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Press Release

    Accounting for Misunderstanding

    07/09/2002

    In the swirl of the political drama that has engulfed Washington, D.C. it seems that some of our nation’s leaders have forgotten, or do not know, that accounting deceptions are not responsible for business failures. On the contrary, accounting gimmickry, duplicity, and outright fraud are used to conceal them. Thus it seemed a bit odd when Senator Tom Daschle (D-S.D.) and Rep. Richard Gephardt (D-Mo.) appeared Tuesday with former employees of Enron and WorldCom to announce their plan for an “Investors Bill of Rights” to expand government oversight of corporate governance, accounting, and pensions.

    While top executives at Enron and WorldCom may be guilty of fraud and punished accordingly by civil and criminal courts, the collapse of both businesses was a product of bad business decisions, not bad accounting. To blame sham accounting for bankruptcy is akin to blaming the Soviet Union’s collapse on the fictitious GDP numbers the Politburo used to pass off on the West.

    If anything, executives at Enron and WorldCom saved jobs – at least temporarily – by concealing their corporations’ poor performance from investors. Had Wall Street known the full extent of both companies’ travails, investors would have undoubtedly demanded the sort of dramatic cost cutting measures that have been undertaken at countless other firms during the bear market. Of the nearly 180,000 jobs lost at U.S. corporations in the past two months, not a single one was the product of misrepresented earnings.

    Of course, this is not to say that accounting gimmickry was not a tool used by executives to mislead the public and bolster their company’s share price. But there is a fundamental distinction between real economic failure and fraudulent accounting. By lumping the two together in an effort to score as many political points as possible, Sen. Daschle and Rep. Gephardt intentionally confuse the issue and undermine any good-faith effort to address the problems with corporate governance.

    Bankruptcies are a necessary component of the capitalist system, as profits – the real representation of economic growth – are dependent upon risk. Inherent to risk is the possibility of returns below the amount of capital invested, or bankruptcy. If bankruptcies were not allowed to occur, the wealth of others would have to be used to subsidize the inefficient enterprise, lessening the incentives for both efficient and inefficient alike.

    But in the case of Enron, and the anticipated bankruptcy of WorldCom, executives embarked on unusually high-risk strategies and used accounting methods to mask debt, or disguise its use. In both instances, the companies’ board of directors failed to perform its oversight role adequately, allowing powerful CEOs and CFOs to act on their own behalf instead of that of shareholders. The most pertinent policy question to come out of these scandals is not why these executives acted in their own self interest, but what institutional shortcomings in corporate governance allowed them to do so.

    While the Democratic Congressional leaders spoke in Washington, the president focused on harsher punishment and more aggressive prosecution before a New York audience on Tuesday. The president offered support for legislative changes to strengthen the Securities and Exchange Commission (SEC), regulate executive compensation, and require more independence on corporate boards. While these proposals are not as regulatory as the Democrats’ bill, and in some ways mirror the changes in listing requirements proposed by the New York Stock Exchange (NYSE), they do emphasize law enforcement and due process instead of the new bureaucracies and complex and redundant civil actions favored by Democrats and trial lawyers.

    In the 1960s, the phrase “the personal is political” took hold in the women’s rights movement to encourage women to recognize that individual experience could serve as a vantage point from which to interpret cultural and public policy problems. Today, the president’s policy recommendations for corporate responsibility may reflect his own personal experience as a businessman and corporate director.

    In 1989, George W. Bush served on the board and audit committee of Harken Energy Corporation. In that year, the audit committee on which Bush served approved the sale of 80 percent of a subsidiary, Aloha Petroleum Ltd., to a partnership formed by Harken insiders, which allowed Harken to reduce the amount of debt on its balance sheet and to claim income from the sale. Ultimately, Harken was forced to restate and downgrade its 1989 earnings the following year after an SEC investigation.

    At a press conference on Monday, Bush explained the sale as “a honest difference of opinion as to how to account for a complicated transaction.” When asked whether he was one of the audit committee members who favored the way the transaction was originally accounted for, Bush replied, “You need to look back on the, the director's minutes,” before re-emphasizing the fact that the SEC had conducted a full investigation and closed the case without further incident.

    Many observers believe this incident may be a political liability for the Republicans in this debate and the 2002 elections. Perhaps, but it could also be a blessing for investors and the financial markets. As our first MBA president, Bush has earned valuable experience that should lead him to fight vociferously for corporate flexibility and fraud enforcement rather than regulatory overkill. Companies from Coca-Cola to General Motors use off-balance sheet transactions to account for research and development projects, segment divisions, or to recalibrate debt-to-cash flow figures. To label all of these transactions bogus, or empower an unaccountable bureaucracy to regulate them – as the Senate Democrats’ bill would do – is not an appropriate response to the problem.

    By worrying so much about accounting methods and regulations, the Democrats threaten to undermine the real economy the numbers are trying to account for by limiting access to capital markets, increasing audit costs, and placing executives in a bureaucratic straightjacket. Instead of attributing so much power and relevance to accounting itself, policymakers would be better served to seek out and punish its intentional misuse.