Not a few bad eggs: Bogus Corporate Accounting Runs Rampant in America

Great Debates
1

Resolved: American capitalism is qualitatively more corrupt than it was a decade ago.

Potted History

Once upon a time (early 1980s), CEOs made a lot of money managing companies that allegedly made some very poor business decisions. To remedy this situation, (and make bundles of money besides) various corporate raiders endeavored to buy up stock in underpriced companies, fire the existing management, chop the company up into functional components, and sell the parts to the highest bidder. (Oh, and fire a lot of workers as well.)

Executive pay increased over this period.

By the early 1990s, most of the easy deals had been made as overall market capitalization advanced until it was comparable to book value. Luckily (ha!) another management theory became popular. It was proposed that shareholders could align their interests with management provided that the latter were paid in stock options. That way, managers would be rewarded for delivering better results.

Options were granted, executive pay zoomed upwards and the stock market enjoyed a very long bull market.

Alas, there was one problem, as noted in a recent column by Paul Krugman, "A system that lavishly rewards executives for success tempts those executives, who control much of the information available to outsiders, to fabricate the appearance of success. Aggressive accounting, fictitious transactions that inflate sales, whatever it takes. " Emphasis added.

Executive pay, of course, has continued to spiral upwards.

Average annual pay of the top 10 Corporate Pay-meisters
1981…$3.5 million. Nice work if you can get it.
1988…$19.3 million. Each year.
2000…$154.0 million. Yowsa. (The indicted CEO of Tyco made this top 10 list, btw. Also Gerald Levin of the AOL-Time Warner merger. [sub]Talk about synergy![/sub])

So much for the story. Now for the evidence.

  1. Enron, Global Crossing, Tyco, Qwest and of course Worldcom are currently under investigation for accounting irregularities. Today, Xerox restated their past 5 years of results.

  2. Now, I suppose the system can handle the above: company breaks rules, company is punished. Whether the associated fines and prison sentences (double-ha!) provide sufficient deterrence is another matter.

  3. More seriously, though, it appears that we’re not talking about a few bad apples. Krugman again: "Statistics for the last five years show a dramatic divergence between the profits companies reported to investors and other measures of profit growth; this is clear evidence that many, perhaps most, large companies were fudging their numbers. "

  4. My calculations shows this divergence to top $100 billion per year, or a full 30% of reported profits. I will present these figures in another post (Appendix A). This point, I must note, represents the core of my argument.

  5. Part of this divergence is made up of stock options granted to top executives. Those grants do not have to be included in costs, according to GAAP. When FSAB started to make noises about changing this situation, corporate lobbyists acting via the US Congress slapped them down. The Fed has estimated that this has led to a 2.5% overstatement of profits over the past 5 years. (Source: The Economist, “A Survey of International Finance”, 5/18/02, p. 20) Tell me, if payments to corporate executives are not costs, what are?

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The Economist printed an incredible graph in their “Survey of International Finance”. It was so extraordinary, that they actually printed it twice over the past couple of months. The source of the data is Dresdner Kleinwort Wasserstein; Thomson Financial Datastream.

The chart tracks “S&P 500 operating profits” and “Whole Economy National Accounts profits” from 1987 to Q1 2002. The former reflects the figures provided by Corporate America in their annual reports. It is based on GAAP. National accounts profits, in contrast, are based upon the tax records of all companies (and possibly partnerships, etc.). Growth in the latter provides an interesting reality check on the former.

Initially, at least, the 2 measures tracked each other very well:

1987=100 [sub]You can interpret the figures, roughly, as S&P 500 profits, US$Billions: actual, reported and the difference. See text.[/sub]

Year ending…Whole Economy Profits…S&P 500 Profits…Difference
Q1 1987…100…100…0
Q1 1990…125…138…13
Q1 1993…140…140…0
Q1 1996…225…225…0

Q1 1997…255…255…0
Q1 1998…280…280…0

Some time in 1998 though, reality shifted. The measures began to diverge. 1999 is particularly interesting: as Whole Economy profits fell, S&P reported profits rose.

Q1 1999…254…310…56
Q1 2000…275…355…80
Q1 2001…275…400…125
Q1 2002…265…380…115

The preceding is based upon my eyeballing of a 2 inch by 2 inch graph. Inaccuracies are inevitable.

