WAG THE DOG ACCOUNTING
ACCOUNTING ENGINEERING CREATES VANISHING VALUE
What others have said
Proper accounting is like engineering. You need a margin of safety. Thank God we don’t design bridges and airplanes the way we do accounting. — Charlie Munger
Almost all decisions based on cost accounting are utterly wrong. — Eliyahu Goldratt
Balanced budget requirements seem more likely to produce accounting ingenuity than genuinely balanced budgets. — Thomas Sowell
Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings. — Diane Garnick
I'm a good learner. I can dig in. I knew nothing about mark-to-market accounting when I started the 'Enron' film. — Alex Gibney
Accounting rules give financial institutions flexibility about when they choose to recognize venture capital profits. — Alex Berenson
I never thought anything like that would have gone on. — Bernard Ebbers, Former WorldCom CEO
There are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues. — Kenneth Lay, Former Enron CEO
Mark-to-market accounting is like crack. Don’t do it. — Andrew Fastow, Former Enron CFO
Accounting is a hot domain with the number of accounting majors up nationwide. I think the recent scandals have brought a new level of attention to the accounting profession as gatekeepers and custodians of social interest. — Paul Browne1
About
As many of you may know, after 17 non-stop years of university teaching, I embarked on a teaching sabbatical a year ago. Although the sabbatical was not completely voluntary—the university and I had a significant disagreement about the necessity of an online professor, who had already survived COVID, taking the COVID vaccine—it was a welcomed time away from the classroom.
Recently, I joined the Forbes School of Business and Technology at The University Of Arizona Global Campus as an associate faculty member initially assigned to teach undergraduate and graduate accounting courses. Getting back into the teaching “trenches” reminded me how important ethical intelligence and ethics are within the accounting profession. Without ethically intelligent and ethical accountants, we get Wag the dog accounting!
Wag the dog accounting
The term "wag the dog" came into popular usage with the movie of the same name.
The expression comes from the saying that 'a dog is smarter than its tail', but if the tail were smarter, then the tail would 'wag the dog'. The expression 'wag the dog' was elaborately used as theme of the movie. 'Wag the Dog', a 1997 film starring Robert de Niro and Dustin Hoffman, produced and directed by Barry Levinson.
The term 'wag the dog' means to purposely divert attention from what would otherwise be of greater importance, to something else of lesser significance. By doing so, the lesser-significant event is catapulted into the limelight, drowning proper attention to what was originally the more important issue.23
I know, as you read that definition, you're wondering what this has to do with accounting. Stay with me for a few more paragraphs and you will understand. Generally, the purpose of accounting is to record and report economic activity, which normally means recording transactions. For example, I purchase a pair of shoes. The seller records that transaction as a sale (revenue), and I recorded it as a purchase (expense), which captures the economic essence of the transaction on both sets of books.
Now, assume the shoe seller borrows $1,000 from a finance company. The economic essence of that transaction is a loan that must be repaid. But, because the shoe seller is behind on revenues for the month, it records the loan as revenue. This overstates revenues [income] and profits, understates liabilities and overstates net worth, which using a much more sophisticated scheme, is one of the practices Enron was engaging in just prior to its demise.
Incidentally, for those accountants and financial types out there, I am keeping this example simple and understandable.
So, what’s going on here? What’s going on here is accounting engineering. Here is a definition of accounting engineering (also called creative accounting).
The process whereby, given the existence of gaps in the rules to manipulate accounting numbers and taking advantage of flexibility, those practices are chosen for measurement and information that allow transforming synthesis documents [the books] from what they should be in[to] what managers want.4
In our simple example, we "created" value—the increase in net worth—simply by recording a transaction in a way that gave us the desired result. Yes, sooner or later, someone will catch this, and the correct accounting will be made. In the meanwhile, the inflated value has circulated in the marketplace, and investors and, perhaps, lenders, have made decisions based on the inflated value. This is why accounting engineering creates vanishing value.
As a licensed CPA and a member of the profession, I could try and mount a defense of these practices. It would be an easy defense to mount because many economic transactions are complicated, opaque and complex. In recording these types of transactions, there are many "gray" areas where accountants exercise discernment and professional judgment. Often, the ultimate outcome of the transaction is ambiguous. So, there must be great latitude for exercising professional judgment.
