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May 9, 2002 On the right side of the ledger, wise to the tricks of the trade



Michel Magnan

Professor Michel Magnan

Photo by Andrew Dobrowolskyj

by Sylvain Comeau

Accountancy seems to be shaking off its boring, staid image — and that is not exactly a good thing.

“The traditional reputation of accountants is that we are boring, which also means reliable, with no surprises,” said Professor Michel Magnan in an interview. “Accountants are not supposed to provide surprises. Recent events like the Enron scandal have compromised that view, and I’m not sure that it’s an asset if people don’t see us as boring any more.”

Magnan, who holds the Lawrence Bloomberg Chair in Accountancy, studies issues of ethics in accounting, particularly “creative accounting,” a term much used in the wake of Enron and similar scandals.

“I am looking at how accountants use ethics to make decisions, and also at what we call ‘earnings management,’ which is using financial statements to deceive investors, or to gain some other advantage.”

In one study he conducted, Magnan looked at anti-dumping lawsuits in which Canadian companies in textiles or steel asked the government to impose tariffs on foreign imports on the pretext that dumping of imports is hurting their business. “I looked at whether they manipulate their earnings in their financial statements in order to get an advantage with the government. I found that they under-report their earnings for a while to show that they have been hurt by imports.”

In other cases, the manipulation of financial statements can take the form of overstating earnings to artificially boost the price of their stock.

“They can get some financing from investors by showing their earnings in the best possible light. This is a recurring practice in North American companies, but it is hard to say whether it is more common today than before.”

Magnan says that creative accounting is “being aggressive in your financial reporting,” including only selected items on your balance sheet.

“In most instances, it means booking revenues before they are actually earned, or pushing back expenses off the balance sheet even if they have already been incurred, so it is usually used to increase reported earnings in the short run.” He added that the recent bull market in stocks put increased pressure on executives to artificially inflate earnings.

“Executives are under pressure to meet the earnings targets of financial analysts; otherwise, their stock can go down tremendously. At the same time, stock options for executives gave them an incentive to boost stock prices any way they could, to line their own pockets.”

Magnan believes that the increasing complexity of business and business deals makes it easier to engage in financial manipulation.

“As businesses enter into complicated transactions, accounting for these transactions will also be complicated. This leaves more room for earnings management.”

That kind of manipulation may not always be accomplished with the complicity of accounting firms hired to audit financial statements.

“There are a few factors coming into play. First, the auditor may not fully understand what a company is doing. And even if they have the full set of competencies, it would be easy to miss some parts of the transactions. Finally, there may be complicity on the part of the individual auditor, the one who actually does the work. What are his or her interests? They may become aligned more closely with those of the client than to those of the auditing firm.”

Thus, individual auditors may risk the firm’s reputation to please a client, because retaining that client is much more important to their careers than to a firm’s bottom line. Magnan points out that Enron accounted for only 0.5 per cent of Arthur Andersen’s annual earnings, while the fallout from the Enron collapse was a disaster for the accounting giant.

“For the [Andersen auditors] in Houston, Enron was their client. So they may be more willing to compromise their principles to keep that client. To counter this, a firm needs a very strong ethical culture and very good internal control mechanisms to make sure that any auditor inclined to cut corners will get caught before he can do any more damage.

“If they don’t do that, they can be guilty by omission, because they failed to take all the necessary precautions.”

In theory, the sheer size of accounting giants like Andersen “should make them independent from their large clients, but their size can make it hard to implement effective internal controls.”
Magnan compares the accounting profession to “a house of cards, because one assumption is built upon another.

“If people stop believing the assumptions that accountants make, the whole structure collapses. Trust is the foundation of our profession.”

That implicit trust now is under attack, especially when public corporations have to restate their earnings long after an auditor put its stamp of approval on the original earnings report.

“Creative accounting is undermining the credibility of accountants, and the assumptions they make. That devalues the work that we do.”

Magnan recently published his research in the Journal of Accounting and Public Policy, the Journal of Management Inquiry, and Gestion, a Quebec journal.