Accounting Rules and Accounting Fraud: Blood Brothers?

Dec 3, 2008

Financial Executive magazine arrived today with “Fraud’s House of Cards: Has Complexity Created an Unmanageable Situation?” by Lynn Brewer, an Enron whistleblower and founder of The Integrity Institute, as the cover story. Ironically (so say I), there’s also an interview with Charles Niemeier, a member of the Public Company Accounting Oversight Board, entitled “Can More. . . or Less Regulation Fix What’s Wrong?”

In “Fraud’s House of Cards,” Ms. Brewer suggests that the very complexity of business today sows the seeds for fraudulent behavior. (She even starts with a very cool quote from Albert Einstein!) Among other problems, it becomes harder for the internal and external people who would normally play watchdog roles to sniff out the behavior.

In the other article, Niemeier’s main focus is on the current hot debate (OK, OK, it’s “hot” by CPA standards) about whether U.S. public companies should move from Generally Accepted Accounting Principles (GAAP) to the emerging International Financial Reporting Standards (IFRS). The main difference is that GAAP is “rules-based” and IFRS is “principles-based.” Niemeier is against the move to IFRS, arguing that GAAP gives American companies’ financial statements more integrity, and that the right approach is to fix what’s broken with GAAP rather than throw the whole thing out. [FYI, I don’t agree – see my post of 10/23/08 on this subject, plus more to come.]

Why do I say that it’s “ironic” that articles about accounting fraud and accounting rules would appear together? Because each creates a market for the other!

Huh? Well, accounting fraud – Enron, MCI Worldcom, flaky revenue recognition practices, etc. – creates the need to tighten up on the accounting rules, at least in the minds of many. These folks figure that tweaking the existing rules, or adding a “clarification” here and there, will close up the loopholes. The result is a set of GAAP documents that currently runs to about 25,000 pages. I am not making this up.

Does it go the other way? YES! First of all, labyrinthine accounting rules are one of the complexities that Ms. Brewer suggests are making fraud hard to spot. Even worse, rules-based approaches create a culture that breeds fraud. When rules get so complicated that it takes enormous effort just to ensure compliance, the issue of whether the financials are presenting an honest picture of the enterprise gets lost in the shuffle.

Until we acknowledge and understand this dynamic, the arms race will continue.

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

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