Michael is back and will be resuming his normal level of blogging. So, my time blogging is at an end for now. Thanks to Michael for giving me this opportunity again. It was fun. I cannot imagine how Michael summons the time and intellectual resources to run this blog solo on an ongoing basis. And, of course, much thanks to all of you who read my posts. I wish that something was going on in taxland, but it isn't. Accounting is deadly dull, but, as demonstrated by the consequences of all of the recent accounting problems, real important to our economy. Let me plug the AAOWeblog again as a great place to keep up on what's happening from a reasonable perspective.
Finally, a correction: Karen commented on my July 22 post pointing out that, therein, I misconstrued an earlier comment that she made. Please consider reading her comment.
Thanks again. I hope that you all have some fun in what is left of Summer. Barley hasn't indicated whether I will be allowed to....
So, here is my fix. It is exactly what one would expect from a former US Treasury tax lawyer: have the SEC affirmatively protect the small investor with regard to financial information of public companies by nationalizing the audit function.
Companies would be required to prepare financial statements that, in management's judgment, best present the company, not that are merely "generally acceptable." (See my post of July 8.) The accounting rules would be set by a government agency (the SEC), not a private group, as today (the Financial Accounting Standards Board). These rules would be codified. The SEC, not private firms hired by the audited company, would do all audits. In appropriate cases, the SEC might even comment publicly on a stock price range that is appropriate in light of what is learned during the audit.
Whoa, socialized capitalism!?!? There's more has a defense.
The most obvious critique is that this would be prohibitively expensive. And it would be spendy (as they say in Minnesota), no doubt. But, my proposal would replace the already really expensive private audit process. The SEC could use the money that companies currently are spending on huge accounting fees. Today, FASB and the Public Company Accounting Oversight Board (which licenses the auditors) are supported by a fee that the SEC collects from public companies. (The PCAOB structure is being attacked in the courts as being unconstitutional. I think that this litigation could be very interesting. Michael, oh Administrative Law guru, what do you think?) These fees could be expanded, perhaps with no net drain on companies. In any event, safer markets would encourage more investment, perhaps even increasing the pathetically low US saving rate, making any net cost of my proposal less troubling.
Another bureaucracy? Hey, I worked at the US Treasury. I had dealings with the SEC. I know first hand of the problems with government agencies. But, I also have had lots of dealings with the big accounting firms. They have their own bureaucracy that confounds reason and efficiency every bit as much as at the IRS and the SEC. (Admittedly, there are numerous government agencies that run much worse than the big accounting firms, however.)
Executives will scream that having the SEC looking over every business decision will stifle management's entrepreneurial spirit so as to seriously hurt the US economy. Unfettered foreign competition will eat our financial lunch. Maybe. But, US firms should have a lower cost of capital, which is one heck of an advantage. And, as recent events have demonstrated, many managements of public companies are driven, not by free-wheeling entrepreneurship, but by unbridled self-interest. Think of all of the talent and resources spent cooking books and in doing transactions that made no business sense in order to get an accounting advantage. A wee bit of oversight actually might make managements get back to making money, which would make companies more productive.
All of which may just demonstrate that I really am no expert on corporations.....
Michael should be back in a couple of days, so it is time to start winding up. Which gets back to the my July 9 post. There, I identified my two key questions: "Is it possible to come up with accountings that investors can understand? If not, what to do?" Since then, we have been exploring the first question. Draw your own conclusion. We now turn to the second question: what to do if we cannot fix the current regime.
Karen's comment on my post yesterday suggested that we should get rid of the public corporation, as it no longer serves a public purpose worthy of holding funds from the public: "I really wonder if it's time to *rethink* this legal fiction and concept of these entities that are now no longer "Citizens" of any particular country...but Global Actors with allegiance to only their Corporate Profit maximization and those of their CEO and management at the expense of even their sponsors (shareholders)." To this point is the movie The Corporation, which certainly is worth viewing. I am not an expert on corporations. But, in the abstract, Karen's comment has a lot to recommend it. Unfortunately, the public corporation plays a central role in postmodern capitalism. Removing that role would make a radical change in the play. So, less radical solutions are worth thinking about.
More after clicking.
A still-radical, but less radical than Karen's, solution is to get the little guy out of the way of the train: Individuals with a net worth below a certain level (and without an MBA or a PhD in economics) would not be allowed to buy stock by themselves. (The Brad DeLong post linked to in my post of July 17 suggests that an MBA may not be much help:)) Purchases with the help of a regulated investment advisor would be allowed, as would owning approved diversified mutual funds.
Which raises a classic American question: Should we interfere with folks' freedom in order to protect them from themselves? We make people wear motorcycle helmets in some states. (This also reduces public health expenditures, of course. Saving folk from getting hosed in the market may be good for society at large, but not as good as keeping people from brain damage in a motorcycle accident.) I think so, but I recognize that reasonable people might disagree.
