Discourse.net/Law: Accounting

Thanks

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....

Bureau of PricewaterhouseCoopers?

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.....

Financial Motorcycle Helmets

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.

A Resource is a Resource -- Of Course, Of Course

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.

Accounting for Howard Stern?

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

A Grand Confluence

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.

Mark-To-Market Mark

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.

Two Supplements

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......

Enron's Special Purpose Entities

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!

Working For a Living

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.