Business

Games auditors play

The Enron debacle has finally focused attention on the accounting follies that fed Wall Street’s late-’90s frenzy

Donald coxe March 4 2002
Business

Games auditors play

The Enron debacle has finally focused attention on the accounting follies that fed Wall Street’s late-’90s frenzy

Donald coxe March 4 2002

Games auditors play

The Enron debacle has finally focused attention on the accounting follies that fed Wall Street’s late-’90s frenzy

Donald coxe

How should the judges assess the real value of S&P? If you mean Salé and Pelletier, the answer seems to be, “It all depends on what arrangements the judges made to determine the outcome.”

If you mean the Standard & Poor’s 500, then the answer seems to be, “It all depends on what arrangements the accountants made to determine the outcome.” Many companies in that august group have been manipulating their scores on a scale that makes French and Russian skating judges look like saints by comparison.

The Enron debacle has finally focused attention on the widespread accounting follies that fed the Wall Street frenzy of the late 1990s. The so-called “Clinton bull market” took on the character of its namesake—brash, energetic, optimistic, mendacious and loaded with bull. Substandal elements of the accounting profession, supposedly the independent scorekeepers and judges of corporate behaviour, were sucked into this long, Fellini-esque orgy.

Disaster was the inevitable outcome.

The U.S. has begun to count the costs to the economy and financial markets of an era in which many companies became wizards at ensuring that their costs went uncounted. Enron supplied villainy and venality on a Texas-sized scale, arousing the public and politicians. But even if every charge of self-dealing and fraud were proved, it wouldn’t explain how the seventh biggest company in the U.S. vapourized.

As Tennessee Republican Senator Fred Thompson remarked, what was really shocking was not so much what they did that was illegal, but the things they did that were legal. That is what roils the stock and debt markets. No serious commentator argues that hundreds of U.S. companies are run by crooks. But many observers (including me) believe that hundreds of U.S. companies—including almost all technology companies—have been issuing misleading financial reports that overstate their earnings, sometimes wildly.

What are the games companies (and their auditors) play? The list, regrettably, is long, but I shall discuss only two, perhaps the most prized recipes for culinary accounting.

First is the way U.S. companies account for stock options in their earnings statements. They don’t. All those corporate insiders who became (and still are) very rich through exercise of stock options didn’t cost stockholders a nickel, according to company reports. (They even get tax deductions, thereby shielding other earnings from taxes.)

Example: assume CEO John Chambers of Cisco Systems Inc. exercises options on a million shares of stock at $10 when

Cisco is trading at $50. Cisco may offset that issuance of a million shares by buying that number in the open market at $50 or so. The company’s accounts show an increase of $ 10 million in paid-up capital, but no costs for selling the company’s biggest asset—its stock—at an 80 per cent discount, or for replacing those shares with shares bought at five times their price.

We’re talking of tens—perhaps hundreds—of billions of dollars of compensation earned by corporate insiders that doesn’t show in the companies’ financials. Why? It’s not because the self-regulating board of the accounting profession didn’t try. The Financial Accounting Standards Board, based in Norwalk, Conn., tried in the early 1990s to get companies to show those costs in their earnings statements. But the technology companies and their Wall Street allies led an assault on the board’s proposal. It culminated in a resolution passed by a vote of 88-9 in the U.S. Senate that blocked the board from imposing the rule. The leader of that fight in Congress: Connecticut Senator Joe Lieberman, who’s now one of those baying loudest against Enron.

Had that rule passed, we’d never have had the tech mania, which would mean we wouldn’t have had the recession either. British accounting expert Andrew Smithers says Cisco would have reported a US$4.9 billion loss instead of a $1.3 billion profit had the rule been in force in 1998. (At the height of the mania, Cisco was briefly the most expensive company in the world, worth more than either Microsoft or General Electric.) Almost all tech companies whose shares skyrocketed would have had major earnings cuts had the rule existed. In other words, this most dynamic of industries has been getting away from reporting 100 per cent of the costs of the biggest component of its entire compensation system—stock options.

Another favoured game is Special Purpose Enterprises, or SPEs. These are companies or partnerships with at least three per cent outside ownership that are set up off the parent company’s balance sheet. The debt for these enterprises usually doesn’t show on the company’s balance sheet, and the profits or losses can be recognized by the parent more or less at will.

The games may be up. Because of Enron, there’s a chance the accounting standards board will try to reissue its options rule and come up with constraints on SPEs. Bad news for tech stocks and crooks. Wonderful news for investors. Great example for the Olympics.

Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-based Jones Heward Investments.