Global Crossing, Enron, Adelphia, Worldcom, now infamous names, represent massive corporate failures.  Many employees, investors, creditors have been damaged.  Who is to blame?

The most obvious blame belongs to the CEO’s who have the overall authority and responsibility for management and financial reporting.  They cannot claim to be doing their jobs and to be ignorant of accounting fraud, at least not in the same sentence.  The CEO may not produce bad accounting numbers but he must not pressure, encourage, tolerate or be ignorant of those who do. The highly paid CEO’s job includes the responsibility to oversee accounting functions.  Executive bonus compensation tied to reported earnings may need to be abandoned or curtailed to reduce temptations.

Accounting functions are the direct responsibility of the corporate accountants.  Corporate accountants understand the corporation and accounting and their duty to produce relevant and accurate financial reports.  Accountants must not be influenced by personal greed or by the pressure to produce the desired result.  If the public is misled or not properly informed, the corporate Certified Public Accountant is to blame.

A similar blame accrues to the external auditors who review the accounting and opine on the financial reports.  The auditing company’s responsibility is to insure that corporate accounting follows the rules.  External auditors must investigate and discover.  There is no excuse for overlooking abuses 10 digits long.  They must form independent, unbiased, and meaningful opinions.  Clearly the external auditing function has failed, most visibly with Arthur Anderson.

Financial analysts diligently evaluate companies and claim to see beyond the deficiencies or biases of corporate reports. They make professional recommendations which they profess represents the interests of the readers of their reports or analyses.  They claim to be unbiased and independent.  Financial analysts have failed in their stated mission.  In some cases they have actively contributed to corporate failures.  They must accept blame for their obvious failures and move forward. Financial analysts can have a very valuable financial role, but clearly not their current role.  Mutual funds advisors, state retirement fund administrators, stockbrokers failed to be alert or even prudent.

The discipline and enforcement arm of the AICPA has accomplished nothing and through inaction has encouraged creative accounting and other misdeeds. Self-regulation and self-discipline is preferred, but only if it has teeth and will.

Regulators have failed their charters.  The SEC has ultimate authority: over financial reporting for publicly traded companies, to regulate capital markets, and to protect the investor.  If the system is not working, it must be fixed.  It has not been fixed. FASB establishes the accounting rules.  In many cases of failure, the rules have been followed, but the principle violated or nonexistent.  In most cases the rules are detailed, complex, and difficult to interpret, apply, or enforce.   FASB has made extraordinary efforts to defend and extend the life of an antiquated accounting model, but it needs to initiate fundamental change.

Congress must share the blame for not appreciating the importance of sound accounting and for not adequately supporting the regulators and their independence.  For the moment, congressmen seem to understand their past mistakes, but they still accept campaign contributions.

Shareholders must shoulder some of the blame. Exuberance and greed have propelled prices to unreasonable and unsustainable levels.  Management was often forced to live up to irrational capital market expectations.  If expectations are not met through actual results, they can, with a little help from friends, be achieved with reported results.   This keeps everyone happy ... for a while.

Employees must assume some of the blame. If they do their jobs, are not overpaid and add real value to the company, the company will generally succeed.  Most are good apples.  Many employees have seen their savings and retirement funds evaporate.  Most of these were, at least, exuberant and did not diversify their investments.  Management and employee benefits advisors within the company also abrogated their fiduciary responsibilities in not advising or requiring adequate diversification.

Boards of directors and their audit committees have generally been yes-people not true overseers.  Involvement, courage, independence, stewardship, and public duty have not been hallmarks of boards.

Bond rating organizations have improved somewhat, but they are often a day late and a dollar short, despite the fact that many failures were years in the making.  Perhaps they are partially shielded from responsibility and blame because bondholders have first claim.  Rating organizations can be a force for financial responsibility.

Banks, investment bankers, and speculators play a major role.   The often accumulate large sums of money through their machinations. Where does that money come from?

Lawyers and law firms were at least as culpable as management. They did not cover themselves with glory.

It’s tragic that that stupidity, greed, dishonesty, self-interest, fraud and incompetence are so epidemic.

There seem to be more blamees than blame.  Can blame be diluted out of existence?  If everyone is to blame, is anyone to blame?  Have we missed something?

The Real Failure

When a problem is widespread and pervasive that problem is systemic.

The common denominator in the above failures is the current accounting system.  The above failures are fundamental accounting failures.  The current accounting system needs to be updated.  There must be a single set of books not GAAP/pro-forma/management accounting/acquisition accounting/SEC filings/regulatory accounting/tax accounting/performance measures/scorecards/financial analysts valuations.  Within GAAP alone there are a myriad accounting treatments and fixes.  Accounting needs to be made comprehensive yet simple, relevant yet feasible, flexible yet disciplined, forward looking yet auditable.  It must be consistent at all levels and across all industries. It must be guided by clear principles not complex and unstable rules.  It must process data and provide high level decision-useful information.

