Extraordinary items

It was a scandal when, five years ago, some divisions of the American optical manufacturer Bausch & Lomb (the makers of Ray-Ban shades) were discovered to have been booking orders as revenue. Heads rolled: but that was 1996. By the end of the techno-bubble, it seemed the same practice was de rigueur, and the subsequent crash of the telecommunications stocks came with the tasteless accompaniment of restated earnings.

It is not merely the Enron bankruptcy that has investors wondering whether they can trust financial disclosure. More and more companies have been forced — whether by insolvency, by regulatory action, or just by being caught out — to reissue financial statements from previous years. Vastly more than that have taken refuge behind one-time charges, and more still behind the practice of stating “headline” earnings that do not reflect the state of their business.

The ever-cozier relationship between accounting firms and businesses has been criticized heavily in recent weeks. Readers of the general (and even some of the business) press could be excused for thinking former Securities and Exchange Commission head Arthur Levitt had spent his last two years at the SEC talking to a brick wall. But then, in a sense he was: Levitt’s warnings back in 1998 and 1999 that auditors were tolerating too much from their clients went largely unheeded by U.S. legislators. Regulators here were slower to react, and quieter. And little has been done to remove the conflict of interest between the audit and consulting roles that large accounting firms have taken on. Until that conflict is removed, doubts will remain about auditors’ work. We suspect stricter professional standards, and not regulation, is the answer: it is better to raise the professional bar than to impose a set of regulations that accountants of easy virtue will immediately begin to work around.

The public may also find reason to be suspicious of investment ratings supplied by brokerage houses. It is very old news that companies tell more to friendly analysts, and equally old news that corporate finance departments can be less than shy about vaulting the famed “Chinese Wall” and putting pressure on research departments to rate good customers favourably. That is but one problem; another is the limited effort analysts can put into checking out any one of the many companies they follow. Dissecting the books of a company that is determined to hide something is more than a one-man job to be completed next Thursday: for example, it will take teams of auditors months, and perhaps years, to establish all the problems around Enron.

Companies have also resorted to the courts to squelch talk of misleading financial reporting. One analyst found himself defending a libel suit when he described a company’s accounting practices as “aggressive.” He agreed to keep silent for two years as part of the settlement; that period ended shortly after the company went into bankruptcy protection and restated three years’ worth of earnings. Its name? Livent.

Business may be ruthless, which is not all bad; but that ruthlessness became handmaiden to dishonesty, which is all bad.

To deceive the market by numerical sleight-of-hand — no matter how much management may feel it wants the public to see a “broader” picture — will finally forfeit investors’ trust. Politicians did that for years: now look at the esteem in which the public holds the people that used to be called “statesmen.”

If businessmen want the public to trust them just as it trusts politicians, then cooking the books is precisely the way ahead.

In this respect, the mining industry is one of the fortunate ones. Apart from the murky world of hedge transactions, commodity producers have comparatively few ways of doctoring revenues. The scope for playing with earnings is similarly narrowed if we discount the sometimes curious ways acquisitions are accounted for. Should the public decide that earnings are not a trustworthy way to rate companies, business in general will be the loser, but discerning investors may also decide that the old-economy businesses have lost the least.