Arnold Kling

Accounting Scandals

Arnold Kling, Great Questions of Economics
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Accounting scandals, called "earnings restatements," have been in the news lately. For example, took a hit, and the CEO resigned. This was not the first time their accounting had been called into question--see this piece in the defunct Industry Standard.

(If you peruse my personal web page, you will see that I developed a web site that competed with and then was bought by Homestore. However, I no longer own any shares in the company.)

Also this week, the Washington Post ran a four-day front-page retrospective on the rise and fall of Microstrategy. Its stock bubble was popped by an accounting scandal in March of 2000, one of the turning points in the Internet boom.

Then of course, there is Paul Krugman's favorite whipping-boy, Enron. Is this the start of an epidemic of accounting fiascos?

Here is a dire warning about accounting:

In short, there is not a company anywhere whose income statement and profits cannot be changed, by the management and accountants, by counting things one way instead of another.

That quote comes from The Money Game, the 1967 best-seller by "Adam Smith."

As the 35-year-old passage shows, there has always been a reason to worry about accounting. So far, though, we have managed to muddle through with only a few isolated scandals.

I am less concerned about accounting than I am about the expectations that investors have for corporate earnings growth. Everyone thinks that the companies in which they are investing are going to have double-digit earnings growth for many years, even though in the aggregate the economy is not going to grow at 10 percent per year. Something has to give...

Discussion Question: Do you think that company managers and their accountants have more incentive to report earnings honestly or to report dishonestly?

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