Which highlights my favorite aspect of the entire accounting mess: what it says about privatizing Social Security. Think about the absurdity of having tax dollars managed by individuals based on the current accounting rules. As Karen's comment catches, this turns the idea of the public corporation on its head.
Tomorrow: An even less radical solution that business may find even more offensive.
Yesterday, the SEC bought the first criminal charges against a Gregory Reyes, the CEO of Brocade Communications, the company's CFO, and Brocade's VP for human resources for options backdating. This is the first criminal action brought with regard to the growing option backdating scandal. The SEC also indicated that at least 80 companies are under investigation. On Wednesday, the Wall Street Journal had an article on how the big law firms are generating huge fees as companies prepare for investigations into their options practices. So, this seems like a good time to review what the problems are here.
There are two problems: lying and theft, as to be discussed after the break.
A primer on backdating is helpful: The shareholders of a corporation authorize paying executives with stock options. These options give the executive the right to buy the employer's stock at a fixed price at a set future date. That price usually is the price that the stock is trading at on the day that the option is awarded to the executive. Customarily, the employee loses the option if her employment terminates before the option can be exercised. The shareholders usually authorize management to award options. The idea underlying options is that they give key employees an incentive to work harder -- particularly to work harder to get the company's stock price up -- by letting the employees share in any increase in the value of the company.
With backdating, a company's management grants options to an employee, say at year end, but pretends that the options were awarded at an earlier day when the company's stock was at a lower value. This gives the employee an option to buy the stock at the old, low price on a day when the stock is trading at a higher price.
Which gets us to the lying.: The shareholders' authorization was to grant options at the stock price on the award day, not on an earlier day. Thus, management had to lie ("backdate") for these options to seem valid. Also, even under the old rules for accounting for stock options, the discount was accounted for as an expense (prorated from the grant day to the exercise day). Backdating hid this expense, making these companies seem more valuable. For example, in Brocade's case, for 2002, proper accounting under the old rule turned the improper, originally-reported $68 million profit into a $951 million loss. (In some cases, the fraud also kept the companies from claiming huge, legitimate tax deductions, while hiding the employees' tax liability.)
And then there is the theft: First, the employees were buying stock at unauthorized discounts. Second, the employees didn't earn what they were taking. By the time the options really were awarded, services already had been performed. The options could not have incented the employee to work harder from the backdated day to the real grant day, as the employee did not own the option in this period, yet the employee got to enjoy any stock value run-up in value during this period. (The employee was with the company during this time and could well have contributed to the run-up, but the later-granted option played no role in motivating this performance.)
Some argue, including commentors to my earlier posts, that stock options cost nothing, as no cash is consumed, so that compensatory options really aren't a problem. The same logic would suggest that if an employee was paid in gold there is no expense. Options are a valuable resource that the company otherwise could sell for cash, just like gold. The metaphysical weirdness that a company cannot own options on itself should not distract from the fact that options are every bit as much a resource as gold bullion. (An option is a contingent claim on a share of the corporation's "real" assets.)
A related scandal is worth note. Companies granted a lot of options after 9/11, when the value of all companies was low. No fraud or theft was involved, per se. But, this practice still is troubling, as any run-up in stock values from 9/11 to a more normal economic climate reflected general market conditions more than the performance of the company. The executives were using company resources to bet on the economy as a whole, not to be incented to work harder. I do not know if any companies had to go beyond their shareholders' authorizations to grant these 9/11 options.
I am in the process of relocating my home office from the dining room to a bedroom, so today's post will be sorta short. Fortunately, there is a development in the papers worth a brief note. Today, the Wall Street Journal reported that it is likely that the SEC will withdrew a proposed rule that would have required companies to disclose the compensation of up to three non-management employees, if they are paid more than management. This proposal became called the "Katie Couric clause" for obvious reasons.
This seems like a bad thing. Admittedly, the principal reason for disclosing employee comp is to make sure that management is not ripping off the shareholders. But, there is another reason. As I have been arguing, investors in the new economy need a variety of non-traditional information to evaluate a company. Mega-star employees like Katie Couric and Howard Stern are key resources. The value of these resources depend upon what they cost. Hence, this comp info would be very useful to investors.
Shawn, in a comment, said that Generally Accepted Accounting Principles (GAAP) are satisfactory to compare apples to apples. That is not the case in the new economy. For example, during the tech bubble, GAAP was unable to distinguish a winner high-tech start-up from a loser. Here is another.
For more, let me give you a link to my favorite accounting blog AAO Weblog
I want to go down a tangent a bit and talk about accounting for taxes. This topic is in the media this week because on July 13 the Financial Accounting Standards Board changed the rules, effective next year. (It is funny that the interpretation released on July 13 says right on the the front that it was issued in June. Backdating may be in the air these days.)
