Accounting's Three Degrees of Separation

"What do I care about the law. Ain't I got the power?" steel magnateFrederick Vanderbilt once said.

As Americans watch an array of equally arrogant, next-generation robberbarons being led away in handcuffs, scorned investors are speculating on who will be arrested next. Meanwhile, it's D-Day for big firms to recertify their number-crunching, and new math problems are surfacing. But the road from aggressive accounting to criminal fraudcan be a tough one to navigate.

If the Securities and Exchange Commission requires a team ofinvestigators and months to determine the severity of a violation, how canindividual investors be expected to determine the difference between, say,the bad-but-not-criminal issues unearthed so far at AOL Time Warner ( AOL) and thealmost-laughable criminal shenanigans of Adelphia executives? Good question.

Those distinctions are tough for retail investors to suss out before thewhip comes down. What will help stem unnecessary panic-selling of manystocks, however, is a better understanding of how regulators and theJustice Department tackle these issues.

Determining the Degrees

Noncompliance with generally accepted accounting principles or evenviolations of SEC mandates are not necessarily criminal acts. But if these breaches are egregious enough, federal or state authorities will investigate and sometimes charge individuals with specific crimes.

As with any other criminal behavior,eventually it's the courts that make that call in determining what types ofaccounting shenanigans are actually criminal behavior, and which were justbad practices.

The SEC employs a three-tiered hierarchy when assessing violations. Thefirst and most basic is simply a breach of securities law. The nextcategory is for violations that were actually fraud; in other words, thatsomeone deliberately attempted to break the law. The third and most seriouscategory of violation are for those in which there was a deliberate intentto break the law, and the public either lost or were put at risk of losing a substantial amount of money.

The now-infamous string of companies currently under investigation wouldall almost certainly fall into the third camp. After all, any intentionallysquirrelly accounting would put the public at risk of substantial losses.

Violations that fall into the second or third tier are considered to bepotentially criminal behavior, although the SEC itself does not have anyauthority in criminal matters. Instead, it refers cases to the JusticeDepartment or a state attorney general's office. The SEC then pursues civilmeans of punishment.

The SEC's hierarchy of violations includes a healthy amount of discretion,and that latitude often surfaces in criminal investigations as well. Forinstance, if an employee -- for fear of losing his job if he did notcomply -- fudged some figures to make a quarterly report look better, he hasclearly reached the third tier of violations. But if that sameemployee had done so for personal profit, that intent could warrant agreater civil punishment as well as less sympathy in the criminal system.

"There's no checklist as to when certain conditions are met," says BrianSierra, a spokesman for the Justice Department. "There are criminallaws on the books regarding fraud, but nothing that says definitively whenfraud has been committed as opposed to bad accounting."

That Fine, Hazy Line

Accountants are fond of saying that the methods employed by theirprofession are art, not science. Snicker if you will, but the assessment isaccurate.

"Companies can choose among several acceptable accounting treatments," saysLawrence Revsine, an accounting professor at Northwestern University'sKellogg School of Management. "There's judgment in financial reportingthat's just inescapable."

Indeed, the financial reports announce just that. "A typical footnote foundin every financial report says something to the effect of 'The preparationof financial statements in accordance with generally accepted accountingprinciples requires management to make some assumptions,'" says KevinPianko, an audit partner at New York's Eisner LLP.

Essentially, the line between aggressive accounting and accounting fraud iscrossed when that judgment, those assumptions, are indefensible -- completelycontrary to established accounting theory.

Take, for instance, the fairly straightforward accounting issue ofdepreciation. (A brief Accounting 101: Depreciation is the allocation of anasset's cost over the estimated useful life of the asset. Each year thatthe asset is in use, a certain portion of its worth is treated as anexpense.)

There are two basic methods for allocating the costs of an asset:Straight-line depreciation and accelerated depreciation. Straight-line depreciation simply allocates an equal amount of an asset's cost every year, making the depreciation amount the same every year of the asset's life. Accelerated depreciation -- as the term implies -- uses shorter life estimates for the asset, and takes a greater amount of depreciation in early years and lower amounts in later years.

A company purchasing a lot of technology should opt for the accelerateddepreciation method, since technology generally loses value more rapidly inits early years. However, that company could opt instead for thestraight-line method, which would mean a lower expense and lead to apumped-up bottom line. Aggressive? Yes. Illegal? Probably not.

"That area is so gray that most of the time companies are not thought of ascrossing any line," Revsine says. "They're choosing between equallypermissive vehicles. One version is certainly more appropriate, but that'sa hard argument to make in a court of law."

And while it seems like a rash of modern-day robber barons are flagrantlyfleecing investors, true accounting fraud is historically rare, saysHarvard Business School accounting professor David Hawkins. "When it hashappened, it's led to significant changes in the accounting profession," hesays. "But we really don't see this very often."

It's anybody's guess how much more of it we'll see.

More from Personal Finance

How Small-Cap Stocks Can Protect Your Portfolio From a Trade War

How Small-Cap Stocks Can Protect Your Portfolio From a Trade War

When Is It 'Worth It' to Work With a Financial Advisor?

When Is It 'Worth It' to Work With a Financial Advisor?

Why Millennials Are Ditching Stocks for ETFs

Why Millennials Are Ditching Stocks for ETFs

Amazon Prime Day 2018: When Is It and What Should You Know?

Amazon Prime Day 2018: When Is It and What Should You Know?

When Is the FAFSA Deadline and What Are the Application Requirements?

When Is the FAFSA Deadline and What Are the Application Requirements?