Aggressive Accounting: How much is too much?
“There are more financial misstatements and fraud now, SEC spokesman Thomas Newkirk said. There
was a time it was a rare day to get caught in a fraud case. In the last year or two lots of big capitalization,
nationally known companies have been involved in financial fraud.” (1)
“The Security Exchange Commission says that it currently has about 260 accounting investigations under
way, according to the Wall Street Journal. About 40 of the companies, or 15 percent of the total, are
among the 500 largest companies in the country. „If we had nothing else to do, the accounting
investigations alone could keep us busy for the next five or 10 years‟, Richard Walker, the SEC‟s
enforcement chief, told the paper, „The size and magnitude are crushing‟ “. (5)
“In November, Waste Management itself paid $475 million in fines to settle charges of violating securities
laws in its 1998 merger with USA Waste Services and its 1999 financial statements.” (1)
“In 1999, Cendant Corp., the travel and transportation conglomerate that owns Ramada Hotels and the
Avis car rental chain, agreed to pay shareholders $2.83 billion to settle a suit alleging irregularities in its
merger with CUC International Inc.” (1)
“Appliance maker Sunbeam Corp. was forced to restate financial results for 1996 and 1997 last May, and
the SEC sued former CEO Al Dunlap (Chainsaw Al) and other executives after he was accused of using
phony accounting to boost profits. The company later filed for bankruptcy” (1)
“The Securities and Exchange Commission said Tuesday that Arthur Andersen LLP‟s audits of Waste
Management Inc.‟s financial statements were false and misleading, and that the accounting firm agreed
to pay $7 million to settle the case. The agency said it was the largest civil penalty ever assessed against
a Big Five accounting firm. The SEC said it found financial statements that were issued as “clean”
opinions by Andersen overstated Waste Management‟s shareholders and the investing public, said
Richard H. Walker, SEC‟s Director of Enforcement, in a statement. Given the positions held by these
partners and the duration and gravity of the misconduct, the firm itself must be held responsible for the
false and misleading audit reports issued in its name.” (2)
“Auditors have uncovered hundreds of millions of dollars in previously unreported accounting fraud at
HealthSouth, . . . a forensic audit by PricewaterhouseCoopers had found enough additional fraudulent
entries to raise the total to between $3.8 billion and $4.6 billion” “. . . HealthSouth expected to name a
chief executive by the middle of the year to replace Richard Scrushy, its founder, who was indicted in
November on 84 counts of fraud.” (3)
“. . . markets were hammered following last night‟s announcement that WorldCom had inflated profits by a
staggering $3.8 billion over the past five quarters” (4)
The examples above are only a few of many accounting fraud cases that have
occurred over the past several years. Accounting fraud can have devastating
consequences for investors, customers, and the employees of those companies that
engage in cooking the books. Accounting fraud rarely begins with outright illegal
activity, but instead usually begins with selection of alternative accounting procedures
and aggressive accounting practices that may not be in and of themselves illegal. The
question of when application of various accounting principles or changes is appropriate
is an important one. The person choosing accounting procedures and principles is
influenced by many forces that may lead them to misstate financial results despite an
original intent to follow the law. Even well-intentioned managers or employees within an
organization can be caught-up in activities that lead to misleading financial statements
when placed in a setting where top executives or the corporate culture may place them
under intense pressure to follow orders.
In this era of greater financial scrutiny, a recent finding by Professor John
Graham of Duke University indicates that rather than engaging in illegal activities, many
CFOs are making decisions that benefit short-term earnings at the expense of long-term
cash flows and profitability. (11) Managers and accountants within the organization, the
audit committee, and outside auditors all should play important roles in ensuring that
financial statements are produced with integrity and that they accurately reflect the
financial position and history of the company. It is important to consider the pressures
and biases of all of these groups and to consider what can be done to motivate
unbiased ethical financial reporting, oversight, and auditing.
There is no question that accounting fraud is wrong. There are many issues that
are not so clear, however. Corporate executives, accounting managers, audit
committees, and outside auditors all must face questions of exactly what financial and
accounting decisions are acceptable and which are not. When presented with a
subjective assessment, how should these groups make decisions on what is right? If
company officers are expected to meet earnings targets as a key component of their
jobs, what can they do to achieve those results and still act in an ethical manner?
When an outside auditor is reviewing financial statements, how much leeway should
company management be given? What should auditors do when they discover a host
of gray or questionable issues that seem to all fall in favor of the company’s short-term
Corporate Executives and Managers
Corporate executives are often judged in a large part by their ability to meet
short-term earnings goals. If executive compensation and job performance are based
on these criteria, is it acceptable for these executives to do everything within their legal
capacity to meet these targets or are they responsible to other stakeholders such as
employees, customers, society, debt-holders, and long-term investors? Some methods
of increasing short-term earnings may come at a significant cost to employees that may
face employment uncertainty including threat of layoffs, low wages, or benefit cuts.
