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by Skeptical in Skokie | May 24, 2012

Subject :Business Ethics

Dear Toolkit,

In light of the recent collapse of several major financial institutions, should we believe anything any accountant says from now on?


Skeptical in Skokie

Dear Skeptical,

My fellow Illinoisan, Abe Lincoln, was fond of posing this riddle: How many legs does a dog have if you call his tail a leg? His answer was four. He observed that calling a tail a leg doesn't make it a leg! We, the consumers of accounting data, need to keep this type of critical thinking in mind when reading annual reports, audited financial statements, or even our own bookkeeper's (or dare I say spouse's) monthly scribblings.

Being a lifelong bean-counter myself, I may be a bit biased, but I think the accounting profession is getting more of a bad rap lately than it perhaps deserves. A few bad apples shouldn't discourage us from keeping the faith with the vast majority of professionals who have always acted in the public interest as a matter of tradition and pride.

Furthermore, it seems to me that we should all take some responsibility for being too easily duped, much and often, on a host of issues including, but certainly not limited to, financial reports.

Cooking the books to pacify or please investors and/or lenders is an age-old practice generally perpetrated by business owners or managers, not accountants. Booking revenue you hope or expect to receive soon, or deferring reporting expenses already incurred (or doing the reverse of one or both) is the first part of the recipe. Misstating inventories, failing to disclose contingent liabilities such as possible lawsuits or questionable insurance claims, and a host of other practices are often employed to get a firm over a rough patch. . .with every good intention of amending the books at a later point in time.

In a small business, this is a dangerous exercise in self-deception. In a large business, this would be appropriately known as fraud.

The problem with this kind of wishful-thinking-accounting is compounded when the professional accountant comes along and quite rightly questions the incorrect statements and the owner/manager presents a forceful and convincing argument for allowing the misdirection to remain. Since the accountant would seem to be employed by the owner/manager and the competition for clients is fierce, one can see how these problems and conflicts of interest persist.

In the olden golden days when I was cooking the books for a conglomeration of small businesses, I was required to report to an accounting firm that shall remain unnamed. In those pre-computer days, the rules were so strict and inflexible that I can recall instances where I was called on the carpet by the auditors for such trivia as using the wrong colored pen in my workpapers or, God forbid, using a lead pencil! If detailed documentation for every journal entry wasn't present, the entry was obliterated and I was chastised for unforgivable imprecision. Audit rules were strictly observed or the accounting firm would refuse to certify the audit, a threat that always kept clients on the straight and narrow path.

Times have changed and accounting has become so much more complex due to technology, government regulation, global commerce and the sheer speed and volume of transactions taking place 24/7 in most businesses. The role of the accountant in the culture also has changed. These factors require that we, you and I, the consumers of this critical product, use our own brains, experience, and plain old-fashioned common sense when interpreting the results of an accountant's work.

Take an earlier example of accountants not staying on top of things. Had the Wall Street analysts done a little more independent thinking and analysis, Enron might not have crashed and burned. Well, you say, if those guys couldn't figure out that Enron's statements were phony, how can Joe Schmoe be expected to do it for himself? Fear not, there are some tools out there to help you separate tails from legs.

One of the best and most entertaining is Howard Schilt's latest edition of his classic book, Financial Shenanigans — How to Detect Accounting Gimmicks and Fraud in Financial Reports (McGraw Hill). Professor Schilt, a respected accounting teacher, author and researcher, testified before the SEC on this very subject, ironically just before the Enron collapse came to light.

Don't be afraid to dig into reports that might appear to be perfection personified just because they're printed in four dazzling colors on expensive parchment. In financial statements as in life, appearances often differ from reality. If you think you see a five-legged dog, persevere and be an ad hoc independent auditor.