Accounting for taxes is tricky for two reasons: First, the accountants want tax expense shown on the financial statements at the same time that the associated pre-tax profit is reflected. For a number of reasons, tax payment timing varies considerably from the timing of accounting profits. Second, the concern here, a company's ultimate tax liability is uncertain. Firms take favorable positions on returns and then end up paying more after audit, and perhaps after having to go to court against the IRS.
Whether companies show low tax expense on their financial statements based on aggressive positions and force investors to gamble with the tax man is discussed below.
Prior to the July 13 interpretation, most companies only showed an uncertain tax liability if it was about 70% likely that they both would be caught and then lose. Footnote disclosure was non-existent, as that would be a roadmap for an IRS audit, perhaps even supporting tax penalties on aggressive positions. This was not a big deal until the growth of corporate tax shelters in the 1990s dragged companies into very aggressive tax planning. Big companies were buying crap. As these companies started losing cases that resulted in huge tax liabilities, shareholders got a surprise. For example, in the first big case, shareholders of Colgate got hit indirectly with a $30 million tax bill.
So, the new rule. As to a given tax position, a tax liability must me shown unless, assuming that the relevant tax authority identifies the issue, it is over 50% likely that the company will win. What a change! Very pro government. An IRS agent need only compare the taxes on the financial statements with those on the tax return (adjusting for timing) and ask for the difference. Very pro investor. As to any other liability, say for a toxic waste spill, the company takes likelihood of getting caught into account in evaluating the risk to the company. Now, not with taxes! I understand that pressure from Treasury was partially responsible for tax liabilities being treated so specially.
I have been arguing that investors need more than just raw financial data. (Of course, CEOs like rah, rah data...) Investors also need financial statements that analyze, organize, and compress all of this information. But, I am not arguing that we should let accountants do all of the valuation work. That is "mark-to-market" accounting, which was the most important factor in Enron's problems. [Haters of early 1990s pop music insert Funky Bunch jokes here.]
Under mark-to-market accounting, all of a business' assets (and liabilities) are revalued ("marked") to fair market value. Any increase (decrease) in the net value is added to (subtracted from) any profit distributions to shareholders (like dividends and share buybacks) in determining the business' profit or loss. (Adjustments also are made for share issuances and the like.)
In theory, mark-to-market gives investors the most useful information, since it presents management's stewardship of all of the busines' resources, not just of financial transactions. In reality, however, matters are much different.
Reality is in the footnote.
Enron, with the SEC's blessing (!!!!), marked a wide variety of assets to market. For example, when Enron signed a long-term contract to provide power out of a new power plant still under construction, they immediately recorded all profits estimated to be made under the contract. One condition that Jeff Skilling put on joining Enron was that he be allowed to use mark-to-market. Skilling thought that the deal was all that matters. Executing the deal (and actually making money) was for the little people. Mark-to-market enabled Skilling to book the deal and not worry about reality. It was when reality intervened and his deals started hemorrhaging money that he had to turn to Fastow for a little SPE juice (not only for profits, but also for the balance sheet and the operating cash flow portion of the cash flows statement).
What was wrong? Easy: there was no market to mark to. Enron created the markets used to determine the values of its assets. These values were Enron's dreams, not money in the bank. Today, brokers and dealers in marketable securities and commodities use mark-to-market. They can look in the Wall Street Journal or on Bloomberg to get values. (OK, if one had to dump a large holding, that could push the price down, but that is a relatively small glitch in the scheme of things.) In contrast, Enron made up its own numbers! And this was the SEC in the Clinton Administration.
Which gets to the point here: Accountants are not appraisers, actuaries, investment bankers, or economists. They cannot value things for which there is no ready market. As to these things, accountants need arms'-length transactions to evidence value. This means that accounting numbers are not as useful as they could be. This also means that financial statements are not just some CEO's dreams.
I want to supplement prior discussion at two points: First, Michael was kind enough to email me from the ether to call my attention to a post 2 days ago on Brad DeLong's blog, at DeLong Post He discusses an experiment that tested smart people's ability to make simple investment decisions. They do not do well. An article quoted concludes that most people cannot be trusted to invest their own money and should hire investment advisors. If so, one legal regime would require small investors to use an advisor, as current law does (or at least used to when I did these deals in practice) if they want to buy a private placement. Then, accountings could be written for investment advisors. Accounting reform still would be needed, as everybody getting snookered by Enron suggests.
CFO below.
My second supplement is to call your attention to an article in the current CFO magazine, which is available free online at CFO on GE The article goes into more detail about how GE and others measure customer satisfaction, which was discussed in an earlier post. The CFO article focuses on using the internet to communicate with customers to get easier, and therefor more, input.