Customers may suddenly receive a lower quality product or receive lower quality
service. Depending on the community, the actions of the corporation may shut down
the major employer in a town or have environmental consequences in terms of air or
water quality. Some short-term financial fixes may be at the expense of long-term cash
flows and profitability and may have negative consequences on debt-holders and long-
term investors. Examples include sale of a promising business segment in order to
recognize a short-term financial gain, finding creative ways to accelerate revenue
recognition, or deferring needed maintenance on capital equipment in order to keep
short-term expenses down.
While the preceding list is not comprehensive, it illustrates some of the choices
and trade-offs that executives and managers often make. Depending on the decision-
makers values, a decision that is legal and in their own best interests or in the bes t
interests of shareholders may not be in agreement with their personal values and may
negatively impact some of the other stakeholders mentioned. The decision-maker must
weigh the effects of their decisions on all affected stakeholders given the legal
environment in which they operate and their personal values. A further complication
that is important for decision-makers to consider is the fact that we all have known and
unknown biases that have significant influence on our decisions.
Audit Committee and Board of Directors
The Audit Committee and the Board of Directors has responsibility for setting
policy, for providing oversight, as well as setting the course and direction for the
company. The values that the Board and the Audit Committee express have a
tremendous impact on what the values of the company will be in regard to all the
various company stakeholders. Like corporate executives and managers, the Board
must balance various stakeholder interests and consider their values when making
decisions. The Board must consider what impacts their decisions will have on company
stakeholders and their responsibility to these different groups. Board members
operating under the premise that they are responsible only to shareholders will do
whatever is legally acceptable to maximize shareholder value. Others may believe that
they have responsibility not only to shareholders but also to company employees, the
communities in which they operate, to society, and to their customers.
Everyone is doing it
Most businesses operate in a very competitive environment. In order to
compete, companies must be creative and innovative. Many corporate executives feel
that this also extends to company accounting policy and financial reporting. Meeting
financial targets is often an important aspect of being a successful company. If
aggressive accounting and massaging the numbers is commonplace and is an
expected practice, managers may feel these measures are necessary and legitimate.
Besides, missing the numbers may unnecessarily scare off valuable customers or drive
up financing costs, which could lead the company into a downward spiral. Corporate
executives and mangers may believe that massaging the numbers is a legitimate way to
help a company live to see another day until the business climate improves, a new
product is introduced, or until a new strategy is implemented. Corporate leaders may
believe that they are protecting investors and employees. After all, after a few bad
quarters, the stock price will likely be hit and there may be intense pressure to let
employees go – to downsize.
Influential Forces and Human Bias
Market Expectations and Executive Compensation
“Aaron Beam, a former chief financial officer at HealthSouth Corp., testified that a $2.7 billion
accounting fraud began in 1996 when company founder Richard Scrushy ordered him to “fix”
a revenue shortfall. Beam said that he and William Owens, a former finance chief who also
pleaded guilty, told Scrushy they could no longer use legitimate aggressive accounting to
meet forecasts. He said, „It‟s not an option to miss our numbers. You guys need to fix the
The financial markets have a short-term outlook and typically will punish companies
that miss quarterly earnings projections by driving down stock price and driving up the
cost of borrowing. Besides their performance being judged by the ability to meet
quarterly earnings targets, top executives are generally provided with additional
incentives to meet these targets through some type of stock-based compensation.
“We find that the probability of accounting fraud is increasing in the percent of total executive
compensation that is stock-based (termed stock-based mix) . . . For managers to undertake
fraud they must perceive positive benefits from it . . . evidence suggests that compensation
committees face a trade-off between the positive incentive effects afforded by stock-based
compensation and the negative effect of increasing the probability of accounting fraud.” (6)
The perceived positive benefits of various accounting decisions for executives must
be considered as a potentially strong influence in the decision-making process.
“Many major corporations still play things straight but a significant and growing number of
otherwise high-grade managers have come to the view that it‟s O.K. to manipulate earnings
to satisfy what they believe are Wall Street‟s desires.” Warren Buffet (9)
Top executives and directors have very strong incentives to meet quarterly earnings
targets. Some executives further create an environment where employees are
pressured to do whatever it takes to meet targets. Even employees that desire to act in
an ethical manner may begin to make small compromises, which in turn may lead to
material misstatements down the road or when combined with a number of other “small
Choice of Accounting Principles:
Many accounting decisions are subjective and therefore aggressive accounting
can be an effective tool for corporate executives to meet quarterly earnings targets.
Aggressive accounting techniques are numerous and are very often the first step down
the path of accounting fraud when, over time, legal aggressive accounting techniques
are not enough to meet earnings targets.
“Sixty percent of senior executives and managers say questionable accounting practices are either
very or somewhat common while only 8 percent say they are very rare, based on our national
“Because of the often subjective nature of accounting and the tight relationships between accounting
firms and their clients, even the most honest and meticulous of auditors can unintentionally distort
the numbers in ways that mask a company‟s true financial status, thereby misleading investors,
regulators, and sometimes management. – Annie O‟Neill, Post-Gazette (8)
Since there is latitude for judgement in selecting accounting principles, it is easy for
those responsible for producing financial statements to convince themselves that
selection of some aggressive accounting principles is ethically ok, particularly if the
outside auditors bless the numbers year after year.