When I entered the profession decades ago, accountants were governed by a broad set of accounting principles within which proper professional judgment was expected. Over the past many decades, many lapses in ethical conduct occurred, and the profession turned to a rules-based system much like the Internal Revenue Code. Proponents of this rules-based system hoped to limit the flexibility accountants had in recording transactions. Unfortunately, the rules-based system hasn't worked any better than the principles-based system it replaced.5
Holding water in your hand
Approaching solving this problem with rules, and even principles has proven a waste of time and have cost multiple billions of dollars in losses. Every time a new rule is introduced, some enterprising accountant finds a way around the rule, which leads to the creation of another rule. It’s like containing water in an open hand.
We know how this ends. Just look at the Internal Revenue Code, which is now approximately 90,000 pages long. Rules, fines and prison terms are not the answer because behavior has not changed. Since the passage of Sarbanes-Oxley, thousands of executives have been convicted of various accounting frauds including hundreds who have gone to prison.
Stalin once famously said, "Show me the man, and I'll show you the crime." I say, "Show me the books, and I'll show you the numbers [earnings, assets, net worth] you want!" As long as executives and accountants are able to make this statement, behaviors will not change. The only solution is for ethically intelligent people remaining true to the truth. If something looks like a fish acts like a fish, treat it as a fish.
Tails wagging dogs
Okay! It was more than a few paragraphs! I call accounting engineering “wag the dog accounting” because the dog is the economy, and accounting is the tail. When accountants “engineer” financial results instead of reporting financial results, economic disruptions occur because the accounting tail is wagging the economic dog. Here is an example.
Worldcom
At its zenith, Worldcom was the world’s second-largest telecom company. Unfortunately, its growth and supposed success were fueled by accounting engineering. Essentially Worldcom was recording its infrastructure maintenance costs and expenses as assets thereby increasing profits, assets and net worth. When the end came, auditors had determined that Worldcom had recorded $11 billion of expenses as assets. It is easy to see the effect this had on Worldcom’s market value. What is not so easy to see is the economic disruption these fraudulent balance sheets created.6
As Worldcom was “growing,” increasing in assets, revenues and profits, its competitors were closely watching, which spurred a real spending spree by those competitors on infrastructure. When the end came for Worldcom, many respected communications analysts asserted that a glut of telecommunications infrastructure existed because of overbuilding spurred by Worldcom’s seeming “investment” in infrastructure as reflected on its balance sheets. The Worldcom failure resulted in an estimated $35 billion drop in GDP.7
The only way to end Wag the Dog Accounting is by insisting on ethically intelligent leadership in business and hiring ethically intelligent accountants who demand ethical accounting judgments.
Next week, we continue the journey.
Remember, you cannot lie and be ethically intelligent.
Until then, Shalom!
Portions of this post were taken from my book Ethical Intelligence: The Foundation of Leadership. my doctoral dissertation Exploring Ethical Intelligence Through Ancient Wisdom And The Lived Experiences Of Senior Business Leaders
References
Unless otherwise noted, quotations are taken from A-Z Quotes, Goodreads, and Brainy Quotes.
The History of 'Wag the Dog'. (2022). Merriam-Webster Word History. https://www.merriam-webster.com/words-at-play/wag-the-dog-idiom-meaning
Cruz, J. d. l. (2021). Wag the Dog Meaning. UsingEnglish.com. https://www.usingenglish.com/reference/idioms/wag+the+dog.html
Ionica, O. (2022). Creative Accounting Affects Corporate Performance: Theoretical Fundamentals and Specific Practices. In O. Ionica (Ed.), Perspectives of Management Accounting for Sustainable Business Practices (pp. 62-76). Titu Maiorescu University. https://doi.org/DOI: 10.4018/978-1-6684-4595-2.ch004
Popescu, L.-M., & Nișulescu-Ashrafzadeh, I. (2019). Accounting Engineering and Management of Results. European Journal of Business and Management Research, 4(3). https://doi.org/10.24018/ejbmr.2019.4.3.56
George, B. (2021, August 11, 2021). Fraudulent Accounting and the Downfall of WorldCom. University of South Carolina Audit and Advisory Services. https://www.sc.edu/about/offices_and_divisions/audit_and_advisory_services/about/news/2021/worldcom_scandal.php
Graham, C., Litan, R. E., & Sukhtankar, S. (2002). Cooking the Books: The Cost to the Economy. https://www.brookings.edu/research/cooking-the-books-the-cost-to-the-economy/
October 25, 2022, Volume 2, Issue 41