Second quarter earnings season, now complete, demonstrated one thing: U.S. management’s ingenuity in using creative accounting to produce a deceptive earnings picture is unabated. Of all the threats to the U.S. economic system, this is the direst.
A new book “Hidden Financial Risk” (J. Edward Ketz, Wiley, $39.95) sets out a taxonomy of the various ways in which late 90s management successfully (in the short term) deceived investors and boosted earnings figures. The extent of the problem is alarming; from 1997 to June 2002, according to a General Accounting Office study quoted in the book, 919 publicly listed companies had to restate their published accounts in a later quarter. While there are no definitive statistics, the rate of frauds appears to have risen sharply in the boom of the late 90s, as one would have expected, but not to have dropped back again in the decline since 2000, suggesting that aggressive corporate managements are still confident of their ability to fool stockholders when needed.
Ketz’ discussion is fascinating, although all too useful to future scamsters wanting to find out just how those clever guys at Enron did it.
Debt and associated assets can be moved into “special purpose vehicles” and thereby hidden from investors and rating agencies. This has now been restricted, in theory, but interestingly, Citigroup last week announced that instead of the $55 billion in debt it had believed it needed to move back onto its balance sheet from SPVs, only $5 billion needed to be returned to the land of the visible. Maybe further restrictions are necessary, after all.
Leasing can be used to remove assets, and their associated debt, from the balance sheet — the rules for this were tightened up in the 1970s, after a previous round of scandals, but may need tightening further.
Defined contribution pension schemes offer many opportunities for creative accounting, notably in General Electric’s non-payment of pension contributions every year since 1987, and accrual of theoretical returns on its fund, thereby creating a $12.5 billion non-existent asset on its balance sheet.
Companies can be accounted for as subsidiaries when convenient, and by the “equity method” in which they are held as independent entities, when not convenient. Boston Chicken took advantage of this, accounting for its franchisee outlets by the “equity method” while they were unprofitable, and taking them over, with full consolidation, once they had moved into profit — thereby expansion costs were capitalized instead of being expensed.
As well as outright fraud, there are also innumerable cases of “aggressive accounting,” where perfectly legal techniques are used to obfuscate the economic reality and make profits appear higher than they “really” are. As the Enron case and the Andersen bankruptcy that followed it demonstrated, it is very difficult indeed for a major audit firm to resist the blandishments of client company management, if the client is a substantial one — it doesn’t even need to be substantial in terms of the accounting firm as a whole, but simply in terms of the revenue stream of the particular partner or group of partners that deal with it.
Accountancy firms, like investment banks, used to be more or less collegiate in their approach to the revenue accruing to each partner, accepting that the loss of a client which leaves the firm because the firm won’t tolerate its bad practices can nevertheless bring credit to the firm with other clients and in particular with the investor public as a whole, the ultimate audience that accounting firms (and investment banks) should be serving. However, the more aggressive business culture of the 1980s and 1990s, and the consolidation of the accounting profession into a tight oligopoly where reputation is much less important than formerly, have brought a change.
Since 1990 or so, accounting firms have adopted an “eat what you kill” approach, which reduces partnership life from a rather well paid Oxford common room to a particularly treacherous jungle, in which all are to be distrusted and the most unpleasant predator wins. This change, so lauded in its early stages because of the boost that it gave to corporate profits and individual partner earnings has, needless to say, been hell for professional ethics.
In addition to oligopolistic and over-aggressive accountants, three other trends have tended to increase the level of accounting chicanery in the last few years. The first is cyclical: because bull markets make investors less careful about where they invest, they increase the temptation for corporate managements to provide investors with “good news” financial data. There was far more accounting chicanery in 1968, at the top of a bull market, than in 1975, when investors regarded new corporate requests for money with the deepest suspicion. Andrew Tobias’ 1972 expose “The Funny Money Game” of National Student Marketing’s revenue recognition methods, for example, is still well worth reading for investors in the U.S. stock market, and will be very familiar to the unfortunate investors in WorldCom.
This trend, at least, is not much to be feared in the future; once investors develop (as, judging by the March-June stock market recovery, they have not yet done) an appropriate suspicion of companies that use aggressive accounting treatments, then we will be back in 1975 again, and chicanery will greatly diminish. Fear is a much more useful motivation than greed for those seeking to maximize investment returns.
