(Some excellent material and suggestions from BusinessWeek, Feb. 18, 2002. The marketplace has already begun to punish those with shady accounting, but we also need stronger corporate leadership, and above all the standardization and strict enforcement of accounting rules - the SEC and its organs must crack down on the lies, tricks and deceptions in, and off, the balance sheets. What we do NOT need is self serving grandstanding and interference from political leaders who pocketed millions themselve from the likes of Enron.)

A Cleanup Job for Corporate America

Investors aren't waiting for the Securities & Exchange Commission or the accounting profession to clean up Corporate America's books. Post-Enron Corp. (ENRNQ ), they're taking action themselves. A huge cleansing is under way in the stock and bond markets as individuals and institutional money managers turn away from companies perceived to have flawed or opaque financial statements. Tyco International Ltd. (TYC ) is but one of many companies whose paper is being dumped for its accounting sins. The good news is that, under investor pressure, dozens of corporations are now scrambling to restate their earnings and make their balance sheets more transparent. The bad news is that the investor revolt could turn into a stock market rout and the growing strains on credit could produce a serious banking crisis. Policymakers and regulators would be wise to move quickly to fix what is a corrupted corporate reporting system. There is more at stake than the economic recovery. The integrity of American capitalism is at issue.

The financial markets are already showing deep strain. Corporate bonds are starting to suffer mightily as companies with questionable accounting throw a shadow over the entire bond market. Investors don't know which company will be hit next--or how hard. The commercial paper market is getting pummeled as well. When the Standard & Poor's rating agency cut Tyco by three notches in one fell swoop, it effectively shut the company out of the commercial paper market. Tyco then had to draw on its $8 billion backup bank lines of credit. If dozens of companies are forced to follow, banks may soon face a liquidity crisis of their own. That increases the chances of a double-dip downturn.

What should be done? The Federal Reserve, of course, should be monitoring the markets to make sure there's enough liquidity to keep them open and steady. There is every indication that it is doing its job. But not so the SEC or the auditors. It's critical for investors to regain confidence in the markets and believe that they have the tools to evaluate risk and value companies fairly. Those companies that are moving back toward more conservative accounting are heading in the right direction. But a new set of common standards for all companies is absolutely necessary and must include better uniform measures of true financial health: unencumbered cash flow or true operating earnings would get us closer to this goal. The SEC and the accounting profession must face up to their responsibilities and act forcefully.

So, too, must Corporate America. The silence of CEOs throughout the slow death of Enron is hurting the reputation of Big Business at home and abroad. With Enron, we have seen self-dealing, the breaking of corporate codes of conduct, the buying off of professional watchdogs, the destruction of pension savings, and widespread political corruption. Congress is investigating, the President is castigating, accounting firms are changing, but CEOs are not talking. Chief executives who are usually not shy about speaking out on taxes, health care, China, or a host of other issues are mum on Enron. The Business Round Table has issued a statement basically saying it was studying the matter. The U.S. Chamber of Commerce and the National Association of Manufacturers have spoken mostly to defend (401)k pension plans in the face of Congressional efforts to reform them. Where is the CEO criticism of Enron managers making tens of millions of dollars in inside, self-dealing partnerships while employees and shareholders are left stranded?

America needs its chief executives to speak out and help restore credibility to the nation's business culture. Who will be the first?

What the SEC, FASB, and the auditors need to do

Bring hidden liabilities back onto the balance sheet

It was the disclosure of billions in off-balance-sheet debt tucked away in "special purpose entities" (SPEs) that first brought Enron's problems to the fore. It now looks as if many of Enron's hundred-odd SPEs, entities created to hide potential losses or debt from public view, were not handled properly. But even the use of legitimate SPEs has been a source of debate for close to 30 years. The Financial Accounting Standards Board hopes they will finally have rules in place by the end of the year, but today the group remains conflicted about how to solve the thorny issues SPEs bring up. "I can describe SPEs that definitely should be consolidated" onto their sponsor's balance sheet, says Tim Lucas, FASB's director of research. "And I can describe SPEs that definitely should not. The problem is, I don't often see either. Most often, they're in the gray area."

Guiding accountants through that gray area isn't easy. But clearly the current rules--which allow companies to remove SPEs from their balance sheets if they can find an investor willing to kick in just 3% of an SPE's capital--are not acceptable to investors. Upping that to a higher fixed percentage, however, is not the best answer, argues New York University accounting professor Baruch Lev. To Lev, the solution is to focus on the "essence of the economics of the contract as opposed to specific rules, which seem objective but are really incredibly easy to manipulate." In other words, instead of complying with the letter of the law, he wants auditors to delve deeper into these deals and dig out their true ramifications. Who really controls the SPE? Could the liabilities come back to the company attempting to get them off the books? If so, they should be consolidated--no matter how much outsiders own.

Highlight the things that matter

Recent pronouncements by the SEC and FASB have attempted to clarify which events and data are important enough to be considered "material." This was another area where simple convention provided too much wiggle room: Anything less than 5% or 10% of earnings or assets was generally considered "immaterial" to overall performance and thus could be left out of the statements. But recently, the SEC made it clear that the issue must be addressed "qualitatively as well as quantitatively," says Bear, Stearns & Co. accounting expert Pat McConnell.

Yet on Feb. 4, many were amazed by revelations that industrial conglomerate Tyco had made hundreds of acquisitions totaling $8 billion over the past three years. Because each purchase was quite small, its impact was considered immaterial. Tyco did disclose the aggregate spent on the deals but did not detail them. "Any one acquisition, if you looked at it in isolation, might not be material, but what you need to look at is the entire course of action," says Lehman Brothers Inc. accounting guru Robert Willens. Auditors should demand that companies report even the smallest transaction if it is important.

List the risks and assumptions built into the numbers

This is something SEC Chairman Pitt has been hot to do. Pitt wants disclosure of the "three, four, or five" critical accounting principles at every company. Although they may involve ambiguity and judgment, the principles are vital to a company's financial status. So far, Pitt hasn't provided much detail on how businesses would accomplish this goal. As the Enron scandal showed, corporate guesstimates can play a big part in corporate earnings: Managers there estimated what the future demand for their products would be and derived current earnings based on those guesses. This is one step beyond "mark to market" accounting, whereby financial instruments are valued based on current worth. David F. Hawkins, a Harvard Business School professor and Merrill Lynch & Co. accounting consultant, calls it "mark to model" and says it's "a big black box for investors right now." He would like to see more information about the assumptions inherent in these calculations in a footnote to the financials.

Standardize operating income

The mushrooming of so-called pro forma operating earnings, calculated according to each company's whim, was an issue even before Enron's collapse. To get more uniformity, Standard & Poor's has put out a proposal for what should be included and excluded in these operating-earnings calculations. Last fall, FASB put the topic on its agenda, although very little progress has been made to date. Setting up a universal formula is just the first step, though. Companies also must provide enough detail to show what they added and subtracted from GAAP net income to get to their pro formas.

Provide aid in figuring free-cash flow

To many investors, this is the real bottom line. How much cash, net of interest, and other obligations will a company generate in the future? Today, analysts make this calculation themselves, largely by extrapolating from past results. But some are now calling for additional information to make the calculation easier. "The real question is, how do you predict the future, and who's best able to do that?" says Ed Nusbaum, CEO of accounting firm Grant Thornton LLP. Companies currently are reticent to provide too much information about the future for fear of being sued, Nusbaum says, but investors are calling for more such data in the section of the annual report entitled "management discussion and analysis."

What investors want from financial statements is a clear picture of corporate performance. Instead, they are often left to guess at information that companies should readily provide.