Changing accounting grays to black and white. (Advertising Supplement: Corporate Expansion & Relocation).

In the aftermath of Enron, WorldGom, Adelphia and others, public confidence in the quality of financial reporting has been shaken. Between the black and white of time-honored accounting principles, unscrupulous corporate executives and accountants have found gray areas to hide unethical activities. It's not that the rules for auditor independence, accountability and full disclosure to the public do not exist. The problem is that they have not been adhered to. Accounting practices must get back to basics. Restoring public confidence in financial reporting begins with a black-and-white rather than gray interpretation of the principles of accounting ethics.

Numbers Without Substance

Corporate accounting methods go awry when the economic reality of the company's financial affairs does not support the accounting result the company needs to sustain the growth of its stock's value. The company starts cutting corners, becomes too aggressive in its accounting practices and fails to ask whether its accounting method has actual economic substance. In a desire to show a constant stream of profits, the company selects an accounting method based on its short-term impact on the bottom line rather than the long-term economic reality of the business' financial results. Similarly, non-publicly-held companies select a method that helps them meet financing covenants instead of striving for the ideal of matching revenue with expenses over the long haul. In either case, the method inaccurately reflects the company's economic viability or sustainability in the marketplace.

Among the most popularly abused accounting methods are:

* Accelerating revenue recognition. Regardless of how explicitly the rules of accounting are stated, there is always room for judgment. The recording of revenues in advance of the completion of the earnings process has received heavy scrutiny in recent days, resulting in substantial restatements of revenues.

* Deferment of expense recognition through aggressive capitalization of intangibles or long-lived assets. Tangible or intangible assets recorded on the balance sheet may lack real future economic benefit.

* Off-balance-sheet financing. Enron, for example, hid potential losses or liabilities by transferring them to separate "special purpose entities" that lacked economic substance or were considered shams. For instance, a bank loan was disguised as a sale, which resulted in a gain being recognized in advance of a subsequent sale.

* Stock compensation. Stock options have become a common substitute for cash wages.

Millions of dollars in expenses have not been reflected currently on corporate profit and loss statements. The practice of any one or more of these abuses will make companies appear more profitable in the short term than they actually are.

Restoring Credibility

Increased visibility and public scorn of the most conspicuous ethics violations are not enough. With only a slap on the wrist, unethical corporate executives escape relatively unharmed and substantially enriched while the American public loses billions of retirement and investment dollars. To restore credibility in financial reporting, it's important to adopt these key principles:

* Return to the practice of CPA independence in both fact and appearance.

* Increase accountability. The new SEC requirement that obligates CFOs and CEOs to sign off on the accuracy of financial statements has already resulted in multi-million dollar changes to revenues.

* Ensure that audit committees have backbone. More than 60 years ago, publicly traded companies began using audit committees under the recommendations of SEC Accounting Series Release No. 19. ASR No. 19 proposed that publicly traded organizations appoint a committee of directors to nominate the organization's auditors and arrange the details of the audits. Audit committees oversee internal and external auditors, coordinate audits, negotiate audit fees and are responsible for overseeing the quality and acceptability of the auditor's accounting principles. The Sarbanes-Osley Act signed into law by President Bush on July 30, 2002 reinforces the mandates of audit committees. Every member must be independent and at least one member must have financial sophistication. Further, the audit committee is directly responsible for the appointment of the auditors, and the auditors report to the audit committee. No longer puppets of management, future audit committees will have the backbone to stop abusive financial reporti ng practices. They must review all cash journal entries with the auditor, as well as scrutinize choices in revenue recognition and expense deferment.

* Increase the degree of severity of the punishment of lying to an auditor. Let the punishment fit the crime!

* Develop a healthy, but not cynical degree of skepticism. Executives and audit committees must ask questions of both internal accounting departments and external auditors on an ongoing basis. They need to continuously evaluate the relationship throughout the year, not only at year's end when the audit is complete. As their businesses move in a new direction, they must understand the financial ramifications.

Back to Basics

The trouble began with the dot-coins and technology companies whose claim to fame was changing the metrics of American business. Although they lacked a formula for ultimate success, their questionable practices and unsubstantiated claims became a model for others. When a banker recently tested Enron's financial statements by running them through a program that evaluates companies' liquidity and leverage, the company clearly failed. According to the program, a company with Enron's financial statements could not exist The tools to recognize that the emperor had no clothes were there all along. The restoration of confidence in American business and accounting practices begins with the application of common sense business principles, healthy skepticism and traditional models of success.

Nanette Lee Miller, CPA is Vice President/Shareholder in Stonefield Josephson's San Francisco Office. Sam Wild, CPA, is a Vice President/Shareholder in Stone field Josephson's Santa Monica office. Stonefield Josephson is a regional California CPA firm.