It is sometimes difficult to understand how, if 1) there are standard accounting rules that all companies must follow, and 2) accounting standards are regulated and 3) certified public accounting firms oversee that companies report their financial results according to these rules and standards, how some companies have been able to publish financial results that did not show a true picture of the company’s financial success (or lack of it).
The reason the last few years’ phenomenon of flagrant accounting abuses by major corporations such WorldCom, Enron, Global Crossing, Adelphia, and Tyco were able to occur is that accounting rules are open to interpretation. The many ways to portray expenses and revenues were exploited by creative accounting practices in order to mask losses. The figures did not lie; they were just hidden so well that they became silent. Some of these abuses may simply be questionable; some are actually fraudulent.
One way to hide losses is to depreciate assets more slowly. If a major capital asset, such as a oil rig has a cost of $10 Million and is normally depreciated over 10 years, each year it would represent an expense to the company of $1 Million. If, however, the company were to change the depreciation schedule to 20 years, the annual expense would be reduced to $500,000, thus increasing the company’s profit, or at least, reducing its losses. Although this might be considered legal, it would not be ethical if the true life of the oil rig was really only 10 years. At the tenth year when it had to be replaced, the cost would not yet have been fully covered.
A similar abuse, but one that is clearly illegal, is to capitalize, that is spread out over a period of years, ordinary expenses that occur in a single year. This appears to be one of the abuses committed by Worldcom. A company should spread the cost of a major capital item out over several years because it will be used over all of those years; it is a question of interpretation how many years should be used as a guideline. However, telephone bills, payroll expenses, monthly rent, any items that are related to a current period must be expensed to that period and may not be spread out over time to make it appear that income is sufficient to cover expenses.
Some companies that trade in energy contracts have established “round trip” trades in these contracts wherein no underlying transaction occurred, but served only to boost the apparent revenues of the company. Global Crossing was investigated by the SEC for the same type of accounting trick wherein it did back and forth swaps of fiber-optic capacity, while the capacity never changed hands.
Another way to presenting financial performance more favorably is to conceal some of the company’s debt. Selling debt to off-balance sheet entities, prepaid transactions where the funds are reported as deferred revenue rather than debt, synthetic leases and derivatives may all serve to increase capital without reflecting debt on the company’s financial statement.
The Securities and Exchange Commission, the various accounting standards boards and many other financial regulating entities are constantly reviewing how to monitor and control these types of abuses. Innovative and often unethical accounting professionals seem to stay one step ahead of them.