A Season of Scandal (cont.)

ILLUSTRATION BY CRAIG FRAZIER

BUT PART OF THE PROBLEM with accountants is the element of interpretation that allows two honest people to arrive at different results. Barth likes to say that accounting is both art and science. In the judgment that is inherent in financial reporting lies the art. She sees the challenge in designing a reporting system with reliability: the notion that two people measuring the same thing come up with the same number.

A member of the International Accounting Standards Board, Barth prefers the IASB’s principles-based standards, as opposed to the more rules-based standards used in the United States. She notes that both systems have their strengths, and both ultimately rely on judgment. But a culture has developed in corporate America to push the envelope in interpreting the rules, she says.

In many cases the result is the equivalent of staying—often barely—within the letter of the law while violating the spirit. For precisely this reason, Barth favors a more principles-based approach.

“That’s part of what got us into this problem. Companies looked at the rules and asked, ‘How can we design around them?’ Their attitude was, ‘We’ll live within the rules, but as long as we do, let’s be creative.’ So there’s been lots of creative accounting.”

Ultimately, the reliability of both systems comes down to the same thing: honest people and checks and balances. “Corporate governance, auditors, management—all these things work together. You can’t erase the judgment, and you can’t get rid of the problem by changing the standard,” Barth notes. “But if you’ve got people trying to do the right thing, the question is, how do you put together a system that facilitates communicating the best possible information to shareholders?”

As for the Enrons and WorldComs, “They didn’t follow the rules. In that case, it doesn’t matter what kind of rules you write. If people want to defraud the system, they will.”

Another issue highlighted in the Enron case is the potential conflict between auditing and consulting services. Accounting professor Karen Nelson examined this issue and found the mere existence of a dual relationship not necessarily suspect. In her study, 95 percent of companies purchased at least some nonaudit services from their auditor. Rather, the relative importance of the company as a client of the accounting firm is more indicative of whether earnings likely were managed. Companies with the least independent auditors, gauged by those who paid the most in consulting fees versus audit fees, were most likely to meet or exceed earnings benchmarks.

“We need to take a look at the regulatory systems in place, to see how to establish a baseline confidence,” Nelson says. “These issues of fraud are not new.”

DESPITE A CLAUSE in the accounting reform law signed in July prohibiting accounting firms from offering a range of consulting services to their audit clients, neither Barth nor Nelson see a complete ban on consulting services as a magic bullet. Nelson advocates full disclosure of auditor–client relationships so investors can judge the quality of financial statements for themselves.

If it came as a shock to many that auditors’ credibility might be suspect, no one should have said the same of Wall Street analysts. Investors are reeling from losses, and in trying to assess who should be held accountable, analysts—those rock stars of the CNBC age—are ready candidates.

Management professor Maureen McNichols has followed analyst behavior for several years and says this should have come as no surprise. Analysts’ appointed task—in theory—is to provide reliable information on the financial health and prospects of companies to investors. But there has long been the suggestion that analysts might be beholden to their investment banking colleagues who garner millions of dollars on underwriting IPOs from companies the analysts cover. McNichols’ research from the 1990s showed a growing pattern of coverage of companies by analysts whose firms were affiliated with the company covered. As the nineties progressed and the pace of ipos picked up, there was great potential for the Internet and technology sectors in particular to go “out of control.”

“Even though you had a sense you couldn’t trust an analyst affiliated with the bank that underwrote an IPO, many companies were covered only by affiliated analysts or analysts who would like to underwrite subsequent offerings. You couldn’t get an independent view of their prospects,” McNichols says. And as conflicts of interest became more extreme during the Internet bubble years, there was no visible enforcement action. “No one could remember a case of an analyst brought up on charges of preparing a faulty report.”

Enforcement with teeth, such as New York Attorney General Eliot Spitzer’s aggressive investigation that so far yielded a $100 million fine (but no admission of wrongdoing) from Merrill Lynch, may temper the most egregious behavior. But this may not be sufficient to result in unbiased company coverage, particularly of IPOs. As McNichols’ research shows, “Analysts don’t have to cover any company. They can pick those that will earn money for [their] company on the banking side.” Likewise, analysts tend to follow better-performing stocks, while companies that are doing poorly tend to get dropped from coverage with no notice. “Either they’re all saying ‘buy, buy, buy’—or they’re saying nothing at all,” she notes.

Going forward, the question of how to ensure quality research remains. At issue is how research is paid for within the firm. Given that the average analyst earns nearly $200,000, while “star” analysts garner seven- and eight-figure salaries, it is a costly operation.

“It’s costly to do good research; how sustainable is that as an activity within an investment bank?” McNichols wonders, noting that research used to be subsidized by trading but that declined through the 1990s. “The issue will be how to get good research if no one is willing to pay for it—without compromising integrity.”