By a supreme coincidence, I estimate S&P 500 profits in the year ending Q1 1987 at 103.5 billion dollars, which is close to 100. So you can interpret the middle column as billions (roughly). The left column would be an estimate of actual S&P 500 profits (as opposed to reported profits) and the right hand column would be (roughly) the difference in billions.

Basis of year ending Q1 1987 profit estimate, from www.barra.com.:
I took the market capitalization of the 500 ($2048.2 billion) and divided it by the PE (including negative earnings) of 19.79. Admittedly, the middle column above is operating profits, but I doubt whether this matters qualitatively to my story.

For those who want sharper numbers, I estimate that reported S&P 500 profits (year end q1 2002) were $393.3 billion, while their actual profits were probably closer to $274.3 billion. The discrepancy ($119 bill) is 30% of reported profits and 43% of estimated actual profits.

Future threads (not this one) might discuss, “What is to be done?” Remember, this is a fairly recent development.

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I think it’s interesting to see the trend repeating, in a way.

Look into EDS creating the EDS RMC division within the US, that a lot of former and current EDS folks think is being left to run in the red as a tax veil.

Sigh

4

Of course, the final ‘Economist’ article in that series ends with:

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flowbark – I tend to agree with you, based on my own experience in the insurance industry. Forty years ago, bonuses were relatively rare. Managements were dumb. The books might not be accurate, but the cause was generally naivite.

Now bonuses are common, ussually based on pre-set profit and sales goals. Those who operate the company set out to achieve those goals. This has led to a tendency to achieve them by hook or by crook.

As you point out, top executives have become more greedy. Some of the good ones deserve every million dollars they get. Others deserve nothing. I know of several cases where the CEO and his henchmen got many millions while the company went down the tubes.

I was a stockholder in one of them, and friends of mine were employees. Unfortunately, their top management was never investigated or prosecuted. I sure hope the guilty parties at Worldcom, Global Crossings, Enron etc. get long prison sentences.

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It is a truism of compensation that people do what they are paid to do… even if it’s not what you expected.

The canonical example is Jolly Green Giant, where the company found too many insect parts coming through the processing. So they paid workers for the number of insect parts they took out of the food. Workers were bringing insects from home, to put into the food, so they could take them out and get paid more.

Over the last decade, CEOs and upper management have been directed to increase the stock price… and that’s what they’ve done, by hook or crook, by fair means or foul. They were paid largely in stock or stock options, and so increasing the stock price meant increasing their personal fortunes. There was an underlying assumption that increasing stock price meant a strong company, and Enron and WorldCom and others have now shown the fallacy of that assumption.

And, of course, most of these executives knew exactly when to sell their stock, right before the house of cards came crashing down. Leaving all the other poor slobs holding the bag.

Now, we add to the mix, the question of what auditing firms are compensated for. The answer: certainly not for performing audit or regulatory functions. They get most of their money from all the add-ons. So, why wouldn’t they bend (or break) the rules to help their clients? That’s how THEY (the auditing firms themselves) make more money!

There’s nothing wrong with capitalism. What’s wrong are the lazy investors who assume that an increase in stock price is the same as a strong company… and the reverse, the idiot investors who assume that a workforce reduction means a strong company!

Greed on the part of the top execs, and stupidity on the part of regulators and investors, an unbeatable combination.

7

But who is the “client” ? The company Exec’s or the shareholders ?

Sure there was shareholder laziness and it was born of the longest bull market in history but false representations of company accounts also played a not insignificant role.

You also have to build in, amongst other things, how these companies were exalted by stock advisors with their own agenda. There are systemic problems beyond US accounting practices, IMHO.

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flowbark, I’m a bit muddy now in the early morning–and I appreciate your post very much. Are you suggesting that the trend reported in The Economist was very surprising? Or only that it helped to quantify something that had long been known? Because I recall reading in various places (Dean Baker’s column in TomPaine.com would probably have been one of them, Krugman might have been another, the Atlantic Monthly a third), that the stock market was valued way beyond its actual value–the number “30x” sticks in my head. I’m not trying to be lazy here but I want to make sure I understand you, as my non-specialist knowledge of these figures might be off. Where does what I recall as being the oft-cited “30x” figure correspond with (or diverge from) the discrepancy you are reporting. (Thanks in advance for explaining :slight_smile: ).