Is it possible to update the accounting model to satisfy the foregoing goals?  Yes.

The model that does this seemingly impossible task is Accounting For The Future (AFTF).  AFTF is the embodiment of existing technologies and existing trends and existing developments within accounting.    In brief, AFTF is a disciplined value-based accounting system employing the Present Value of Expected Cash Flows (PVECF).  Please refer to my other essays or the draft proposal Accounting For The Future for details.

AFTF informs.  All those blamed for recent accounting failures would have been protected by being informed.  All those suffering financial damage would have been protected.

It may be of some current interest to briefly consider how AFTF would have applied to above companies.

First, we note that AFTF is value-based and decision-relevant.  Clearly, the GAAP financial reporting model, as it was applied, was not based on value and did not properly inform.  But this is more than a problem of improper application.  Current GAAP make no attempt to value and is marginally decision-relevant.  There is a fundamental lack of principle.  AFTF, on the other hand, has a bright beacon to guide: capital market value.  AFTF is decision-useful.  In fact, decisions are AFTF accounting elements.

Second, many accounting fiascoes are the result of accounting allocations, the near arbitrary shifting of revenues, to produce the desired current GAAP earnings.  With AFTF there is no shifting of revenues; none is needed; none is possible.

Third, AFTF is based on cash flows and only on cash flows.  These may be past cash flows (used for model validation), current cash flows (used to compare actual-to-expected), and future expected cash flows based on a validated model.  The measure of these cash flows (PVECF) is scaled to the capital market and represents shareholder value.  This value is defined uniformly and is decision-useful at all levels within the corporation and across all industries.  Cash flows are defined unequivocally and are measured to the penny within the books of account or within published expected cash flows.  Users of accounting information increasingly recognize the advantages of cash flow over reported earnings.  For example, the Price/Cash Flow ratio is often used instead of the P/E ratio.  The best ratio measure is Price/PVECF.  It compares price to value providing a easy decision criterion, is normalized at 1.00, making comparisons between companies or across industries meaningful, and takes into account a shareholder cost of capital for the entity.

The problem with Worldcom, Enron, etc., was that earnings substituted for cash flows and that earnings exceeded cash flows, past, present and future.  Any accounting system must ultimately reconcile to cash flows, otherwise money is manufactured or expropriated.  There was no such balancing of the books at Worldcom or Enron.  The most natural solution to this balancing requirement is to base accounting directly on cash flows.  This is foolproof.

Enron would not have failed so dramatically with AFTF in place.  For one thing, the share price would not have outstripped share value.  Growth would have been controlled and pressure to manage earnings would have been non-existent (see the draft proposal for reasons).  Cash flow measures could not have been exaggerated.  Capital markets would have been informed and would have better restrained and guided management.

AFTF reports Actual to Expected (A/E) cash flow ratios.  These would have revealed the true situation at an early stage.

The AFTF cash flow models used to project cash flows would have to fit (validate to) the past.  This anchors the expected future to the actual past, restraining exaggerated projections.  The measure (PVECF) of expected cash flows depends on the discount rate. For AFTF, this rate is the historic cost of capital arising from the dual validation.  The dual validation eliminates the motive and opportunity for financial finagling.

The historic cost of capital represents the expected shareholder yield; it is a prominent feature of AFTF financial reporting.  It readily reveals any misalignment of value and price.

Recent accounting failures are dramatic and have caused hardship to many people, while others profited.  Should we be overly concerned about who wins and who loses?  Are we, in essence, dealing with gambling outcomes in a zero-sum game?  Why not clone Las Vegas and close Wall Street?

It is clear that the capital market is not a zero-sum game.  Capital markets exist to efficiently allocate scarce capital resources to productive enterprises, enterprises that create or add value and enhance total capital resources.  Our economy and standard of living depend on efficient capital markets.  We have the most efficient and most trusted capital markets in the world, but that efficiency and trust is dependent upon relevant and reliable accounting information.

Enron, Worldcom and other recent corporate failures have damaged the capital markets far beyond their own huge losses.  A continuation of such failures could depress capital investment enough to produce a major economic recession.  The greatest risk is that capital market efficiency is gradually eroded by bad or irrelevant accounting creating a pervasive and sustained decline in financial and economic activity.  Such erosion is insidious and, indeed, may be well under way as the economy shifts and accounting stagnates.  AFTF has the potential, not only to maintain capital market efficiency, but to substantially improve it.  AFTF is anticipatory and accounts for the long term; this will tend to stabilize the markets and further improve capital market efficiency.  AFTF can also improve company efficiency since it provides forward-looking decision-useful management information.

Recent corporate failures are human failures and accounting system failures.  As a by-product of its relevance, AFTF would have prevented or reduced those failures.