When Standards Are Unacceptable
When Lawrence Summers spoke from his U.S. Treasury pulpit, he preached that no innovation was more important to the success of U.S. capital markets than "generally accepted accounting principles." The transparency and accuracy of corporate reporting, he would say, was part of the intangible infrastructure of the financial system that made American prosperity possible.
That's what makes the Enron scandal so serious. It's more than an isolated case of corporate venality. It highlights that the bookkeeping that is "generally accepted" these days is too often meaningless, if not false.
Enron wasn't the only company to make debt disappear altogether from its books. Global Crossing and Elan weren't the only companies to give money to someone else, take some of it back and count the income as revenue without counting the outgo as expense. Amazon wasn't the only company to resort to "pro forma" accounting when it was uncomfortable with GAAP.
Honest bookkeeping is fundamental to a system in which savings are funneled, not through banks, but through stock and bond markets to finance investments that pay off in better living conditions. The decisions of mutual funds, insurers and pension plans are supposed to direct capital to the most promising uses. If the numbers are bad, the decisions are bad. Savings flow not to the most promising investments but to the ones that paint the prettiest pictures.
This isn't just theory. When companies confess that they didn't make as much as they said they had, their shares suffer. In 2000, investors in companies that restated earnings had losses of $31.2 billion in the three days following the announcements. That's a small slice of the stock market, but it's still a lot of money.
The practice of audited corporate financial statements is a modern one. U.S. Steel Corp. was a lonely pioneer in 1903 when it hired Price, Waterhouse & Co., as it was known then, to certify the accuracy of what's considered the first modern corporate annual report, 40 pages of narrative, numbers and photos. Other companies were slow to follow.
Widespread allegations of fraud and skulduggery after the 1929 stock-market crash changed all that, prompting legislation that forced publicly held companies to submit regular reports that met certain standards. Congress first told the Federal Trade Commission to regulate accounting, then, in 1934, gave the job to the new Securities and Exchange Commission. The SEC promptly delegated it to the accounting industry and, later, to an independent outfit, the Financial Accounting Standards Board.
But over the past decade or two, the truthfulness of the audited reports has deteriorated.
When financial wizards describe some three-card-monte transaction, too many bosses nod rather than risk appearing too dim-witted to understand modern finance -- or suggest after the fact that they didn't know what was unfolding.
"It's not good enough for a manager to say, 'The smart guys understand and the MIT guys understand. I don't need to understand. I just manage them,' " warns William McDonough, president of the Federal Reserve Bank of New York. "If the management and the outside directors do not understand the risk transactions that an institution is taking, they are incapable of exercising appropriate oversight. They must either educate themselves or forbid that the risk be taken."
Clever lawyers, investment bankers, chief financial officers and accountants exploit the gaps in GAAP. "While developments in our capital markets, corporate finance and risk management are racing along at 100 rpm, the evolution of our accounting and disclosure regime crawls along at 10 rpm -- and the gap between them is forever widening," Treasury Undersecretary Peter Fisher said in a recent speech. The latest guidance on accounting for derivatives and hedging is 804 pages, and some MBA is already looking for a crevice to exploit.
The incentives for corporate managers to distort the information they provide investors grew during the 1990s bubble, Harvard economist Andrei Shleifer argues. With compensation more closely tied to stock prices -- through initial public offerings, stock options, takeovers -- there are huge rewards from moves that boost shares, even if just temporarily. And there was an urgency to keep stock prices up in order to continue to sell shares to raise capital. "The argument that 'honesty is the best policy' does not work in such markets, since firms would not be around to reap the benefits of their honesty if they cannot raise current finance," Mr. Shleifer says.
So today, too many companies treat accounting rules the way they treat the tax laws: If it isn't expressly forbidden, it's OK. Too few ask: Do our reports give outsiders a reasonable picture of our performance?
The reaction to Enron is heartening, though. The public outrage is unmistakable, which is why Congress is so exercised. The stock market is punishing companies whose reports hide more than they reveal. The result may be the changes in rules, in oversight and -- perhaps most important -- in attitudes toward corporate honesty that have been so slow in coming.
-- David Wessel
Write to David Wessel at capital@wsj.com
Updated February 7, 2002 10:56 a.m. EST |
