Meet the Street: Where Other Accounting Pitfalls Might Lie

While Enron clearly went too far in trying to make its results look as good as possible, creative accounting lives on.

Charles W. Mulford Co-Author, The Financial Numbers Game: Detecting Creative Accounting Practices

Recent Meet the Streets

Author John Cassidy

Compensation Design Group's Frank Glassner

Needham's Dan Scovel

Penn State Professor Emeritus John A. Lucas

Federated Investors' Jim Zhao

Salomon Smith Barney's Alex Henderson

For that reason, we turn today to chat with Charles W. Mulford, professor of accounting at Georgia Tech's DuPree College of Management.

In the hopes of training financial professionals and serious investors to spot the practices that bend or break accounting rules, Mulford co-wrote the new book The Financial Numbers Game: Detecting Creative Accounting Practices, with fellow accounting professor Eugene E. Comiskey. The book draws heavily on a decade of Securities and Exchange Commission enforcement actions as a road map to where things can go wrong.

Mulford, who consults with commercial banks on accounting issues, shared some thoughts with TheStreet.com on where nasty accounting surprises might still lurk.

TSC: According to a survey you discuss in your book, when public companies manage their earnings, nearly half the time they do it through the timing of when they recognize expenses. Nearly 20% of the time, it's through revenue recognition. Are there particular industries that are magnets for the massaging of earnings like this?

Mulford: Software and technology have been at the top.

TSC: In what way?

Mulford: I'd say, more than anything, on the revenue side. They've got new rules to help bring down the aggressiveness on revenue recognition in the software industry. But until recently, things have run rampant in that industry. Is everything cured? I don't think so. We still see some fairly premature revenue recognition there.

On the expense side? Gosh, that's all across the board.

[One problem] on the expense side would be writing things off over too long a period. And this is one that we've seen and I think we're going to see more of. And I think it's more of a problem ... when you're in an environment of declining prices and rapid technology advances. You're depreciating fixed assets or you're amortizing patents and technology over periods that are longer than can be realized.

TSC: Who has done that?

Mulford: Waste Management(WMI) is a good example. And they got slapped by the SEC. They took way too long to depreciate trucks and write off costs -- capitalize landfills, things like that. When you do that, what you're saying is currently earnings are higher than they really are, because depreciation charges are understated.

It's a prescription for impairment loss. Down the road somewhere, you'll have a big impairment loss when basically you catch up with depreciation that should have been taken in prior years.

TSC: But the market doesn't seem to care about depreciation at all, whether it's done properly or assets are all impaired at once.

Mulford: I think that thinking is going to change. These costs are costs of doing business. You're talking EBITDA [earnings before interest, taxes, depreciation and amortization].

EBITDA has a place for lenders. If I'm lending money, and the interest on my loan is paid with earnings before interest, before taxes -- I think EBITDA makes sense in that limited setting.

But if you're an equity investor and you start using EBITDA to guide how the company is doing, I think you're being sorely misled. You're going to be set up for a disappointment. Because that's saying that they don't have to replace equipment to stay in business. That's saying they don't have to pay taxes to stay in business.

TSC: Well, the cable industry has an extensive physical plant, but cable operators and the analysts who follow them tend to focus on EBITDA or operating cash flow.

Mulford: I've thought about this a little. Initially, I think, an argument was made for [focusing on] EBITDA in that industry because they'd say, "Well, we don't have to replace the cable. Once it's in the ground, it's in the ground, and it's not going to be replaced."

So to include a charge for depreciation, which is in effect a cost for replacing that cable -- I could see, "Well, okay."

But then, as soon as they said that, then we started seeing, Well, now we're moving to different kinds of cable and fiber optic. And we're having to put that in. ... So there you go. Technology changed, and they do incur a cost of putting in new cable. So I'm not sure EBITDA even made sense there.

The next story, I think, is going to be how operating cash flow is easily managed, just like earnings are easily managed.

TSC: How?

Mulford: Through the techniques of showing investing activities as operating cash flow. Through capitalizing expenditures. Acquisitions, I think, are an easy way to overstate operating cash flow. You buy a company, and it's up to management to decide how much of that acquisition is an investment, and how much of it is innate operating cash flow.

[Another technique is] the inclusion of cash provided by discontinued operations in operating cash flow. Sometimes it's broken out, but sometimes it's not. So what you think is operating cash flow is, in fact, discontinued operating cash flow. And that's not going to sustain.

TSC: You've said that people who worry about off balance sheet liabilities like Enron's may be gearing up for the wrong war. What do you mean?

Mulford: Don't get me wrong. I believe off balance sheet liabilities are something to beware. But among all the examples we looked at, this is not the primary reason for accounting failures. ... If you're preparing just for that, I think you're going to miss a lot of the accounting problems that are out there.

TSC: If you were king, what would you change in financial reports?

Mulford: I think we need from the FASB [Financial Accounting Standards Board] right away more definitive guidance on what constitutes control [of a related party]. These SPEs [special purpose entities]. ... when those should be consolidated. And if I was the accounting lord and I had a say, I would like to see compensation expense for options put on the income statement.

TSC: Why didn't people catch Enron sooner?

Mulford: People wanted to believe. The thing had gone through such a tremendous run that, I think, caution was thrown to the wind. And they wanted to believe in the story.

TSC: That means we had a large number of people who didn't notice anything wrong with the financial statements.

Mulford: The average investor couldn't have gotten his hands around it. So I think they were looking to analysts. And analysts wanted to believe. And then you're getting down to not such a large number of people.

At the end of any party, you've got messes to clean up. I think the Nasdaq meltdown was the main party hall. And that gets done. And now we start looking in the little rooms -- the little party rooms. And in one of the rooms, we open it up, and there's an accounting mess or two to be cleaned up.

Next time, we'll hopefully have some changes, and it won't be quite as bad. But, look, anytime there's a bubble like that, I think there are messes to clean up.

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