Federal Contract Law: On financial statements, who should feds trust?

Joseph J. Petrillo

Federal contracting officials are notoriously risk-averse. Often they will prefer large contractors to small-business competitors because they think size equals dependability.

But the size of a company cannot guarantee its stability, as recent economic implosions--Enron Corp., Global Crossing Ltd. and WorldCom Inc.--have shown. The latter two have had, or have sought, federal contracts. Yesterday's sure bets have become today's risky propositions.

This makes it tough on government buyers, who must rely on audited financial statements, same as investors. But recent bankruptcies and scandals have undermined trust in the reliability of these statements.

In my view, the problem started with the accounting profession's efforts to cut its clients' taxes. The tax code favors certain transactions. To take advantage, accountants devised methods to convert ordinary income into capital gains, to offset income with apparent losses or to spread current income over several years. Often these methods were merely sham transactions intended solely to avoid taxes.

One notorious dodge is to incorporate in a tax-sheltered jurisdiction such as Bermuda and then set up internal transactions which artificially export income to that corporation. Voila, no taxes!

This sort of manipulation led to a mind-set that an economic event could show up in financial statements in several ways. Sometimes this meant transactions with no purpose other than to change the accounting treatment of an event. The result was that financial accounting became more and more flexible, with aggressive and conservative approaches.

But even if one is justified in this sort of skullduggery to avoid taxes, it is an entirely separate matter in financial accounting. If a company hides substantial expenses in off-book transactions, then its statements no longer meet the expectations of investors and customers who read them.

Investment, lending and vendor selection decisions are comparative. Do I buy this stock or that one? Do I award a contract to this bidder, the other or neither?

To make such decisions rationally, people need financial statements that are comparable across companies in a given industry. If one company can treat an expenditure as a capital cost and another as an ordinary expense, then you can't make an apples-to-apples comparison of the two.

To make the process work, for contracting officials as well as investors and bankers, we need to restore rigor, uniformity and predictability to audited financial statements. Is the auditing profession, compromised as it is, really up to the tough task of radical reform?

Some say that the problem stems from the use of auditing as a loss leader to obtain lucrative consulting jobs. But severing the two activities simply means that auditing must pay its own way. If a company can move its auditing business to a more aggressive accounting firm, then it will still be able to exert pressure for more favorable and therefore inconsistent accounting treatment.

Someone immune from economic pressure needs to set and enforce the limits. Do we really want to trust the auditors with self-regulation?

Joseph J. Petrillo is a lawyer with the Washington law firm of Petrillo & Powell. E-mail him at jp@petrillopowell.com.

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