Also, on the same page that is linked to above is a link to another article on CFO.com which talks about how CFOs should temper CEO's optimism. Now they figure it out. (Remember that Fastow was Enron's CFO.) It never will happen, sadly......
My pet gripe in the whole accounting simplification debate is how business and the accounting industry citie Enron as evidence that we need less detailed rules. They argue that detailed rules provide a roadmap for technical compliance that violates the spirit of the rules. In contrast, simple rules could not be gamed. In fact, Enron demonstrates the need for detailed rules.
Enron is best known for its use of Special Purpose Entities (SPEs) to manipulate accounting results. Enron would own most of a subsidiary corporation or partnership, but outsiders would have voting control, so that the entity would not be treated as part of Enron on its (consolidated) financial statements. Practice at the time was that outside investors put up at least 3% of the equity capital. In fact, in many of the Fastow/Enron deals, outsiders did not, and would not, put up 3% because the deals were so screwy. Clear rules worked. (Substantive accounting rules cannnot stop fraud.) End of story.
But, argues business, the 3% was so tempting that it encouraged the deals. Rather, if the rules left the separateness decision to the accountant's judgment, she would have stopped these deals. Wrong! Details below.
The 3% rule came from a 1990 pronouncement of an ongoing task force on emerging accounting issues that was formed by the Financial Accounting Standards Board. This pronouncement dealt with SPEs formed to do sale/leaseback transactions. (The SPE would lease debt-laden property to its economic parent in order to get the debt off the parent's financial statements. Tax benefit transfers to the outside 3% usually also were involved.) The exact language of the pronouncement was:
The initial substantive residual equity investment should be comparable to that expected for a substantive business involved in similar ... transactions with similar risks and rewards. The SEC staff understands from discussions with Working Group members that those members believe that 3 percent [now 10 percent] is the minimum acceptable investment. The SEC staff believes a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated {with the SPE's activities]...
Enron's SPEs did incredibly risky hedging, not safe sale/leasebacks, and yet nobody even thought about requiring more than 3% outside equity. In other words, the rule applied in Enron had a non-detailed facts and circumstances test in addition to the 3% rocky shoal, and the non-detailed rule failed completely!
So, it is time to make my central point about accounting: The more work that the accountants do, the less work that the user has to do.
Accountants could just give investors the raw books and records. (As discussed in an earlier post, modern computers probably could handle this info if in a standard format, but something still would be missing: analysis by those familiar with the day-to-day of the business) Accountants analyze, compress, and format all this information so as to make it usable by investors and other consumers of financial information. It is work hard making a lot of data tell the kind of story that the users need. Business managers do not want to pay for this hard work. Unfortunately for them, their bosses, the shareholders, need for this work to be done in order for them to be able to police management's stewardship effectively.
Unaccountable accountants below!
To be useful, accounting must be comparable across companies. If 2 otherwise-similar firms use different accounting rules, it is hard to figure which is better run and which is the better investment. Yet accountants want fewer and less detailed rules. Of course, detailed rules can be arbitrary. But, the accountants do not argue that current accounting principles are arbitrary. No, the accountants argue, the current rules are just too hard to work with. Trust an accountant's judgment rather than make-work rules. But, it is unlikely that accountants across the country will exercise their judgment in a uniform a fashion in the absence of detailed guidance. In the current debate, simplification is the enemy of comparability -- and therefor is the enemy of usefulness.
Tomorrow: Accounting rules and Enron's shell entities.
After much backing and filling, it is time to get serious about talking about financial statements that the average investor can understand -- simplified accounting. This is not what an accountant means when she talks about simplification, however. To her, simplification is anything that makes her life easier: particularly, fewer and less detailed rules. In almost every case, the two views of simplification are at war. That will be the topic tomorrow.
There is one, easy first step toward real simplification: standardization of the form of financial statements. Today, no 2 companies' financial statements look alike. The statements themselves have different names. Microsoft's "balance sheet" is GE's "statement of financial position." Also, the items are presented differently using different language. Microsoft's balance sheet shows 12 types of asset. GE, which is a much more complicated empire, has only 11. (GE's "other assets" are almost twice the size of their property, plant, and equipment.)
More in the footnote.
Further simplification can be achieved as part of this standardization. The categories of the items measured and disclosed should be chosen so as to be optimally useful. For example, any investor should know what "property, plant, and equipment" are. This is a useful category. In contrast, the largest type of asset on Enron's financial statements right before the bankruptcy were "assets from price risk management activities." Much evil slept in this black box.
Which gets us back to our earlier discussion of whether it is even possible for the average investor to understand modern business. Perhaps it is not possible to come up with a comprehensible standard form for the financial statements for all businesses. But, of course, nobody has tried. As a lawyer, I cannot understand what accounting regulators have been doing for the last 73 years (since the first federal securities act).
