Magic Tricks on the Corporate Books

With the stroke of a pen, companies can make themselves appear more financially fit than they are

By Mara Der Hovanesian

Accounting shenanigans bubble to the surface every few years. In the dot-com days the trick was to book virtual revenues. After the tech bust, tinkering with expenses was all the rage. Now forensic auditors and analysts worry that troubled companies are playing fast and loose with asset valuations and cash management.

These recent numbers games, which rely on some familiar techniques, may be the most troublesome yet. Companies that employ aggressive accounting tactics aren't just inflating earnings and cash flow—their motive may also be to hide a true financial picture from lenders to avoid losing credit and other lifelines. "It's not like a penny of earnings-per-share problem," says Mark LaMonte, chief credit officer at ratings agency Moody's Investors Service (MCO). "These things will knock you off the cliff completely." And the gimmicks only underscore the tenuous nature of the earnings recovery, which currently is lifting investors' spirits.

New discretionary accounting rules have made it easier for companies to engage in such behavior. In recent years companies have moved to "fair value" accounting, in which assets are based on current market conditions rather than on historical prices. With many markets like real estate drying up and buyers fleeing, the exercise isn't an exact science. "When it comes to valuation, what one person thinks can be completely different from the next," says John P. Glynn, a partner at PricewaterhouseCoopers who heads the firm's valuation practice. The fear is that companies may be relying on inflated estimates for all sorts of assets, including contracts, commodities, and real estate. If so, some nasty surprises for investors and lenders may be lurking on the books.

Delaying Writedowns?

Consider the accounting for boom-time acquisitions. When a company purchases another business, it books any premium paid as an asset called goodwill. Amid the bust, many deals have eroded in value. But corporate accountants, who have a lot of leeway under the accounting rules, may be delaying writedowns until the last possible moment. When they recognize the acquisition-related loss, the hit could be substantial. "We won't see the problem until it's clearly worse than expected," says Richard G. Sloan, a professor at University of California at Berkeley Haas School of Business.

That's just the kind of situation investors in Huron Consulting Group (HURN) could face. The firm, launched by former consultants of the defunct Arthur Andersen Group, snapped up several companies after going public in 2004. Huron's related goodwill: $506.5 million, according to research firm Audit Integrity. But the researchers figure goodwill shouldn't be that high, and estimate Huron has inflated its earnings over the years by $56 million.

The company already restated three years of earnings for compensation issues related to those acquisitions, revising profits during the period from $120 million to $63 million on July 31. The Securities & Exchange Commission is investigating the restatement, according to the company's Aug. 19 earnings conference. Huron says it's cooperating.

To ferret out potential problems, accountants look for companies whose goodwill assets amount to 20% or more of total assets. That's a sign that goodwill is making up an increasingly large portion of the balance sheet—and profits may get whacked later. Goodwill represents more than 65% of Huron's assets. In January, Gannett (GCI) announced a $7.46 billion writedown on goodwill, which at the time represented 45% of assets.

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