Beyond the analysts, McNichols says, the simultaneous failure of so many safeguards was a huge surprise. “Like the emperor’s clothes, many looked at their colleagues’ actions to assess whether a company was doing as well as it said. The auditors took assurance from the analysts; there was a cloak of legitimacy provided by the banks. It was a failure on so many sides. When so many traditionally respected parties stand up for the company, they take comfort from each other’s presence.”

If analysts are a tempting target for investors’ wrath, the issue of excessive executive compensation, particularly stock options, is equally provocative. In the early 1990s, options were thought to be a useful tool: They would align senior management’s interests with those of the company by tying their compensation to its performance via the stock price. But the system went awry. As awards piled on, so did executives’ personal stake in the share price. With so much money at stake as the market soared through the later 1990s, executives began regarding the stock price as the single most important corporate value and acted accordingly. Bad news had an instant downward effect on stock prices, creating a costly incentive for executives to squelch any negative information or even to fudge the good. It became a vicious circle.

“This mess has been fed by tremendous amounts of money; it’s a terrible contaminant,” worries George Parker, professor of finance and management, who also cites poor corporate board leadership and compromised analysts and auditors.

A FIERCE BATTLE IS BEING WAGED over how to account for the cost of options issued to employees, which virtually everyone except companies themselves agrees should be recognized as an expense in the income statement, rather than disclosed in the footnotes. Not only does that inflate the balance sheet, says Barth, but “managers can delude themselves into thinking options don’t cost anything.” If options are in the income statement, they are more clear and present for shareholders to examine and ask questions about, she adds. “People manage what they measure.” But the political opposition from Silicon Valley and the Business Roundtable has been fierce and, so far, successful. Yet a shift is under way. Starting in July, a growing number of companies, led by Coca-Cola, began announcing they would expense options.

What about the second part of the options problem, executives who cash out their options and walk away with millions even as they run the company into the ground? Parker argues that corporate officers should be required to hold their options for up to three years after they leave the company.

On the larger question of rebuilding investor confidence, there is little consensus.

Looking forward, Kramer dismisses the common argument that the issue is not more rules but better enforcement. “That argument is always used, that we just need to enforce the rules we have. Well, we never do. All professions want to ‘self-police.’ The truth of the matter is they are very good at detecting problems but no good at deterring or punishing.”

Barth is hopeful that something good eventually may come out of this awful period. “Many companies have learned a lot from this mess. They watched what happened to companies who play games, not even being dishonest but just pushing the rules. The price management pays in the marketplace when that comes out is severe.”

The other potential benefit may be a humbling of attitudes in corporate America. During the boom years, when the U.S. market was the envy of the world, “there was no room to argue for doing things differently,” says Barth. “Now, in the wake of Enron, there is room for open-mindedness, admitting that there may just be a better way to do things.”

Political scientist David Brady takes a more cynical view of what might force the system to clean up. He sees the accounting reform law signed in July as a matter of political expediency. “Congress had to pass something. The Democrats need to pick up 10 seats in the House, and they need a national issue that will give them those seats.” He allows that such a bill might go some way toward restoring investor confidence, but he doesn’t put great store in Congress to clean up corporate America’s shaky bookkeeping.

“If you want to see really creative accounting, just look at the federal budget,” Brady says. “The notion that these guys who write that are going to somehow solve the problem is really stretching credibility.”

	“Nobody could understand Enron, not analysts or anyone else. But still they trusted Enron’s management. As long as things are going well, people will believe anything.” —HARRISON HONG, Associate Professor of Finance
	“Companies looked at the [accounting] rules and asked, ‘How can we design around them?’ “ —MARY BARTH, Atholl McBean Professor of Accounting
	“We need to take a look at the regulatory systems in place, to see how to establish a baseline confidence. These issues of fraud are not new.” —KAREN NELSON, Assistant Professor of Accounting
	“It was a failure on so many sides. When so many traditionally respected parties stand up for the company, they take comfort from each other’s presence.” —MAUREEN McNICHOLS, Marriner S. Eccles Professor of Public and Private Management
	“This mess has been fed by tremendous amounts of money; it’s a terrible contaminant.” —GEORGE PARKER, Dean Witter Professor of Finance and Management (Teaching)
	“All professions want to ‘self-police.’ The truth of the matter is they are very good at detecting problems but no good at deterring or punishing.” —RODERICK KRAMER, William R. Kimball Professor of Organizational Behavior
	“Congress had to pass something. The Democrats need to pick up 10 seats in the House, and they need a national issue that will give them those seats.” —DAVID BRADY, Bowen H. and Janice Arthur McCoy Professor of Political Science and Leadership Values

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