Close relationship between auditors and the companies that hire them:
Auditors are hired and fired at the will of the company being audited.
Auditors often have a lot of revenue on the line with their clients, particularly with
large corporations. Auditors may not feel that they can afford to lose a large
corporate client. Further, auditors generally develop long-term relationships with
management, which will often introduce bias into their decision making.
“. . . most of the proposed reforms, including recently enacted legislation, ignore the
deeper, more pernicious problem with corporate auditing, as it‟s currently practiced – its
vulnerability to unconscious bias.”
“Three years ago, Moore, Bazeman and Loewenstein received a grant from the American
Accounting Association to study auditor independence. Their experiments found that an
auditor‟s judgement is likely to be biased and that these biases aren‟t easily corrected
because an auditor might not be fully aware of them. Auditors aren‟t evil people. Most
don‟t set out to break the law or mislead investors or the public. Indeed, their profession
already has high ethical standards. But Moore said there was ample research showing
that our desires influence the way we interpret information even when we try to be
objective and impartial. If people want to reach a certain conclusion, they usually do.
Auditing isn‟t an exact science but an art. Besides, auditors have powerful incentives to
please their clients – that is to come up with a report that supports the claims of a
“The fact that auditors work closely with corporate executives increases the chances of
biased thinking, since they will be less likely to harm those with whom they are familiar
than they would be with strangers.” (8)
For the reasons referenced above, auditors frequently operate with bias and are
therefore more likely to allow significant aggressive accounting practices that would not
otherwise be deemed appropriate in the absence of such bias.
Considering all the pressure to use aggressive accounting principles to manipulate
earnings, the question becomes: when is it ok to change accounting principles or to use
so-called “aggressive” accounting principles that may move earnings in the desired
direction? Generally Accepted Accounting Principles (GAAP) provide guidance on how
to make such decisions. While GAAP spells out appropriate accounting principles for
an extensive number of circumstances, there are still many situations (too many to
discuss in this paper!) in which management and auditor discretion is called for. GAAP
tells us that when given the choices between various options, the accountant is to select
the accounting principle that best represents the value of a transaction, asset, expense,
or financial condition of the company. For example, when an accountant is faced with
the decision of whether to capitalize or expense an item he/she should honestly
consider the nature of the item and its useful life rather than capitalizing everything that
they can get away with in order to boost short-term profits.
If the accountant is putting together financial statements and the auditors
examining them acted with integrity, were objective, and were unbiased there would be
no problem with financial misstatements outside of honest errors. Leaving intentional
fraud aside, even otherwise honest accountants and auditors are subject to bias that
can result in the use of accounting principles that may be inappropriate. Several of
such decisions can lead to a material misstatement or be the first step leading to fraud.
Corporate Audit Committees
While corporate employees, executive officers, and even outside auditors have
been subject to liability for faulty financial statements, audit committee members have
gone largely untouched. Corporate audit committees are charged with ensuring that
company managers are reporting financial results honestly and with integrity. Audit
committees are also to ensure that outside auditors act with independence and are
provided the resources and cooperation needed to conduct a comprehensive and
objective audit of the financial statements of the corporation.
“A report issued by the National Commission of Fraudulent Financial Reporting in 1987 recognized
that a key factor in reducing the incidence of fraudulent financial reporting was the establishment of
an informed, vigilant, and effective audit committee to oversee the company‟s financial reporting
Unfortunately, audit committees frequently do not live up to their responsibility.
Many members do not have a financial or accounting background and do not even have
the ability to read and understand basic financial statements. Few audit committee
members put in the time necessary to accomplish the task set before them. Many audit
committees spend only a few days per year to fulfill their duties. Meanwhile, in case
after case of accounting fraud, audit committee members have escaped any liability for
reporting failures and frauds.
Due to the complexity of financial transactions and the fact that no two situations
are every exactly the same, there will always be subjectivity and the need for human
judgement when putting together financial statements and making financial decisions.
There is no simple answer to financial fraud or accounting misstatements. Regulations,
laws, policies, and procedures cannot completely compensate for human greed and
bias. Understanding what influences decision-makers and understanding the biases
that they operate under is important to consider when dealing with questions of what is
appropriate and what is not.
1. What are some important things for company executives and mangers to keep in
mind when making accounting / financial decisions?
2. Is “some” aggressive accounting OK? How should those decisions be made?
Where should the line be drawn?
3. Is recent Sarbanes Oxley legislation an important part of the solution to accounting
4. Is the Board of Directors / Audit Committee responsible for corporate financials and
executive accounting decisions? If so, to what extent?
5. How should corporations balance the sometimes conflicting interests of various
stakeholders including shareholders, employees, community/society, the
environment, and debt-holders?
6. How do company employees decide if what they are asked to do (accounting
entries) by managers is OK?
7. What should employees and managers do if they feel their company’s financials are
misleading or if they are asked to do something that they feel may not be right?
8. Should outside auditors be rotated? – i.e. should the employees within an auditing
firm or the auditing firm itself be changed every few years?
9. Should executive compensation programs be geared toward goals other than short-
term net income? What are some better/other goals to use?
10. How much are individual and institutional investors to blame for accounting fraud?