Aggressive Accounting Practices Examined

Aug. 16, 2002 (The Internal Auditor) A recent study suggests that aggressive accounting techniques -- or earnings management attempts -- such as those allegedly practiced by WorldCom and Xerox, may be common in the business world.

"Evidence From Auditors About Managers' and Auditors' Earnings-management Decisions," conducted by Mark Nelson and John Elliot of Cornell's Johnson Graduate School of Management and Robin Tarpley of George Washington University, is based on confidential interviews with 253 audit partners and managers from one Big 5 firm.

In the study, the participating auditors and managers said they had come across nearly 2,630 earnings management attempts by corporate clients. Auditors said they waived adjustments of 56 percent of the attempts in the study sample for various reasons:

* 21 percent because the client demonstrated compliance with Generally Accepted Accounting Principles.

* 17 percent because the auditors didn't have evidence that the client's position was wrong.

* 18 percent because of other reasons, mostly because they were immaterial.

Of the 55 earnings management techniques examined, the largest percentage 25 percent -- involved reserve transactions. The next two most commonly found earnings techniques were revenue recognition - 15 percent and business combinations transactions - 14 percent.

A related study by Weiss Ratings Inc., an independent financial ratings agency, reveals that auditors often fail to warn of accounting irregularities. The report, "The Worsening Crisis of Confidence on Wall Street: The Role of Auditing Firms," states that audit firms gave a clean bill of health to 93.9 percent of companies that were later cited for accounting irregularities. The survey group comprised 33 publicly traded companies, and the audit firms involved were Arthur Andersen, Deloitte & Touche, Ernst &Young, KPMG, PricewaterhouseCoopers, and Tullis Taylor.

Only PricewaterhouseCoopers issued a warning on any of the 33 companies. The other firms failed to issue any warnings in their audit reports. Arthur Andersen audited 11 of the survey companies.

Due to various factors, including the accounting problems, the stock of the audited companies dropped from a total peak market value of $1.8 trillion to $527 billion, which implies an aggregate loss to shareholders of approximately $1.3 trillion.

"The first and most important line of defense for investors is manned by the nation's auditing firms," says Martin D. Weiss, chairman of Weiss Ratings. "Unfortunately, the accounting industry has overwhelmingly failed in its responsibility to deliver independent oversight to corporate financial statements."

To read the interview-based accounting practices study, go to aaahq.org/qoe/ taracceptedpapers.htm. The Weiss study can be found at WeissRatings. com/worsening_ crisis.asp