Corporates: Ordinary mortals are not often forced to consider the complexities of corporate accounting. Yet it became difficult for investors to ignore the subject last week as a spate of rumours about accounting irregularities sent the entire US stock market down sharply.

When President Bush brought up the subject in his State of the Union address, it became clear that something must be seriously amiss.

Mr Bush called for "stricter accounting standards and tougher disclosure requirements". US companies needed to be "more accountable to employees and shareholders, and held to the highest standards of conduct".

Behind those comments and the jitters on Wall Street lies a full-blown crisis in accounting. If the basic financial language that companies use to communicate their business performance is flawed, there must be a question over how much their reported profits can be relied on.

The stock market boom of the 1990s was supported by a surge in corporate earnings. But what if at least part of that improvement was a mirage? "There's no question that headline earnings during the boom period were overstated," says Mr Martin Barnes, an economist at Bank Credit Analyst.

The increase in reported profits was ultimately unsustainable, he says. "Profits can't grow faster than the overall economy over a long period of time."

It may seem bizarre that the financial system could have turned a blind eye to this state of affairs but, amid the stock market boom, it became very difficult for investors to look more critically at company accounts.

"We all knew it at the time," says Mr Rob Gensler, who runs a media and telecommunications mutual fund at T Rowe Price. "But we all ignored things like one-time charges and pension fund costs."

He says institutional investors could not afford to be sceptical during the stock market bubble, because selling equities would have damaged their short-term performance.

All that has changed. The reliability of earnings reports is under greater scrutiny than ever. That means corporate profits may appear more muted in future than they did in the past.

Since movements in share prices are closely tied to perceptions about corporate earnings, that also carries implications for the stock market at large.

"The quality of earnings has been going down - and eventually earnings and stock prices pay the price," says Mr Mike Mayo, a banking analyst at Prudential Securities in New York.

It has taken the collapse of Enron to start this crisis of confidence. The energy trading giant's spectacular demise proved it was possible for a company to present a picture of health at the same time as its finances were crumbling. Enron simply parked the inconvenient items it did not want people to know about in partnerships that did not appear in its accounts.

"This is not a one-off thing," warns Mr Bill Miller, a fund manager at Legg Mason.

Big companies such as Waste Management, Cendant and Lucent Technologies have been forced to concede they seriously overstated earnings in recent years. And last week PNC Financial Services, a well-regarded Pittsburgh-based bank, was forced to restate its profits under pressure from the Federal Reserve, in the process wiping a quarter from last year's reported earnings.

Unlike Enron, PNC is not a product of racy financial engin-eering. But like Enron, it kept some transactions out of its accounts that regulators believe should have been included.

The new level of scrutiny applied to corporate accounting has also spread to a wide array of practices that have become common in recent years, and which together may have helped US companies to present their figures in an unduly favourable light.

Most have been openly debated for years: unlike the off-balance sheet shenanigans of Enron, they are entirely visible to a scrupulous investor. But taken together, they may have been allowed to significantly distort the headline earnings that companies report - the single profit number that Wall Street looks to first each quarter when trying to assess a company.

Among the most significant of these practices are the big write-offs against profits that have become a familiar part of the corporate landscape; the ability of companies to insulate their profits from the cost of issuing stock options to employees; and the over-inflated assumptions on which corporate pension funds are run. Big write-offs can eat up a large part of a company's regular quarterly earnings. According to Mr Mayo, write-offs at US banks consumed 13 per cent of earnings last year - well above the 5 per cent average of the past decade.

As they fire workers, write down the value of assets and sell or close businesses to cope with difficult markets, some companies have turned to such charges repeatedly in recent years. That makes a mockery of the claim that these are "one-off" events. AT&T, for instance, has taken $13.5 billion (€15.7 billion) of restructuring charges over the past four years. The US telecoms company now believes that the big hits to profits are over and its future earnings forecasts will take into account the effects of restructurings such as these.

A second issue that has agitated many investors has been the way companies account for stock options, which became a popular form of remuneration in the 1990s, particularly in the technology industry. After a long battle with the accounting profession, technology companies won their fight to keep these costs - which appear only in footnotes - out of their profit and loss accounts.

Corporate pension funds have also become a cause of concern. Companies that promise a certain level of pension to employees when they retire are obliged to make up any difference if the pension funds fall short. Any expected shortfall has to be deducted from current profits.

Writing in Fortune magazine, Warren Buffett, whose long-term track record as an investor is virtually unsurpassed, pointed out how easy it was for companies to influence these figures. General Electric, for instance, assumes its pension fund will earn an annual return of 9.5 per cent over the long term, well above the 7.5 per it assumed 20 years ago, resulting in a credit to its profits of $1.74 billion last year.

The new level of scrutiny being applied to US earnings may not guarantee that the numbers will be any less subjective. Forecasts of investment returns, for instance, will remain as conjectural as ever. But it does mean that the assumptions behind the figures will be tested far more thoroughly.

- (Financial Times Service)