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flowbark, I’m a bit muddy now in the early morning–and I appreciate your post very much. Are you suggesting that the trend reported in The Economist was very surprising? Or only that it helped to quantify something that had long been known? Because I recall reading in various places (Dean Baker’s column in TomPaine.com would probably have been one of them, Krugman might have been another, the Atlantic Monthly a third), that the stock market was valued way beyond its actual value–the number “30x” sticks in my head. I’m not trying to be lazy here but I want to make sure I understand you, as my non-specialist knowledge of these figures might be off. Where does what I recall as being the oft-cited “30x” figure correspond with (or diverge from) the discrepancy you are reporting. (Thanks in advance for explaining :slight_smile: ).

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Yeesh–I clicked once! I clicked once! <off to get way more coffee>

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Who knew about these companies though? The investors were defrauded. I don’t think it’s fair to blame them.
It’s simply a case of power corrupting. I’m sure we’ll see yet another round of ad hoc duct tape from the legislators in response to this latest manifestation.

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december “sure hope(s) the guilty parties at Worldcom, Global Crossings, Enron etc. get long prison sentences.”

So do I. But I doubt that it will happen. And even if it does, it would address only part of the problem.

Today’s NYT (Saturday) noted a hedge fund manager who was circulating a list of 20 methods of massaging earnings.

The problem is only partly a matter of laws being broken. The problem is a system of accounting that allows for the publishing of misleading numbers. This system is, in turn, supported by a corrupted FASB and legislature.

Dex: “Greed on the part of the top execs, and stupidity on the part of regulators and investors, an unbeatable combination.”

That certainly is unbeatable. And let’s not forget a press that prefers happy-talk over tough analysis. Or financial analysts who essentially function as marketing departments for their company’s underwriters. (See associated thread(s)).

Let’s also remember that many investors made a lot of money for a few years trading stocks on the basis of “momentum” as opposed to “fundamentals”. Indeed, for a while they outperformed those who preferred to take a sharp pencil to the 10-K’s and annual reports of Corporate America.

So while there’s no shortage of candidates for blame, I would argue that cleaning up the accounting standards -and strengthening financial oversight- will play a critical role in reforming the current system. Investor education, in contrast, will play a relatively small role.

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Mandelstam: I’m not sure what you’re asking, but let me make a stab.

  1. Long term price earning ratios hover around 15. During the 1990s they rose to around 30 (for the S&P 500). I think that’s the number you’re thinking of.

Note, however, that the price that a rational investor would be willing to pay for a dollar’s worth of earnings (over the past year) is a function of :

  1. the interest rate (i.e. investment alternatives in the bond market)

and

  1. the forecasted growth of earnings.

Productivity growth rebounded after around 1995, after a 20 year era of lower growth. Long term interest rates fell during the 1990s as well. Thus, there was justification paying out higher PEs in the 1990s than investor paid previously, due to the different investment environment.

Dirty little secret: Take a “present discounted value” formula from an introductory economics course. Transform so that a PE ratio is a function of projected growth rates. The resulting formula is extremely sensitive to estimates of long term future earnings growth. This is especially awkward, since the latter is (in turn) rather difficult to forecast.

Conclusion: Investors can be forgiven for tossing out tools of “fundamental analysis” in favor of quasi-rational approaches.

The preceding, however, is wholly separate from the trend reported in the Economist. Let me contrast.

  1. There was a debate about whether the stock market was over-valued, based on what prices were paid for reported earnings.

  2. In contrast, the graphs in the Economist suggest that reported earnings themselves were massively overstated. Different point. (Incidentally, Krugman’s report on this “divergence” came after the initial publication of that graph in the Economist. Hey, he reads the financial press.)

14

Sorry, but this argument is laughable. Investors are intrinsic to capitalism: in practice they will prove to be lazy, energetic, smart, stupid, successful and otherwise. Furthermore, blaming investors isn’t exactly a policy prescription.

The fundamental error here is assuming there is but one capitalism when in fact there are many. The bank-driven method of allocating capital is different from the equity-driven US model. Both are different from the South Korean and Japanese models.

It is my fear that an equity-based system, where investors practice low direct oversight but high entry and exit, depends crucially upon clearly published accounts backed by a serious regulatory framework. It is my hope that reform will occur before this hypothesis is fully tested.

