Wharton: "Accounting High Jinks and Stock Prices"
>>> Accounting High Jinks and Stock Prices
By now they are something of a rogues gallery, symbols of maverick accounting in the new century — Enron, Tyco, Qwest, Computer Associates, Global Crossing. Many investors worry these firms may be the tip of the iceberg, just the start of what will become a relentless parade of accounting scandals that will dampen stock market returns for months to come, perhaps years.
There is some precedent. In 1973, Equity Funding Corporation of America, an insurance and mutual fund company, disintegrated amidst revelations of fraudulent financial reporting. The Equity Funding scandal was a major factor in the bear market that lasted a decade. While the 1970s were not completely analogous to the present, since they were a time of high inflation and slow economic growth, financial markets never benefit when investors grow distrustful of corporate earnings statements.
Enron-type accounting shenanigans do appear to be hampering the broad market, spilling over to undermine stock performance for companies that have not been subject to controversy, says Wharton finance professor Jeremy Siegel. "It's definitely impacting the market. There's no question about that. I think it's accelerating a solution to a problem that had really been festering for a long time, which is the proper accounting for earnings."
Wharton accounting professor David F. Larcker agrees. "Clearly, the prevailing news story is that these accounting practices have cast a pall over the market," he says. "I think there's some truth to that … People have made some adjustment for how risky their holdings are." Siegel and Larker note, however, that accounting scandals are not likely to sweep the corporate landscape. "It's still my feeling that the vast majority of CEOs and CFOs are honest," Siegel says.
Meanwhile, Federal Reserve Chairman Alan Greenspan gave his own, somewhat reserved, vote of confidence in the economy during remarks February 27 before the House Committee on Financial Services. In addition to predicting a modest recovery from the current recession, Greenspan said the Enron scandal was "not a significantly negative event" and might even result in more corporate accountability and transparency. He also noted, however, that the scandal, and others like it, could adversely affect the economy by creating uncertainty and loss of confidence among investors.
In terms of the market, both Larcker and Siegel predict that the worst stock-price damage probably will be concentrated in so-called new economy companies - high tech and financial-services firms which, like Enron, deal in products and services that are NOT easily understood or valued. These companies are hard to evaluate even when they keep honest books, and many are in new industries in which it is hard to apply traditional accounting standards or to gauge performance against well-established yardsticks. As Siegel says, "There's going to be a cloud over those sectors for a little while."
Global Crossing, once a high-flying company that laid fiber optic cable, filed for bankruptcy in January amidst accounting irregularities that, as at Enron, inflated earnings and concealed debts. A year ago the company's shares traded above $20; today they're worthless. Qwest, a money-losing phone and data-services provider, is mired in problems involving the way it recognized revenue and accounted for "bandwidth swaps." It trades at around $8 a share, after trading above $40 a year ago.
Computer Associates, an e-business software company, has been accused of double-counting some revenue. In the past month its shares have fallen from nearly $40 to about $17. Tyco, the international conglomerate, has been hammered by criticisms it has not disclosed enough detail about $8 billion in investments. Tyco shares have fallen by half to around $30 since the start of the year.
Despite all this, the Dow Jones Industrial Average has been surging in the past month. The S&P 500 is about 15% higher than it was when the Enron and other accounting scandals began last fall. Even the Nasdaq Composite, brimming with money-losing high-tech companies, is nearly 30% higher than it was when Enron began to unravel last fall, though this index has fallen about 10% this year.
Of course, the market might have been doing even better if not for the shadow cast by accounting and disclosure problems. "The short- to medium-term impact might not be so good, because it might be awhile before we have all this figured out," says finance professor Andrew Metrick. "I don't think there will be many as nasty as Enron, but it's not clear how much is lurking out there."
While there may be new controversies, he says, the broad market has already adapted. "You can think of accounting risk as being an extra kind of business risk." But Wall Street analysts and sophisticated investors already have accounted for this risk in pricing stocks at the levels they are at today, he adds.
