In years past, it was the hallmark of good management to return steady, stable earnings to shareholders. Give shareholders predictable growth, and they will reward you with high multiples on your stock. Conservatism in a company’s accounting decisions was generally viewed positively. For example, a bank with substantial credit loss reserves was well regarded by investors, regulators, and the public. That view has changed in recent years, however, as regulators and those who set accounting standards expect neutrality with consequent earnings volatility, not conservatism.

By the mid 1990s, the wheels seemed to be coming off the financial reporting wagon for more and more companies. Restatements by publicly traded companies increased significantly—by more than 350 companies between 1997 and 2000. And restatements were not limited to microcaps new to the public securities markets. Furthermore, shareholder lawsuits grew 750% in that same period.

Beginning in 1998, Securities and Exchange Commission (SEC) chairman Arthur Levitt and his staff raised increasingly strident warning flags about “earnings management”—the inappropriate manipulation of reported accounting through a variety of devices. The SEC responded to increasingly lax financial reporting by creating more stringent auditor independence rules, creating a fraud task force within its enforcement division, and taking high profile actions against individual companies.

Mr. Levitt proved to be especially prescient. The spectacular failures of Worldcom and Enron in 2002 heightened public awareness of corrupt financial reporting and its consequences. The fallout of these collapses were passage of Sarbanes-Oxley, which substantially increased the exposure of companies with weak internal controls, and creation of the Public Company Accounting Oversight Board (PCAOB) whose mission is to strengthen regulation of the accounting profession. What will result from recent revelations that AIG and some other insurance companies offer policyholders protection for inconvenient accounting results? That remains to be seen.

The stunning reversals of companies that were once darlings of Wall Street have cast a pall over virtually all companies. The company that increases reserves during good times is accused of building a “rainy day” fund—managing earnings—and tarred with the same brush as aggressive companies that shipped software that was likely to be returned, yet booked a sale nevertheless. Banks that had touted their financial strength in terms of reserves were forced by the SEC to reduce allowances to better reflect today’s credit loss exposure.

In the old days, for an accounting standard that said “no,” an auditor might have passed on a “not quite” judgment call, but would have insisted that a “not even close” be changed. In today’s environment, the “not quite” judgments earn the response, “What part of the word no don’t you understand?” This would be evident to any reader of the reports on its special investigations of Fannie and Freddie published by the Office of Federal Housing Enterprise Oversight (OFHEO).

Take, for example, Fannie’s woes with the shortcut method of hedge accounting for derivatives. The Financial Accounting Standards Board (FASB) designed the shortcut method for the “casual hedger.” If a company could align the critical terms of a hedge with the hedged item, it would avoid the baggage of SFAS 133 effectiveness testing. FASB wrote that terms had to match; close was not good enough.

A second example is measuring loan yield under SFAS 91. The standard is straightforward. It’s a simple problem of solving for the present value of future cash flows, dependent on the interest rate. Therein lies the rub.

According to OFHEO’s report, Fannie had a convoluted process of meeting three-year-plan amortization, relying on periodic catch-up adjustments for prepayments. Fannie defended its position that interest rates are not predictable and used materiality relative to annual income as a guide of how much of an adjustment to take.

Freddie, on the other hand, used a much more straightforward method. It simply booked a favorable tax change as an SFAS 91 reserve rather than in income. Management then changed the reserve to offset SFAS 91 yield adjustments. The report discusses at length the GAAP prohibition on general contingency reserves. The embarrassing conclusion is that Freddie fell into using the “cookie jar” reserves that have been an SEC hot button for years—and that were explicitly mentioned by Chairman Levitt in his 1998 speech.

A common theme to both reports is that the accounting departments are overworked, overwhelmed, and over their heads in accounting technicalities, particularly those applying to derivatives accounting. OFHEO dishes out a large serving of criticism to management of both companies for starving the accounting function of resources at a time when the complexity of accounting for financial instruments is increasing exponentially. Lastly, the boards of directors and audit departments of both GSEs are not unscathed in the reports.

So in the current environment for financial reporting, how can a company protect itself? First, management, accountants, and board members should read the SEC’s public statements about integrity in financial reporting. These are readily available on the SEC’s Web site. Further, Arthur Levitt’s speech, the “Numbers Game” provides a roadmap of the enforcement actions that have been taken over the past six years. Some might argue that these are the views of the previous administration, but the agency’s actions have been consistent with those words. Banking regulators have fought the SEC on accounting for credit losses, but have reached an accommodation on requiring banks to document their decisions on how they develop a reserve. Safety and soundness examiners have been coming around to the SEC’s view on transparency of financial performance. There is also convergence on reporting on the quality of internal controls.

In conclusion, there may be a “but for the grace of God” element to the travails of Freddie and Fannie. But, it’s not too late to make a critical self-assessment before that next examination.

Join me for my presentation, FAS Times in the Banking Industry, at the Seattle Bank's 2005 Management Conference to learn more negotiationg your way through today's complicated accounting rules and standards.

Gregory Eller, C.P.A., C.F.A., is accounting policy manager and the Federal Home Loan Bank of Seattle.

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