The AICPA Code of Professional Conduct proclaims that its members should serve the public interest, defined as “the collective well-being of the community” (Section 0.300.030, https://pub.aicpa.org/codeofconduct/Ethics.aspx#). This community includes investors and creditors, as they are the recipients of financial reports, are helped by useful financial reports, and are hurt by reports that contain errors or omissions. The code exhorts CPAs to carry out these duties with “integrity, objectivity, due professional care, and a genuine interest in serving the public” (Section 0.300.030.04).
The American Accounting Association (AAA) represents academic accountants, and it has an objective that resonates with the AICPA’s code. Accounting academics teach, research, and engage in service activities, including not only service to the department, the college, and the university, but also to the greater community. The AAA’s “Statement of Responsibilities” makes this clear when it declares that members “accept a responsibility to perform service to society, their institutions, their academic discipline, the profession, the business community, and the social community” (http://bit.ly/2GLFosf). The statement does not add specificity, recognizing that how this responsibility is fulfilled depends upon the member’s “skills, passions, and background.”
Over 20 years ago, I chose to serve the public interest by critiquing the work of corporate managers and auditors. I tried to use my skills, passions, and background to improve financial reporting by pointing out aggressive accounting in reports I read, endeavoring to do so with integrity, objectivity, due professional care, and a genuine interest in serving the public. This article is a summary of my journey, detailing its origins and supplying reminiscences of events along the way. My hope is to encourage others to serve the public interest by continuing in this vein. Investors, creditors, and the greater community need useful and accurate information. By criticizing erroneous or incomplete reports, perhaps with governmental agencies as catalysts, accounting critics can better serve the public interest.
Genesis of My Criticism
I started my academic career in a conventional manner, having been educated at Virginia Tech primarily in what was called “income measurement theory.” I wrote several articles on income measurement, including the importance of cash flows for avoiding arbitrary and capricious allocations. I also conducted empirical research studies.
I met Abe Briloff in 1978 at an AAA conference in Hartford, Connecticut, where he spoke about accounting frauds and auditing failures. My interest was piqued: I started reading his books and articles, and I also read a number of essays by Eli Mason.
During the 1980s, there were a number of accounting frauds, such as Crazy Eddie’s and ZZZZ Best, which led me to wonder if critics like Briloff and Mason were correct. I also started asking whether the debate about the best income measure is irrelevant in a world in which managers manipulate accounting numbers. Aggressive accounting practices would influence the measurement of current cost income and exit value income, just as was happening with historical cost income. Accounting fraud would distort and possibly render meaningless all of these income measures. Aggressive managers could also distort cash flow measures, making estimates of free cash flows quite difficult. I tried writing research papers for academic journals about accounting shenanigans, but to no avail, because some reviewers and editors said accounting scandals were not a topic worthy of interest to readers. I needed to find other outlets to communicate my concerns.
In spring 1996, the dean of Penn State’s Smeal College of Business engaged the services of a New York marketing firm to put the business school in the spotlight. I told one of the firm’s associates about my interests, and he arranged for me to travel to New York in June 1996, setting up approximately 20 meetings. One meeting was with Rick Telberg, at that time editor at Accounting Today. He enjoyed a paper I wrote with Paul Miller of the University of Colorado at Colorado Springs, and asked us to carve it into smaller segments for the practitioner audience; thus was born the column “The Spirit of Accounting.” As Miller and I proclaimed in an early column:
Accounting is not a game, and generally accepted accounting principles and ethical rules should not be construed as rules to a game. Instead, accounting has a goal, an objective, a telos: financial accounting reports should promote the efficient performance of national and international economies by providing information that enhances the likelihood of efficient allocations of resources in capital markets. … We believe that there are significant ethical deficiencies in the accounting profession and few nonradical solutions. There is a need to reexamine and rebuild accounting institutions in order to improve the ethical condition of the profession (Ketz and Miller, “Some Ethical Issues About Financial Reporting and Public Accounting and Some Proposals,” Research on Accounting Ethics, 1997).
