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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the recent stock market bubble, the traditional financial reporting model was assailed as a backward-looking system, out of date in the Information Age.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 analysts 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-com 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...