Yesterday, I wrote about how companies are measuring customer satisfaction. This is an example of the variety of useful information that investors might find helpful that are not required to be collected and disclosed today. Another example is new metrics that quantify the success of a company's development of technology (research and development and all that goes with them). And so on.
Which gets me back to my discussion about a week ago of the goal of financial disclosure, which is to help investors value stocks and bonds. These newer metrics are not measured in dollars. There is no precise way to use this information in valuing a company. (As compared to, say, accounting earnings; which can be converted into a value of a company just by multiplying by them by an average of the price-earnings ratios of similar companies.)
Nothing below. Don't look....
But to reject the disclosure of this information because folk don't know how to use it is not right. People got comfortable with price-earnings ratio analysis only after there was a wealth of public earnings information over a number of years that could be analyzed and valuation models tested. The accountants have rejected these new metrics out of hand because they are not founded in accounting records, and the accountants thus far have had a monopoly on the numbers side of securities disclosure. That does not mean that it makes sense for that monopoly to continue, particularly when, as in the tech bubble, the monopoly works to undermine our public capital markets. New dollar-based, non-accounting measures of components of business value must be developed. Collection and public disclosure are a necessary first step.
Tomorrow: Can accounting be simplified?
Sorry my post is so late. I used Atlantic Broadband's server problems this evening as an excuse for a nap. My one-year-old, black lab mix, rescue dog just exhausts me.
Yesterday, I started ruminating about how one helps investors understand a business' principal investments in the new economy: a business' intangible assets. Monday, The Wall Street Journal (on page B3 of the print edition) had an interesting article about this. (Can't provide a free link, sorry. The article is only available online with a pay service, and I do not want to cause Michael problems by violating a WSJ copyright.)
The article discusses how to measure customer satisfaction. A satisfied customer is likely to become a repeat customer or recommend the company. Satisfied customers make a business more valuable, as they mean future business.
Big companies, like GE and Enterprise Rent-A-Car are learning a lot about how their businesses are doing by polling customers and asking them to score the companies on a 1 to 10 scale on a few simple questions, such as how likely that the customer would recommend the business to a friend. These customer polls generate numbers, although not in dollars. Numbers beyond the domain of accountants.
More apres click.
The obvious question is whether all companies should be required to do similar polling and provide that info to investors. Sounds like government meddling with business. That's what business said about the securities acts in the 1930s, too. Not worth the money. That's not what companies that have tried it believe.
Another problem with this information is that it is separate from the financial statements and is not in dollars. There is no ready way to use the info to temper the accounting numbers in valuing a business. Customer satisfaction data could just confuse investors. More work clearly is needed, particularly on converting customer satisfaction into dollars. But, it is clear that investors need some information about the intangible values in businesses and traditional accountings do not do so. Think about how, during the tech bubble of the 1990s, a joke high-tech business and a winner had very similar financial statements. The accounting statements were useless. A great series of Doonesbury cartoons had Doonesbury running a high-tech firm and trying to lose more money so as to look more like a successful bubble firm. Something should be done to help investors here, and the accountants, who lack the required expertise to act here, are ignoring the problem.
Tomorrow we will look more at the dollars here.
So, we start trying to decide whether accountings that the average investor can understand are feasible. The first question is whether the average investor can understand business in the "new economy." To oversimplify, it seems to me useful to divide the new economy into 2 pieces: First, there is the world of post-modern finance: derivatives and their progeny. Second, is the world of high-tech.
When I think of derivatives, I always think of the old Eddie Murphy movie, Trading Places. Ralph Bellamy and Don Ameche are trying to explain the futures markets (the first public derivatives market) to the street person played by Eddie Murphy. Insightfully, Eddie noted something like "you guys are bookies." Black and Scholes (after whom the first model for valuing derivatives is named) could not have put it better. Derivatives are just fancy bets on the value of something, with little or no investment in the item gambled on. Pricing the gamble is hard. Understanding the gamble is easy.
High tech below.
Understanding a high-tech business actually is trickier. The problem is that high-tech investments tend to be unusual and intangible. Buildings and machinery clearly are long-lived investments. They can be sold, if necessary. In contrast, for example, what about computer software? It costs real money to develop software. But, the software may be useless. (Think about the luggage software at the Denver airport.) Or, the software may the cornerstone of an intergalactic empire. Only time will tell? (But, the markets can't wait.) Big software projects are not bought and sold sufficiently frequently that they feel like hard investments.
This intangibles problem is not limited to the new economy, however. GM and Honda have similar tangible assets, and yet are very different companies. (Another car analogy, I know.) And that Samuel Adams recipe...
More on beer and other surreal investments tomorrow.
The question today is what to do in light of the fact that the accountings currently provided to individual investors are impenetrable. Most obviously, one would like penetrable accountings. Unfortunately, that is easier said than done. The question is how hard we should try to come up with penetrable accountings. Today, I argue that we should try real hard, as the alternatives are not happy.