Siegel notes, however, that the spotlight on accounting is causing many companies to take the conservative approach on earnings, revenue or debt figures that fall into gray areas. As a result, reported earnings may well be lower this year than forecasters had expected before the scandals broke, even if business does as well as the experts had predicted. "The truth is, earnings numbers do affect stock prices," he says. Lower earnings mean lower prices.
Metrick, Larcker and Siegel all say, however, that the broad market could benefit if companies adopt better practices and government strengthens regulations. Many companies are voluntarily adopting more conservative reporting standards because they expect investors to reward such behavior by bidding up prices of companies that clearly disclose data that other companies obscure, Siegel points out.
Still, it's likely to take some time for the post-Enron environment to evolve, Larcker adds. Setting new accounting standards, he cautions, is difficult. "The problem is that standard-setting is inherently political. Experts have a hard time agreeing on what new rules should be and, even when they do agree, there inevitably is opposition from groups that would suffer if the rules change. The way you keep score affects the numbers. Depending on how you choose to do these things, the numbers can go up or down. A lot of people weigh in on these things."
After looking at Enron, for example, many argue that companies should be required to disclose "off-balance sheet" transactions with subsidiaries, partnerships and other "special purpose entities." Enron used such transactions to conceal massive debts. But many other companies used such transactions for perfectly legal purposes. They won't be happy about any rule change that would suddenly make their businesses look less profitable, or which would force them to disclose dealings they had agreed to keep confidential. "I think what's going to happen is that we are going to see some expedited way for developing standards," Larcker predicts.
Ultimately, says Siegel, accounting for earnings will be more standardized than it is today and corporate activities that have been kept hidden will be revealed. "This is long overdue."
Adds Metrick: "It looks like we might end up with more and better disclosure. Ten years from now we might be glad this happened." <<<
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>>> What’s on the economic horizon for 2002?
Emory University economy-watchers don’t see many storm clouds on the horizon, but remain pessimistic about the chances of a strong recovery in the coming year.
“It’s not clear where the growth on the demand side is going to lead us out of the recession,” said Paul Irvine, professor of finance at Emory University’s Goizueta Business School. He ticked off three reasons: Consumers are unlikely to spend more than they are now; exports are unlikely to grow, given the state of the world economy; and business, which is still recovering from their capital spending binge of the late 90s, is unlikely to make much of an investment in capital spending anytime soon. Nor is Irvine sure which sector will lead the recovery, though he did say that he was investing in some financial and energy stocks.
Still, Irvine, like many of his colleagues, remains “conservatively optimistic” about the market, and foresees a U-shaped – as opposed to a V-shaped – recovery in the coming year, meaning that he anticipates that the economy will begin expanding again gradually, rather than accelerate sharply.
One reason for the guarded optimism many Emory professors have about the economy is that two important costs – energy and capital - are at historic lows and are likely to remain so for the coming year. Gas prices fell 12 percent last year and diesel prices an even sharper 19.5 percent, according to the Department of Labor. At the same time, the Federal Reserve has pushed interest rates down to their lowest levels in 40 years, 1.75 for the federal funds target rate.
Ujjayant Chakravorty, a professor of economics who follows energy, said that mild weather this winter, declining travel in the fall, and weak industrial demand are all likely to keep energy costs lower through 2002.
T. Clifton Green, a professor of finance at Goizueta, believes that the 11 short-term interest rate cuts the Federal Reserve made last year have already had an effect, softening what might have been a much tougher downturn. Ironically, however, he believes that this moderating effect may dampen prospects for a dramatic recovery as well.
“…[U]sually when things are a little starker in a downturn, when the upturn happens it’s a little more glowing,” Green said. “The people have been saving their money, setting things aside, because they’re worried about the future, and then when things get better they go out and start making the big purchases and the economy kind of booms.”
