What the Accountants Should Have Done and Didn't

Dot-coms were desperate for sales to sustain their high valuations, and found a way to get some. They engaged in creative accounting. Unfortunately, the accountants permitted it.

“The only way most Internet companies were showing any money on the books,” a close observer commented, “was by doing deals with one another. The business development heads would meet for lunch. They wouldn't have any idea what the outcome of the meeting would be, but they'd work it out at lunch, and then they'd both show some revenue. But it wasn't real revenue.”^[82]

So the income statements of dot-coms filled up not with real sales, but with exchanges of services from each other, which each company booked as sales. Accountants approved to these deals on the dot-coms' financial reports. They didn't have to give unqualified approvals; they could have cited qualifications—essentially that a firm will need to raise more capital to be successful—that it's not likely to be “pay as it goes.” This would have tipped off investors to be careful in buying the shares of these firms; it might have kept the bubble from forming as quickly and going as far as it did. But the accountants failed to do this.^[83]

Further, the accountants permitted companies to exclude from their balance sheets large quantities of debt which were laid off instead on so-called off-balance-sheet vehicles, such as partnerships. The result was to have the company appear financially stronger than it was and to allow it to report higher levels of profit than otherwise possible. Off-balance-sheet accounting was a key to the Enron financial scandal.

Would it have mattered had accountants done their job properly? Did the IPO buyers really think they were getting companies that had economic value? Probably the day-traders didn't think so, at least—they were speculating on the direction of stock price movements—that is, betting that the upward momentum would continue. And many other retail investors were at least basically aware of the inflated prices of Internet stocks. But the magnitude of the deceptions permitted by American accounting during recent years was concealed from investors, professional and novice. “Creative accounting,” in which the traditional measures of a firm's financial position were sacrificed to clever devices that concealed rather than exposed the true financial condition of a firm, became a norm in the new economy.

Signals by accountants to the financial value chain and to retail investors might have helped to keep the bubble's momentum from building if those signals had come during the bubble's two-year gestation period. They would have saved Enron investors from disaster had they come even after the bubble had burst.