We could no nothing and let things go on. After all, if it made economic sense to have better accounting, market forces would make companies have better accountings. Well, no. Market forces likely encourage a company competing with others for capital to provide comparable accountings. Market forces do not necessarily protect entire markets or investors as a class. The US saving rate is frighteningly low. Bad accountings, and the resulting distrust of the markets, particularly the stock markets, may be part of the problem.
One still might not care. Let people do stupid things. I'll put my money in the bank or a mutual fund. But, if a rising tide raises all ships, even a smart loner could benefit from better markets.
Old Europe down under.
Another obvious solution to bad accountings is to have a government agency collect information and regulate prices. That seems like a non-starter in the US. Or we could go to the traditional systems in Europe and Japan, where most stock is owned by financial institutions and pension plans. These big investors can get the raw data, meet with management to get their insights into the data, and make their own analyses. In the US, mutual funds also could fulfill the financial intermediary role, so that individuals can more directly enjoy the kinds of long-term returns available for investing in the stock market.
In Europe, the trend seems to be toward US-style public capitalism. Here, because of the growth in pension investments, stock owned directly by individuals is not growing as quickly as in Europe, but still is a major part of the market. A return to old Europe seems unlikely.
Remember that the President still wants to privatize Social Security so as to let individuals buy stocks and bonds with their federal social security money. Think about what pressure this puts on accountings.
OK, that is my argument that we really should try real hard to improve the accounting information provided to individual investors. Tomorrow, we start trying to decide if that is feasible. Hint: I have no easy answers.
Betty the Crow News called my attention to a great little piece about Enron in the the San Francisco Chronicle that expresses my views about Enron and my point the numbers matter far better than I could On Facing Facts
Yesterday, I wrote about the process by which corporate financial information is processed and presented to investors. It was my plan to write about how that process effects the quality of the product. But, it seems more fun to cut to the chase and think about, in light of this process, what financial information should be given investors. (Perhaps later we can chat about the audit process.) The goal here is to evaluate whether it is troubling that most investors could not understand Enron's financial statements, which is where this discussion began.
Should investors understand the basic financial attributes of a company they invest in? Few car buyers understand modern automotive engineering; yet nobody thinks that this means that there is something wrong with the automotive markets. (Hey, I'm from Detroit: Cars are an analogy to everything.) Individuals can get expert analysis from places like Consumer Reports and JD Power. Reputation and brands provide useful non-technical information about a car. Experience over time drives (pun intended) bad cars out of the market. And so on.
But, cars are not corporate stock. Click for the analysis underlying this surprising conclusion.
Most people do not buy cars primarily to enjoy their engineering. One wants the performance, features, reliability, and the like that comes with good engineering, but most really see the engineering as a means, not as an end. Also, there are non-engineering aspects of car ownership, like style and status. With stocks and bonds, the finances are the heart of the investment. Occasionally one will buy stock for fun, like stock in a sports team or a beer company, but usually one is looking for a financial return, not some other intangible personal benefit.
If you accept this analysis, and I admit it is not overwhelming, financial information is to stock what information about brand, style, color, features and the like is to a car. A rational buyer would not buy without knowing what she is getting.
Which raises two intertwined questions: Is it possible to come up with accountings that investors can understand? If not, what to do? Since the second question goes to what is at stake here, it will be tomorrow's topic.
Yesterday, I argued that raw cash flow numbers alone are not enough information for an investor to understand a company. The accounting industry always understood this. In fact, cash flow statements were not required until 1987!
What about giving an investor complete access to all (non-confidential) financial information, which the investor then can massage as she sees fit? While this would have seemed impossible in 1933, presumably it could be done today. The SEC is trying to get companies to do financial filings in a format called XBRL, which permits the reader to analyze underlying data. More sub fold.
Of course, the average investor would not be able to deal with all of this information. But software would become available. And the brokerages and other investment advisors would provide their analyses to customers. But that is not enough.
Investors need management's analysis of the numbers. Today, the principle expression of that analysis is the financial state usually called the "income statement," also called the "profit and loss statement" and, most precisely the "statement of operations." This statement shows management's analysis of how the business did over the year (or quarter). Lots of judgments are reflected in the numbers. Revenues are shown as earned, not when paid for. Expenses are booked when incurred. Borrowings are not reflected, as they make a business no better or worse off. Buying assets per se is not reflected, since the cash spent bought the company an asset and the business is no better or worse off. And so on.
Which gets us back to 1933. How is the key information on how the business is doing going to be assembled, analyzed, and presented to the markets? A government agency could work with management to provide the best possible analysis. This is what happens with the taxation of most large corporations. The company prepares its tax returns; but the largest corporations are continually under audit, frequently by IRS personnel who are permanently assigned to the company's audit, so that the final taxes really are a negotiated deal.