My essays criticized managers for poor accounting and auditors for permitting the poor accounting, and these comments were noticed. One large audit firm that Paul Miller and I criticized decided to send representatives to chat with me in the late 1990s. Two partners from this Big Four firm came to my office, one asking questions and the other taking copious notes. After 45 minutes of discussion, the partners said their next meeting was with the university president to discuss future firm donations. The threat was obvious. Interestingly, the firm never pressured Miller in this manner.
Also during the late 1990s, Miller and I remarked that investment banks should not acquire accounting firms; the essay addressed a circulating rumor that suggested the possibility. My dean received an advance copy and called the editor of Accounting Today to try to kill its publication. The editor called me and asked me whether I wanted to rescind the paper; I answered no. Shortly thereafter, legal counsel at the university required me to add a disclaimer to each column I wrote stating that I was not speaking for the university. Miller’s university never asked him to include a disclaimer.
One proud moment came when I was the first to suggest publicly that Computer Associates was engaging in accounting fraud. This came about when Alex Berenson wrote on the subject (“A Software Company Runs Out of Tricks; The Past May Haunt Computer Associates,” New York Times, April 29, 2001, https://nyti.ms/2Ef9vXt); I was not quoted in that story but supplied background information and commentary.
As I further researched the accounting statements, I became convinced that the firm was not just aggressive but fraudulent in its reporting. I reported this conclusion in “Curious Accounting at Computer Associates” for Accounting Today. Ira Zar, the CFO for Computer Associates, flew to Penn State in an attempt to convince me otherwise. He visited on November 13, 2001, but talked about business strategy and incentivizing the sales staff and never addressed the accounting questions. I was proved correct in 2004 when the SEC charged Zar and other executives with accounting fraud. He pled guilty and served as a witness against CEO Sanjay Kumar, who was found guilty. Kumar was sentenced to 12 years in prison and fined $8 million; Zar was sentenced to seven months in prison and seven months of home detention.
Another satisfying moment was assisting the Wall Street Journal in its investigation of Enron’s Nigerian oil barge deals with Citigroup and other banks, testifying that the deals were not sales but, in substance, debt transactions. These deals transferred the oil barges from Enron to a bank, but Enron made a side deal with the bank to repurchase the oil barges and pay the bank more than the initial amount disbursed. Enron booked the transaction as a sale and recognized a sizable gain, but the existence of the side deal implied that the transaction was actually a loan, with the cash difference being the interest, amounting to over 20%. This work required the reading of hundreds of pages of internal Enron documents and contracts that they obtained from an insider. Anita Raghavan wrote the story (“Enron’s McMahon Is in Spotlight For Involvement in Merrill Deal,” April 9, 2002, https://on.wsj.com/2IiJsCL).
In 2002, there were many stories about Arthur Andersen and its audit failure at Enron, which prompted vehement censures from Arthur Andersen partners who had attended Penn State. They questioned my sources of information, not knowing that I was receiving internal Enron documents from the Wall Street Journal and other sources. Amazingly, they asserted that audits are not designed to detect fraud and never have been. These professionals must never have read Statement on Auditing Standards (SAS) 82, Consideration of Fraud in A Financial Statement Audit, which clearly enunciated some auditor responsibilities to detect fraud (http://bit.ly/2GqlT9z). They vowed not to support Penn State as long as I was an employee.
During 2006 and 2007, I was asked by Shughart Thomson Kilroy, attorneys for a consortium of Coca-Cola bottlers, to analyze Coca-Cola. Specifically, they wanted to confront Coca-Cola’s practice of avoiding consolidation by owning only 49% of the stock of Coca-Cola Enterprises and some other companies. I created the consolidated statements for them.
On September 28, 2009, Hertz sued Audit Integrity, claiming defamation when Audit Integrity wrote a report claiming Hertz was in danger of bankruptcy. I wrote that the lawsuit merely represented intimidation by corporate America. Hertz had negative income and negative retained earnings, its debt-to-equity ratio was over 10:1, and the Altman bankruptcy model strongly predicted corporate failure. Anybody could see that Hertz was in financial trouble. In December, Hertz saw the light and withdrew its lawsuit.