15

I think it’s one thing to say that investors were “stupid” with respect to dot.coms, and another thing thing to say that they were “stupid” to trust the analysts and other supposed experts (including in the press) that continued to be bullish about the very stocks (Enron, telecommunications) in so much trouble.

OTOH, I do think there was no shortage of talk of a bubble-market–even Greenpsan said something of that sort (“overexuberance”, no?) when he raised interest rates–for those willing to listen.

flowbark, thanks, I searched around for the mysterious #30, which definitely did have to do with price/earnings ratio being out of whack, and I wasn’t able to find it. (I did discover one article I’d read in the Atlantic Monthly a few years back that was arguing that P/Es could be ignored and perhaps one of the rebuttals to it was what stuck in my mind.)

Your distinction was, in any case, exactly what I wanted to know, so thanks. That is, what I’d been reading about so frequently was to do with overvaluation based on P/E ratios, and what The Economist (and later Krugman :wink: ) reported on was a a vast overstatement of “E.”

16

Permit me to talk out of both sides of my posterior.

  1. When I read that the average CEO on the top-10 pay chart received $150 million for a year’s work, it seems borderline preposterous to believe that anyone’s labor can be worth that much.

  2. At the same time, I have no problem with Warren Buffet accumulating some $38 billion (?) over a lifetime of public service. (Yes, I’m claiming that the virtuous capitalist operating in an open and transparent society will indeed serve the public trust.) The jury is still out on Jack Welch, IMHO.

I recognize that the above 2 statements conflict with each other.

17

For anyone who didn’t catch the June 9 New York Times article on CEO compensation, it is well worth the $2.50 you’ll have to pay to read it from the archives (or a trip to your local library to read it free). It’s called “Heads I Win, Tails I win,” the author is Roger Lowenstein, and it’s about the CEO of a very typical company, SBC, whose compensation soared even as the company performed did less and less well. (To his credit, at least he wasn’t cooking the books; but then he didn’t seem to have to.)

But the morality tale is nowhere near complete until you read the article in tandem with this disturbing article on how WalMart regular cheats $7.00 an hour employees into working extra hours off the clock. Managers are basically pressured into doing this for fear of losing their jobs if they payovertime.

18

Fascinating thread. By the way, my understanding is that compensating executives with stock options etc. became much more popular after Congress changed the tax code, some time in the 1990s, to prevent corporations from deducting fixed compensation in excess of $1 million.

Can anyone confirm this?

19

Lucwarm Here’s my understanding. In 1993 Congress capped the tax deductibility of executive pay at $1 million dollars.
http://www.taxfoundation.org/frontandcenter10-99.html

Business sidestepped this rule by granting stock options: when they are granted they are a taxable event for neither firm nor individual. http://www.financeprofessor.com/summaries/Murphy1998.htm

From the last article, "There are many theories (better alignment, bull market) to explain the tremendous growth in option use. "

Indeed. As I have noted earlier, stock options were (and as far as I know continue to be) popular with management theorists. So I don’t think we can pin the blame on Congress. Still, this point seems relevant when discussing possible reform.

My characterizing of certain comments as, “laughable” was uncalled for. I do however wish to emphasize that categorical statements regarding capitalism are problematic, as that term covers a variety of economic systems. I would venture to say, for example, that capitalism as practiced in the US from October 1929 to February 1933 doesn’t work very well.

To be more specific, capitalism has certain vulnerabilities which need to be addressed. One is its tenancy to investment booms and busts, treated with counter-cyclical fiscal and monetary policy.

Another is “liquidity traps”, treated by policy makers who are wise enough to avoid deflation like the proverbial plague.

Cronyism, corruption and the alchemy of transforming money first into legislation then back into money are other vulnerabilities. These are not unique to capitalism, of course.

Then there are Principle-Agent problems, which apparently resist simple fixes.

20

<<The problem is only partly a matter of laws being broken. The problem is a system of accounting that allows for the publishing of misleading numbers. This system is, in turn, supported by a corrupted FASB and legislature. >>

I disagree. I know a lot about accounting and FASB actions in my own industry (property-casualty insurance). There have always been lots of loopholes through which misleading numbers could be published. The FASB has changed the rules and eliminated some of worst of them.

The problem is that it’s impossible to eliminate all the loopholes. Acocounting is just too complex and there are too many judgements that inevitably must be permitted. Maybe the FASB could do a better job, but I’m not sure. In any event, they have been trying and they’re having some success.