Congress decided to keep government out of the financial information process as much as possible. Under current law, a company's management prepares its financial statements. Private outside auditing firms hired by management then opines on the statements. The auditors do not opine as to whether a company's statements are the best analysis, merely as to whether they are "generally acceptable." In a Supreme Court opinion, the late Justice Blackmun, a former tax law professor, cited authority for the proposition that, to an accountant, "generally acceptable" can mean "somebody tried it." Most big public companies today use one of the Big 4 audit firms: Deloitt & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers.
Tomorrow: what the process means about the result.
Back to the discussion of understandable accounting.
So, it is 1933. You are Congress. You want to give investors all of the information that they need to make informed decisions on buying and selling securities. What material would you require companies to make public? Obviously their locations, goods and services sold, brands, management, history, and the like. But, in the end, everything comes down to numbers. The investor has to decide what is a fair price in dollars for a stock or bond. So, investors must have financial information in dollars.
Which raises the question of what financial information is relevant to investors' -- and therefore to the markets' -- pricing decisions. This is the fundamental question of corporate finance: what is value? More below.
Most believe that the value of a business is roughly related to the present value of the cash that is rationally-estimated to be generated by the business. There is some debate about how rational these estimates are, but pretty much everybody thinks expected cash is a good start in valuing a business.
Under this analysis, investors need info on cash to be generated by the business. Unfortunately, that is easier said than done. Current cashflow may not be prophetic. Businesses can borrow and generate cash -- but, in this case, today's cash inflow is tomorrow's payment, with no net cash generated. (As I noted in a comment to a comment on an earlier post, this was Enron's biggest scam: disguising borrowing as operating cashflow). An asset can be sold for a loss and generate cash, but that does not bold well for the future prospects of the business. Employees can be paid with stock or stock options. And so on...
So, investors need a lot of financial information. But the goal is to guess future free cash. This requires judgment, not bean counting. Nevertheless, Congress and the SEC left this key judgment -- the heart of the modern public capital markets -- to the beancouters. Tomorrow!
Sorry, but I am going on another tangent because I actually was a bit player in a drama that made the headlines today: Engle, the $145 billion judgment against the big 5 cigarette companies, which was overturned today by the Florida Supreme Court -- essentially on procedural grounds, as discussed below. But, by the way, the Court upheld the jury's findings that the tobacco companies behaved wrongfully and are liable to Florida smokers!!!!!
I was one of two finance experts for the plaintiff class (Florida smokers). My involvement began very late in the trial in 2000. I testified before the jury that the companies' ability to pay punitive damages should be measured by the companies' ability to generate cash. The $145 billion was near the upper bound on the present values of the companies' discounted cash flow generating potential.
Rather than respond to this analysis, the tobacco companies called their CEOS, mostly marketing guys, to testify. The CEOs said that they can only pay their accounting balance sheet value. This "book" value shows no value for the companies' brands (except for RJR) and is a tiny fraction of the market value of the companies. (The key economic resource of a tobacco company is its brands.) Not surprisingly, the jury rejected this self-interested testimony.
In this posture, the $145 billion judgment was completely reasonable. The tobacco companies gambled and lost. While this aspect of the our trial system is disconcerting, it is the law. If the tobacco companies had won, they would have laughed all the way to the bank.
Which gets us to today's decision by the Florida Supreme Court. Down under....
The Florida Supreme Court, in Footnote 8 to today's opinion, accepts that financial value is the legally-relevant standard for evaluating punitive damages here, but then goes on to say that the award was not supported by the "Engle Class's expert," presumably referring to me. They are just wrong on this for the reasons discussed above.
As to the heart of today's opinion, procedural stuff, I want to remind the reader that I do accounting and tax. Litigation is not an area in which I have expertise. That said, I obviously have real problems with the decision.
A little background: The trial was held in three phases. First, the jury found that the tobacco companies had engaged in wrongful behavior. Second, they found millions of dollars in damages for three members of the class. Then, the jury determined the punitive damages for the entire class: $145 billion.
The Florida Supreme Court ruled today that punitive damages must be decided as to each smoker and not with regard to the class as a whole. There are hundreds of thousands of Florida smokers in the class. The jury in this case was the longest sitting jury in history -- over 2 years. Requiring injured smokers to sue separately for punitive damages, including explaining the wrongs committed by the tobacco companies to hundreds of thousands of juries, could well be an insurmountable burden. The Florida Supreme Court's tortured reasoning makes it likely that the tobacco companies will never be punished for what they did. This is wrong.
But, like I said, I am not a litigator. Decisions like this would push me over the edge.....
Glad that I am pretty much done with dissing Enron -- out of respect for the late Mr. Lay.