The downside risk of the rate cuts, contends Nicholas Valerio III, a professor of finance at Goizueta, is that if the economy does not start rolling again, that tool can no longer be used, and the economy could end up in a “liquidity trap” of the kind from which the Japanese economy now suffers, where no one is buying or investing although interest rates have sunk to zero.
Green did not think such a scenario was likely. “The thing that’s hugely different from Japan is the consumer,” he said. “There, consumers don’t buy anything - and we don’t seem to have that problem,” he quipped.
While Valerio does not think that we’ve heard the last of economic bad news, he did offer one positive personal anecdote. Every year, he organizes a trip to New York to introduce Goizueta MBA students to Wall Street. Last fall, he had a hard time getting firms to commit to student visits, but now, he said, firms are suddenly scheduling interviews for summer positions – which he read as an indication that they believe things may be getting better.
Past recessions have usually left some kind of lasting impression on the public. No one who lived through the energy-induced recessions of the 70s ever thought of energy in the same way. In the 80s and 90s, millions of layoffs may have led to a new social contract between employer and employee. The lesson this time around? Green predicts a new realism about the stock market.
“Hopefully that kind of irrational exuberance that Greenspan was talking about is gone a little bit,” he said, and people are becoming more realistic about the stock market. “Maybe that’s an end of innocence of sorts that’s a good thing.”
Corporations may also be becoming a little more down to earth, according to Andrea Hershatter, a lecturer in organization and management and assistant dean and director of Goizueta’s BBA program. Hershatter said she believes the downturn is leading many managers to take a more back-to-the basics approach to management. “The 90s was a whole decade of fads,” she said. Today, fad-driven, one-size-fits-all dogmas, such as zero-defect tolerance or the “need for speed” are out. In their place, she said, people are looking for time-tested approaches, tailored more carefully for a given industry. “Now they’re saying, well, if you’re in the semi-conductor business, speed rules, but if you’re in the brand management business, speed is your enemy,” she added.
Chakravorty said that although he expects energy prices to remain low in 2002, decisions made this year are likely to have a significant effect on the price of energy for years to come. Congress will decide whether to approve the Bush Administration’s plan to encourage the construction of up to 1300 new electric power plants, including some nuclear power plants, and to open up new areas to oil drilling in Alaska and off the Florida coast. That would be likely to increase the supply of energy and reduce the cost.
At the same time, Chakravorty predicts that President Bush will come under increasing political pressure from Europe to compromise on the Kyoto accord, an international agreement intended to reduce the output of pollutants believed responsible for global warming that he has rejected. A compromise would have some impact on long-term energy costs, according to Chakravorty.
One energy issue that should not be a matter of economic concern is Enron, Chakravorty said. The aftermath of the company’s collapse may end up being “a huge political circus,” he said, but it should not have any lasting macroeconomic effect.
Of course, as a number of analysts have pointed out, the only thing we can know for sure about the future is that our predictions about it will be wrong. Even the country’s very best economic forecasters’ look through a glass darkly – very darkly. Daniel Rodriguez, a professor of organization and management, cautions against putting too much stock in economic predictions. Rodriguez recently reviewed the outcome of GDP predictions made by a group of 54 top economists polled in July by the Wall Street Journal and found that 88 percent were off by more than a full percentage point – and 51 percent were off by more than 2 percent. “That’s huge,” Rodriguez said. “GDP averages about 3 percent. If you’re two percentage points off, that means you’re significantly off the mark.”
For this reason, Rodriguez said that he is skeptical of the quick turnaround many experts now predict. “The same group of forecasters that failed to predict this year's recession are the same group predicting a fairly rapid turnaround,” he said.
“The problem is that a comprehensive forecasting model, although built on several key relationships, must be constantly modified to account for the many dramatic changes in these relationships and new variables that become more important than previously,” he explained.
“The truth is, nobody has a clue,” Hershatter said. “This year, the difference is we all know we don’t have a clue.” <<< |
