• See Biovail Exposed, Part I

Specifically, the SEC claimed that the managers of Biovail understated research and development expenses, understated foreign exchange losses, and overstated revenues. What makes Biovail interesting is that various analysts and hedge funds concluded that Biovail's stock was overvalued in 2003 and started selling the stock or taking short positions. The stock price plunged during that year.

Biovail and its management team fought back. It sued David Maris, a research analyst at Banc of America Securities, but dropped the lawsuit on September 10, 2007. Biovail also sued Gradient Analytics and SAC Capital, among others. Biovail claimed that the research analysts and the hedge funds colluded to produce a disheartening picture about the firm. Clearly, we now know that these lawsuits were an attempt to divert attention away from the cooked books.

I found these lawsuits smoke-and-mirrors from the very beginning because Banc of America Securities (BAS) hired me and two other accounting professors to analyze Biovail's financial statements. (BAS did not inform me who the other two professors were, and to this day, I am unaware of their identity.) BAS did nothing to influence me one way or another; they merely hired me to analyze Biovail's SEC filings. I saw no evidence of collusion or untoward influence that attempted to sway my opinion. Further, when BAS released its report to their clients, I noticed that they cited my opinion correctly and without bias.

This strategy of using the courts to intimidate research analysts and short sellers and financial journalists and anybody else who dares to criticize their accounting, their financial position, and their business operations is a sad avenue to take. If these critics are incorrect, the firm should be able to garner the evidence and disseminate an argument to the investment community that explains the company's position. Lawsuits seem out of place.

Accounting reports of public companies purport to tell the economic history of the business enterprise; in particular, listing its assets and liabilities as of the balance sheet date, measuring the revenues and expenses during the period, and documenting its cash flows during that same period. The investment community employs accounting reports and other information to evaluate managers and the prices of the corporation's securities. It is therefore not surprising that managers attempt to thwart that communication process whenever it is to their advantage. During the past decade, we have witnessed myriad companies that "cooked the books" so that managers were favorably received (e.g., Enron's Andrew Fastow won a prestigious award as a leading and innovative CFO) and so that common stock prices would be buoyed up, thereby maintaining their wealth as denominated in the valuation of common stock shares and stock options.

What, then, can shareholders and bondholders do to protect their interests as they recognize these natural tendencies of business executives? More particularly, how did the investment community learn of the exaggerated numbers in accounting reports during the last decade? It turns out that there were four sources of information that revealed the hanky-panky in corporate headquarters.

First, investors and creditors and those willing to take short positions performed their own research, and some correctly discerned accounting discrepancies and misinformation. Second, independent analysts and consultants researched 10Ks and other filings to determine whether securities were undervalued, overvalued, or correctly priced. Third, financial reporters investigated annual and quarterly reports to assess their accuracy. Fourth, some insiders blew the whistle on the egregious behavior of corporate managers. In the latter case, the whistleblower often reported the problems to financial reporters who were in a position to follow up on the lead; sometimes they reported the irregularities to the SEC.

The SEC did not unearth very many of the recent financial frauds and irregularities; instead, the SEC relied on the research efforts of the investment community and financial reporters, and on whistleblowers. The SEC is effective in its setting of accounting regulations, coordinating its work with that of the FASB, investigating tips of alleged violations, and in its enforcement of known violations. But the discovery of improper accounting depends greatly on the work and efforts of investors, independent research analysts, financial reporters, and whistleblowers.

A court decision favorable to Biovail might not affect investors' and creditors' performing their own research as they would not expose themselves to increased litigation risk. On the other hand, such a decision would adversely affect the work of independent analysts and consultants, financial reporters, and whistleblowers as it provides them very little protection from managers who try to obscure their accounting shenanigans by suing whoever challenges their financial reports.

The best antidote to opinions expressed in financial statement reports is not defamation or similar lawsuits but corporate answers and explanations to inquiries and critical comments. If analysts, consultants, financial reporters, or whistleblowers make errors, then the business enterprises and their managers should be able to defend themselves from these mistakes via open and transparent clarifications and disclosures. Truth can prevail as long as there is sufficient free speech to pursue the truth. Lawsuits are the ammunition of choice when one cannot defend oneself with facts and explanations, and are appropriate only when analysts, consultants, financial reporters, or whistleblowers act in an unprofessional manner and with reckless disregard to facts. That does not appear to be the case here.

In the previous column, I discussed how the SEC exposed the accounting fraud at Biovail. In this column we have exposed the unsavory strategy of intimidating accounting critics by lawsuits. This practice must stop if financial reports are to be trusted at all. Eliminate the critical research analysts, the pesky financial journalists, the capitalistic short sellers and hedge funds, and you will eliminate the search for accounting lies and securities fraud. Of course, some managers are trying to persuade Congress and the courts to create just such a world so they can loot at will.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.

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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.