
Companies have evolved ever-more complex ways
many companies disclose as little as possible, and the
to limit risk. Baruch Lev, accounting and finance pro-
financial reports of an increasing number of companies
fessor at New York University, says a venture into for-
have become impenetrable and confusing.
eign markets creates a need for a company to use
The result has been a rise in so-called black-box
derivatives, financial instruments that hedge invest-
accounting: financial statements, like Enron™s, that are
ments or serve as credit guarantees. Many companies
so obscure that their darkness survives the light of day.
have turned to off-the-books partnerships to insulate
Even after disclosure, the numbers that some com-
themselves from risks and share costs of expansion.
panies report are based on accounting methodologies
This is where the accounting has a hard time keep-
so complex, involving such a high degree of guesswork,
ing up”and keeping track of what is going on fi-
that it can™t easily be determined precisely how they
nancially inside a giant, multifaceted multinational.
were arrived at. Hard to understand doesn™t necessarily
Accounting rules designed for a company that makes
mean inaccurate or illegal, of course. But, some com-
simple products can end up being inadequate to por-
panies take advantage of often loose accounting rules
tray a concern like Enron, which in many ways exists as
to massage their numbers to make their results look
the focal point of a series of contracts”contracts to
trade broadband capacity, electricity and natural gas,
The bottom line: There is a lot more open to inter-
and contracts to invest in other technology start-ups.
pretation when it comes to the bottom line.

Unfortunately, Enron was hardly alone in preparing financial statements of questionable
quality or utility. The nearby box points out that financial statements have increasingly be-
come “black boxes,” reporting data that are difficult to interpret or even to verify. As we noted
in the previous chapter, however, the valuations of stocks with particularly hard-to-interpret
financial statements have been adversely affected by the market™s new focus on accounting
uncertainty. The incentives for clearer disclosure induced by this sort of market discipline
should foster greater transparency in accounting practice.

International Accounting Conventions
The examples cited above illustrate some of the problems that analysts can encounter when
attempting to interpret financial data. Even greater problems arise in the interpretation of
the financial statements of foreign firms. This is because these firms do not follow GAAP
guidelines. Accounting practices in various countries differ to greater or lesser extents from
U.S. standards. Here are some of the major issues that you should be aware of when using the
financial statements of foreign firms.

Reserving practices Many countries allow firms considerably more discretion in
setting aside reserves for future contingencies than is typical in the United States. Because
additions to reserves result in a charge against income, reported earnings are far more subject
to managerial discretion than in the United States.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

(concluded) has been virtually a new accounting system without any
set rules, in which companies have been free to show
“The boundaries of corporations are becoming in-
their performance any way they deem fit.
creasingly blurred,” says Mr. Lev. “It™s very well defined
Finally, add to the equation the increasing impor-
legally what is inside the corporation but . . . we must
tance of a rising stock price, and investors face an un-
restructure accounting so the primary entity will be the
precedented incentive on the part of companies to
economic one, not the legal one.”
obfuscate. No longer is a higher stock price simply de-
Because of the leeway in current accounting rules,
sirable, it is often essential, because stocks have be-
two companies in the same industry that perform iden-
come a vital way for companies to run their businesses.
tical transactions can report different numbers. Take
The growing use of stock options as a way of compen-
the way companies can account for research-and-
sating employees means managers need higher stock
development costs. One company could spread the
prices to retain talent. The use of stock to make ac-
costs out over 10 years, while another might spread the
quisitions and to guarantee the debt of off-the-books
same costs over five years.
partnerships means, as with Enron, that the entire part-
Both methods would be allowable and defensible,
nership edifice can come crashing down with the fall of
but the longer time frame would tend to result in
the underlying stock that props up the system.
higher earnings because it reduces expenses allocated
And the growing use of the stock market as a place
for companies to raise capital means a high stock price
Another area that allows companies freedom to de-
can be the difference between failure and success.
termine what results they report is in the accounting for
Hence, companies have an incentive to use aggres-
intangible assets, such as the value placed on goodwill,
sive”but, under the rules, acceptable”accounting to
or the amount paid for an asset above its book value.
boost their reported earnings and prop up their stock
At best, the values placed on these items as recorded
price. In the worst-case scenario, that means some
on company balance sheets are educated guesses. But
companies put out misleading financial accounts.
they represent an increasing part of total assets.
Further complicating matters for investors, many
companies have taken to providing pro forma earnings Source: Abridged version of the article of the same title by Steve
that, among other things, often show profits and losses Liesman for “Heard on the Street,” The Wall Street Journal,
without these changes in intangible values. The result January 21, 2002.

Germany is a country that allows particularly wide discretion in reserve practice. When
Daimler-Benz AG (producer of the Mercedes Benz, now DaimlerChrysler) decided to issue
shares on the New York Stock Exchange in 1993, it had to revise its accounting statements
in accordance with U.S. standards. The revisions transformed a $370 million profit for 1993
using German accounting rules into a $1 million loss under more stringent U.S. rules.

Depreciation As discussed above, in the United States firms typically maintain separate
sets of accounts for tax and reporting purposes. For example, accelerated depreciation is used
for tax purposes, while straight-line depreciation is used for reporting purposes. In contrast,
most other countries do not allow dual sets of accounts, and most firms in foreign countries
use accelerated depreciation to minimize taxes despite the fact that it results in lower reported
earnings. This makes reported earnings of foreign firms lower than they would be if the firms
were allowed to follow the U.S. practice.

Intangibles Treatment of intangibles can vary widely. Are they amortized or expensed?
If amortized, over what period? Such issues can have a large impact on reported profits.
Figure 13.2 summarizes some of the major differences in accounting rules in various coun-
tries. The effect of different accounting practices can be substantial.
A study by Speidell and Bavishi (1992) recalculated the financial statements of firms in
several countries using common accounting rules. Figure 13.3, from their study, compares P/E
ratios as reported and restated on a common basis. The variation is considerable.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

476 Part FOUR Security Analysis

Accounting rules

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