The Quality of Financial Statements: Perspectives from the Recent Stock Market Bubble

SYNOPSIS: During the recent stock market bubble, the traditional financial reporting model was assailed as a backward-looking system, out of date in the Information Age. With the bursting of the bubble, the quality of financial reporting is again under scrutiny, but now for not adhering to traditional principles of sound earnings measurement and asset and liability recognition. This paper is a retrospective on the quality of financial reporting during the 1990s. Did reporting under U.S. GAAP perform well during the bubble, or was its quality suspect? My premise is that financial reporting should serve as an anchor during bubbles, to check speculative beliefs. With a focus on the shareholder as customer, the paper asks whether shareholders were well served or whether financial reporting helped to pyramid earnings and stock prices. The scorecard is mixed. A number of quality features of accounting are identified. Inevitable imperfections due to measurement difficulties are recognized, as a quality warning to an alysts and investors. A number of failures of GAAP and financial disclosures are identified that, if not recognized, can promote momentum investing and stock market bubbles. INTRODUCTION Concerns about the quality of accounting intensify as economies turn down, companies founder, and investors lose. With the bursting of the recent stock market bubble, the quality of accounting is again under scrutiny. This essay questions the quality of financial reporting against the backdrop of the stock market bubble. Bubbles work like a pyramiding chain letter. Speculative beliefs feed rising stock prices that beget even higher prices, spurred on by further speculation. Momentum investing displaces fundamental investing. One role of accounting is to interrupt the chain letter, to challenge speculative beliefs, and so anchor investors on fundamentals. Poor accounting feeds speculative beliefs. Warren Buffett recognized the dot-corn boom of the late 1990s as a chain letter, with investment bankers the "eager postmen." (1) He might well have added their assistants, the analysts, many of whom shamelessly disregarded fundamentals. (2) But was accounting also to blame? GAAP accounting certainly came in for criticism during the bubble. Commentators argued that the traditional financial reporting model, developed during the Industrial Age, is no longer relevant in the Information Age. Is this bubble froth or something to be taken seriously? In their statement responding to the Enron-Andersen debacle, the Big 5 accounting firms blamed "backward-looking financial statements." (3) Is this an insight or a self-serving defense? Consider the view, common among new-technology analysts during the bubble, that "earnings no longer matter." Untested metrics like clicks and page views became the substance of "value reporting" for the Information Age. Price-earnings ratios over 50 were viewed as acceptable, with the implicit criticism that earnings are deficient. These views are less compelling in retrospect. We now understand that the losses reported by dot-corns were a good predictor of outcomes. The statement that earnings do not matter was bubble froth. The high P/E ratios of the 1990s are now seen as more to do with the quality of prices rather than the quality of earnings. Joe Berardino, chief executive of Enron's auditor, Arthur Andersen, claimed (in a "wake-up call") that "Enron's collapse, like the dot-corn meltdown, is a reminder that our financial reporting model is out of date." (4) Others might argue that accounting served us well during the dot-corn meltdown. But accounting was an issue in the Enron affair. What is a balanced view? My commentary provides a way of thinking about accounting quality, and then applies that thinking to prepare a list of good and bad features of financial statements. I identify not only poor features of GAAP, but also, in response to the criticisms during the bubble, point out quality features of the traditional model. …