March 27, 2003

Unintended Consequences of Earlier Reforms Bite Market Hard

Washington Times, March 16, 2003

The Number: How The Drive For Quarterly Earnings Corrupted Wall Street And Corporate America By Alex Berenson Random House, $24.95, 274 pages

By Paul Craig Roberts

Alex Berenson is a New York Times business reporter, who sniffed out a couple of the accounting scandals that investors and Wall Street analysts failed to spot. In "The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America," Mr. Berenson capitalizes on the public's interest in the accounting scandals that have contributed to investors' disappointed hopes in equity performance during these first years of the new millennium.

The book consists of two parts. The first is a journalistic history of previous booms and busts and the reforms and regulatory responses they provoked. The second part is a journalistic account of the long bull market beginning in the early 1980s and the subsequent bust of the past three years. There are two brief appendices that illustrate with simple examples how executives can fudge their financial statements.

Mr. Berenson's unifying theme is the focus that analysts, investors and executives place on quarterly earnings as a company's success indicator. He shows how this focus intensified over time and concludes that quarterly earnings became a cult on the altar of which were sacrificed the ethics of executives and accountants and the caution of analysts and investors.

The introduction of price competition among the Big Eight accounting firms combined with the use of stock options as a major source of executive compensation to unleash incentives to fictionalize the quarterly earnings number. In some instances misleading earnings reports were created without violating Securities and Exchange Commission rules by pushing accepted accounting practices to the point that they became misleading. In other instances, fictional reports were cases of outright fraud.

 Mr. Berenson separates cases of accounting gimmickry from fraud as he takes the reader through scandals that led to investor disappointment in Lucent, Lernout & Hauspie, Cendant, Computer Associates, Enron, Tyco, WorldCom and Green Tree Financial. In some of these cases executives took fortunes out of companies by exercising options on the basis of fictional earnings.

Clearly, there are executives who value money more than reputation, or perhaps they believe money is reputation.

Mr. Berenson believes that the legislative response (Sarbanes-Oxley) to the scandals is insufficient and that Wall Street and the accounting industry have succeeded in blocking measures that would have strengthened the Securities and Exchange Commission.

"The Number" is readable and succeeds on one level. However, it fails on another. A reader could come away thinking that quarterly earnings and stock options are devices designed by Wall Street and corporate executives for the purpose of enriching themselves through corrupt accounting. A reader could also come away with the belief that accounting firms broke up their cartel with price competition in order to be able to sideline straight-laced partners and chase the fast buck.

What Mr. Berenson fails to tell us is that the very factors that produced the scandals focus on quarterly earnings, stock options, and price competition between accounting firms are themselves the reforms of yesterday, reforms that were supposed to increase investor protection. Without realizing it, Mr. Berenson has explained the recent accounting scandals as unintended consequences of previous reforms.

Quarterly earnings reports are the result of reform that aimed at providing investors with more timely information about the profitability and financial condition of public companies.

Stock options resulted from reforms that sought to tie executive compensation to shareholder return as measured by the company's stock price. Another reform capped executive salaries at $1 million. Compensation above this amount must be paid out of after-tax profits or justified by performance.

The practice of giving executives large options whose value depends on driving up quarterly earnings (the measure of performance) came from this reform.

In the early 1990s the S.E.C. itself launched fictional quarterly earnings reports when the agency changed Rule 16b. Previously, executives who exercised their stock options were required to purchase the stock at the option price and to hold it for six months before selling. The rule change permitted executives to sell the stock the minute they exercised their options, thus eliminating the executives' exposure to the market.

Where were the accountants? They, too, were victims of government policy. Traditionally, accounting relied on character and internal censure. In a judgmental era, loose dealings ruined reputations. Partners were paid according to seniority. The accounting industry operated under self-imposed bans on price competition and advertising.

With charges that the absence of price competition was anticompetitive, the Federal Trade Commission and the U.S. Department of Justice foolishly destroyed this accounting culture during the 1970s. Competition on the basis of reputation and probity was replaced with price competition. Partners ceased to be paid by seniority; instead, they were paid according to the business they brought to their firms. Accounting firms began consulting with the corporations that they audited, adding conflict of interest ingredients to the more accommodating stance toward clients that price competition had forced upon accountants.

Mr. Berenson missed the big story of the reform roots of the recent accounting scandals, because he believes that government regulation and S.E.C. rules are substitutes for character. In truth it was government rules and reforms that created the incentives which destroyed a culture that valued ethics, reputation and good character.

Standard accounting practices are like door locks. They keep honest people honest. But they cannot prevent fraud any more than a door lock can prevent forcible entry. Accounting principles focused on providing an accurate picture of financial health. Government responded to cases of fraud with rules and regulations, and gradually a rule-based system took shape. In today's rule-based system, misleading accounting is permissible as long as companies and their accountants stay within the S.E.C. rules. Character shortage is not limited to the business arena. After the Clinton years not even the naive can view government as a house of rectitude.

Recent books from media insiders have made it clear that big media has agendas that subordinate objective reporting. High schools, universities and even the military academies are sullied by cheating. The General Accounting Office reports that the government's own books are in such terrible condition that they cannot even be audited.

What becomes of character when quotas push less qualified people ahead of the meritorious and when character-building institutions, such as the Boy Scouts, are attacked for attempting to protect youthful members from homosexuals and pedophiles? When universities teach that character is a social construct that masks an elitist, repressive, or hegemonic outlook, how can character flourish?

Mr. Berenson believes that arming the S.E.C. with bigger budgets and more power is the key to more accurate financial reporting. But when character is lost, rules and punishments cannot take its place. Redemption lies not in bigger government, but in restoring the culture that valued character. The scandals have made executives and accountants look worse than they are.

Malfeasance remains the exception. During the recent scandals, several hundred firms restated their earnings, a small percentage of more than 14,000 public companies. Moreover, a restatement is not an admission of fraud, and could merely indicate a company's preference for a more conservative posture in light of the changed environment.

The federal government's decision to destroy Arthur Andersen, an accounting firm with 85,000 employees worldwide, for the misdeeds of a few seems as reckless as Enron's accounting. Surely if so many accountants were looking the other way while executives falsified earnings reports, more than 25 people would be facing charges today. How much additional accounting and regulatory costs do we want to impose on businesses which are already operating with a high degree of compliance with the rules?