In 2010, Kirkland & Ellis, who represented Orange County, California, asked me to write an amicus letter for an appellate court and then the California Supreme Court holding to the opinion that municipal projected pension obligations are in truth liabilities. I invited Walter Schuetze, former member of FASB and former SEC Chief Accountant, to join me in this effort, and I then obtained additional signatures from a number of accounting professors and executives. Unfortunately, the courts ignored economic reality and said that projected pension obligations are not liabilities.
Anthony Catanach at Villanova University and I were the first to point out a significant deficiency in Groupon’s registration statement, Form S-1, in 2011. In “Trust No One, Particularly Not Groupon’s Accountants,” we noted that Groupon recorded its revenues at its gross amounts even though it had to remit funds to merchants for their activities. We reviewed Emerging Issues Task Force (EITF) 99-19 on how to determine what constitutes a primary obligor. The fact that the merchants were responsible for fulfilling the obligation to deliver goods and services implied that Groupon was not the primary obligor, which meant that Groupon should have been recording its sales at net amounts, not gross amounts. To make sure we got the SEC’s attention, we completed the whistle-blower form on its website, asking them to investigate the matter. A few months later, the SEC forced Groupon to amend its registration statement, requiring it to record revenues at net amounts.
In May 2012, Catanach and I criticized Zagg for its aggressive accounting in our article, “Don’t Gag on Zagg.” Zagg sued us, claiming that we published an essay “that contains false and defamatory statements.” We eventually settled with the firm, which required no money but removal of the articles from the website, as well as information about Joseph Ramelli, whom the firm also sued. (At the time Ramelli was the managing director of Eos Funds; I had no contact with Ramelli, and Anthony Catanach had only one phone call with him.) In the end we felt vindicated because soon afterward, Zagg replaced its CEO with another man, who then incorporated almost all of our suggestions for improvement within their financial reports. Perhaps KPMG, Zagg’s auditor, felt there was merit in some of our comments. We also became aware of several potential whistleblower suits, although as far as I know nothing came of any of them.
In 2014, David Maris, now at Wells Fargo, asked me to analyze Valeant. I found the business model suspect because Valeant was sacrificing long-term profits in an attempt to enjoy short-term profits; revenue recognition was aggressive and cash receipts significantly trailed the accrual earnings; goodwill had a large risk of impairment; and free cash flows were weak. Valeant’s managers asked the investment community to ignore the GAAP numbers and concentrate on “cash eps,” a metric of their own invention. That argument was bogus because cash eps eliminated some real cash expenditures, did not adjust for changes in working capital, and were unique to Valeant, which made the metric uninterpretable. At some point the journalist Jesse Eisinger called me, and I reported my findings to him (https://nyti.ms/2Xcqpxq). Approximately one year later, Valeant’s stock fell approximately 90%.
In the end we felt vindicated because soon afterward, Zagg replaced its CEO with another man, who then incorporated almost all of our suggestions for improvement within their financial reports.
The concluding chapter in each of Briloff’s books was typically titled “Quo Vadis?” The expression is Latin for “Where are you going?” The question is appropriate because accounting reports are still deficient from time to time, auditors occasionally miss key aspects in the audit, FASB does not always perform its mission well, and accounting professors are sometimes aloof to the problems of practitioners. Managers must be rewarded for honest and accurate reports and punished for deceitful statements. Auditors should be exhorted to carry out the important task of auditing corporate financial reports. FASB needs to assist investors and creditors better without overly worrying about pampered preparers. Lastly, academics should enter this arena with impartial, objective analysis.
There is no hope of improved accounting and disclosure and little chance of meeting the needs of the investment community unless and until somebody points out the problems. The errors and omissions do not stand a chance of correction if accounting experts remain quiet. Do we wish to repeat the events of 2002, when dozens upon dozens of firms announced restatements because of accounting mis-cues? Do we wish to see headlines bashing accounting as we did during the banking crisis of 2008–2009? If not, objective and independent accounting experts must stand up whenever the system reveals cracks and leaks.
My mission has always been to serve the community and the accounting profession. My criticisms are meant to be constructive, to point out things that should be amended and point out things that ought to be done. My hope is also to encourage others to join in the effort. Given the importance of fair and full disclosure to our capital markets and other users, the gains to the public interest are worth the struggles.