Don’t Account Out the Market
Wall Street will make sure that corporate America gets transparent.

By Victor A. Canto and Peter Mork of La Jolla Economics
February 20, 2002, 8:00 a.m.

ro-regulation groups credit the government with providing the solution to the corporate fraud problem that can be traced to the 1929 crash. At the time, allegations of widespread fraud forced publicly held companies to submit regular reports that met certain standards.

Congress did first delegate the FTC to regulate accounting. And the job was later passed to the SEC and in the end to an independent entity, the FASB (Financial Accounting Standards Board). All of which was good news. The new transparency rules financed the emergence of the U.S. as the preeminent economic power in the world.

Yet free-market economists need not concede this success to government regulation. The practice of audited financial reporting was not initiated by regulators. In fact, it was a voluntary action on the part of U.S. Steel that pioneered the practice at the turn of the century. Market forces identified the need and provided a solution. The government actions only accelerated the move towards transparency.

During the last two decades, we've seen an increasing focus on the incentives in executive compensation plans. Unfortunately, long-run value creation was not the only way that management could increase compensation. Management could also benefit from raising share prices in the short run. Options could be exercised, capital could be raised, and so on. There was continuous pressure to produce a share-price hike, even if it was of a temporary nature.

Then, the economic environment of the 1990s led to a significant expansion of the investment horizon. The future began to weigh much more heavily on current valuations. Corporations were under greater pressure to deliver the earnings estimates and/or beat them. Those companies who failed to meet their estimates faced the heat on Wall Street. And in response to market demands companies began to "manage" their earnings.

Here's an analogy. Most accountants automatically estimate an individual's taxes under alternative scenarios (the simple form, alternative minimum tax, etc.). Corporate accountants do the same. And if a personal accountant has a pretty good idea of an individual's future income, he can offer planning that can help smooth out the taxable income stream. So the question some corporations have asked is why not do that for earnings, too?

Looking back it is clear that corporations did in fact begin to do this. In addition to the GAAP earnings — or earnings calculated using the Generally Accepted Accounting Principles — we began to see a proliferation of profit reporting variations where one time charges became the norm. The pro forma reporting era had begun.

To continue with the tax accounting analogy, a criticism of pro forma reporting is that some companies did not also report the income/earnings as they were calculated under the various alternative scenarios — much like accountants do when they calculate our taxes. If the corporations had also simultaneously reported the earnings under GAAP, investors may have been able to identify those companies who were managing the short-run profits without regard for the long run. (This does not rule out getting fooled by illegal or dishonest behavior.)

In the aftermath of the Enron debacle, the financial press has focused on companies that may have somewhat similar — and hopefully less significant — accounting problems. In fact, some reports suggest that the difference between the pro forma and the GAAP earnings of the S&P 500 companies may be as high as 70%. Other people estimate that the Nasdaq 100 companies reported losses to the SEC that were as much as four-times larger than the losses reported to shareholders. The implication is that the accounting problems go well beyond Enron and a few other companies. If the problem is as large as reported by some analysts, we're going to see the carnage in the stock market.

Greater transparency and more accountability and a change in the incentive structure are needed to alter corporate behavior. The market is in the process of providing a solution — the corporations that played the short-run game will suffer the market wrath. And there are some simple ways to identify the likely losers. One easy method is to look at the annual reports and count the footnotes. Those with the least footnotes are likely to have a cleaner balance sheet. The market has already punished some of the companies that have used an abundance of footnotes in their reports.

More, investors must now also be on the watch for pro forma reporting, defined benefit plans, and explicit or implicit un-hedged positions. Regulation may force greater disclosure and transparency — but that will not be enough. Market forces will also be key. With an investor class remaining watchful, the offenders will certainly be punished.