The second trend that has made accounting chicanery more prevalent will not go away so easily. That is the rise of the “entitlement culture” in the U.S. and worldwide, in which people feel themselves entitled to whatever they can get, however spurious the means — accounting chicanery, political manipulation or frivolous lawsuits — by which they get it. In a society in which McDonalds has to worry about getting sued for selling hamburgers, it is not surprising that corporate management seeks to utilize every angle it can find to maximize its personal wealth. The stock options scandal, in which the political process was perverted in order to bring pressure on the Financial Accounting Standards Board to prevent that body from requiring proper accounting for stock options, so that corporate management could reward itself ad infinitum at shareholders’ expense, was the most egregious example of this, but in today’s culture it should not have surprised anyone.
Rep. John Dingell (D.Mich) claims that the rise in accounting fraud is largely due to the 1995 legislation that banned class action lawsuits by investors who had lost money in Initial Public Offerings. Not so; that legislation was sound, in that it removed the option of quasi-fraudulent lawsuits from investors, but at the same time, legislation was needed to remove the option of quasi-fraudulent accounting from management. In a society in which all options for self-enrichment are equally valid, the ethical rush to the bottom needs to be prevented by all means possible.
Finally, investors have brought this upon themselves by ceasing to focus on dividends, and by allowing the stock market to become so overvalued that dividend yields become negligible. Traditionally, public company financial statements were of only moderate importance; their purpose was to demonstrate to the investor how secure was the company’s dividend, and what were the prospects of its being increased. A period of very high earnings from a company, if un-sustainable, was of little interest, because there was little prospect that those earnings could translate into an equivalently high, but maintainable dividend. Instead, the focus was on maintaining existing earnings, sufficient to allow the dividends to continue being paid in an economic downturn.
This has of course all changed. The “Fed Model” for estimating the “correct” value of the stock market, developed in the early 1990s by optimistic investment bank stock promoters, and endorsed by the Fed in its July 1997 report to Congress (as an attempt to justify why stocks were not, after all, “irrationally exuberant”, as Fed Chairman Alan Greenspan had warned six months earlier) is an extreme example of the change.
Under the Fed Model, it is assumed that an investor requires an investee company earnings stream, projected into the future, sufficient to give him the yield of long term Treasury bonds, plus a modest risk premium. But of course, investors never actually receive company earnings; they receive only the dividends that are paid out of earnings.
Retained earnings, that remain with the company, are subject to three depredations over which the investor has no control. They can be “diluted” out of existence through overpriced acquisitions. They can be diverted to management through stock options grants. Finally, they can remain with the company until the end of its life, eventually being consumed in the inevitable losses of bankruptcy. Retained earnings certainly have some modest value to investors, but it is far less than the value of an equivalent dividend or bond coupon, and they should absolutely not be valued as if they were cash in the investor’s pocket. The Fed model, by using earnings instead of (as we were taught thirty years ago) dividends as the basis of its valuation, seriously and consistently overvalues the stock market as a whole, with consequent distortions in the allocation of capital. Of course, when the earnings themselves are only partly solid, with a substantial layer of fiction and flimflam added, the Fed’s valuation model becomes even more hopelessly delusional.
We can do very little (though surely more than we are doing) about the standards of ethics in business and political life today. We can do only a moderate amount to correct the temptation to inflate earnings, in particular by educating investors (by all means through means such as the Bush administration’s 2003 tax cut) to focus on steady and maintainable dividends as their primary investment return. But we can do something about the unhealthy relationship between accountants and the company managements that appoint and pay them.
By forcing all accounting services proposals to be put to shareholders via the company website, and mandating competitive elections by shareholders of the auditors for each year, we can greatly reduce the influence of management, and increase that of shareholders, in the selection of company auditors. That way, accountants will be working for the shareholders, as is their proper function, and not for company management, in an unholy alliance that perverts the capitalist economic system.
Until this happens, expect more accounting scandals, and more disillusionment among the public at large with equity investment and business as a whole. Our grandparents saw what that can lead to, in the fiercely anti-business climate of the 1930s, that pulled the U.S. economy off its established growth path for almost a generation, and impoverished the lives of many citizens thereby.
Better accounting standards, and enforcement of those standards, are not optional!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.