Monday, I suggested that it is troubling that the average investor could not understand Enron's accounting. Later, I will talk at whether it is possible to have accountings for new economy businesses that the average individual investor can understand. (Enron pretended that it was all new economy. It really was just another energy trader.) But, a little background seems helpful.
After the amazing business scandals, even by Enron standards, of the late 1920s and early 1930s, Congress had to do something about the public securities markets. Public faith was nigh zero. The question on the table was what to do. One answer would have been to have a government agency that really regulated public capital. For example, a government agency could look over the shoulder of corporate managements and second-guess the stock and bond markets. Congress instead decided to put their faith in, among others, the accounting industry. Really! Laff, laff! More below the fold....
This background discussion should be taken with a boulder of salt. I am not a securities lawyer. My study of the history of the US securities laws has been quite limited. Butt covered, lets dive in!
OK, so it is 1933. Congress decides to seek a middle road. They decide to give truly free and fair capital markets a chance. The 1933 and 1934 securities acts, which, with some refinements (such as the 1940 Investment Advisors Act), still are the law today, are enacted: People with a lot of wealth cannot manipulate markets. It is illegal to lie to the markets. Folk cannot trade on inside information. And, the biggie for my purposes, companies must make lots of information, including, very importantly, audited accountings, public (on file with the SEC); so that people can understand the companies whose stocks and bonds they are buying.
Today, those accountings are online, along with a lot of other stuff (also mostly required in the 1930s), in the SEC's EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database, at www.sec.gov/edgar.shtml
Tomorrow: Accountings?
With all of the media attention given this week to Joe Lieberman's waivering loyalty to the Democratic Party, I decided to go on a slight tangent and discuss how, more than anybody else in America, Joe Lieberman is responsible for some of the worst corporate abuses during the recent tech bubble and for the current growing options backdating scandal. The Connecticut media has noted this, but not the national media, and it is real important. In short, in 1993, Lieberman saved amazingly bad accounting for when a company pays an executive with stock options instead of cash. This caused options to flourish. Options make an executive more concerned with short-term fluctuations in her company's stock price than in running the company well. Disaster resulted. Details below the fold. Back on track tomorrow.
In 1993, the Financial Accounting Standards Board (FASB) was set to fix the accounting rules for compensatory stock options. The rules had been that paying an executive with a stock option reseulted in no cost or expense to the company. Cash compensation is an expense. Giving an executive a piece of the company for nothing dilutes the value of the stock for the other shareholders every bit as much as paying cash, but no expense was booked. There were a few weak technical arguments in favor of the old rule: Options are hard to value. The real compensation is when the executive exercises the option ane that is not when the compensation was provided. And so on.
FASB rejected these arguments. Along comes Joe Lieberman! Reflecting the cost of options on financial statements will hurt high-tech companies. This will destroy America. Lieberman pushes through a Sense of the Senate resolution that Congress would disband FASB if they require expensing of stock options. FASB caved. PBS has a nice discussion of all this online at Lieberman v. FASB
Just this year, FASB began requiring expensing of stock options. The Republic did not fall. FASB was able to hide behind residual post-Enron public distrust of corporate executives and Europe adopting options expensing to finally get things right 13 years later.
One can wonder how much better American business would have been run for the last 13 years were it not for Joe Lieberman.
Thanks to Michael for giving me the chance to guest blog. It was fun 2 years ago. Hope you out there find my stuff somewhat interesting.
I am a tax guy. Unfortunately, from my blogging point of view, in the US, the only interesting discussion going on about taxes these days is about the estate and gift tax, and I have little to add to that debate. (Yes, we should not be Mexico...)
But, in the other area in which I know something, law and accounting, lots is happening. The ongoing option backdating scandals make it clear that much still is wrong with the accountability of corporate managements. So, for now, accounting seems more worth writing about.
Which gets me to Enron. Many have noted the importance of the recent convictions of Lay and Skilling: The convictions restored some faith in justice. More importantly, for my purposes, they saved public capitalism. If Lay and Skilling had been able to get away with what they did, it would have seriously undermined the public's faith in the capital markets.
But another aspect of the convictions has not received public scrutiny and merits discussion: how the convictions were achieved.
(My analysis is based on public reports and various blogs by reporters who were present at the trial.) The prosecution quite smartly did not attempt to try Lay and Skilling on their misleading accounting. After all, the jury would not have understood. Instead, the prosecution's case was that Lay and Skilling are real smart guys who must have known of Enron's problems, yet they said all was well. The company went belly up. Thus, Lay and Skilling must have lied. Do not pass go. Go to jail
OK, good for the prosecution. Right way to win! But, what does that say about modern investing? If the best lawyers and experts could not explain Enron's accounting to a jury, the average individual Enron shareholder could have had no idea what she was investing in. This strikes me as a bad thing. Which is where we will pick up tomorrow.