Contact FreedomWorks

400 North Capitol Street, NW
Suite 765
Washington, DC 20001

  • Toll Free 1.888.564.6273
  • Local 202.783.3870

Press Release

    Outraged, or Just Confused?

    07/02/2002

    The president has expressed outrage at the disclosure that WorldCom misreported expenses by nearly $4 billion over the past 2 years and demands “full investigations” and that any wrongdoers be “brought to justice.” At his behest, the Securities and Exchange Commission (SEC) has subpoenaed documents and filed a fraud claim in the civil courts. The Justice Department has begun a criminal investigation for potential illegality on the part of WorldCom executives. Both actions are consistent with the law enforcement functions of both agencies.

    The swiftness of the president’s response can be attributed to the rising belief that America is in the midst of a “white collar crime wave.” But what we are really in the middle of is a protracted bear market and sluggish growth in corporate profits. As Holman W. Jenkins, Jr. points out in a recent Wall Street Journal column, “On a single day in 1999, the SEC brought civil actions against 11 CEOs and 57 other senior officers.” Yet such action went unnoticed because we were in the midst of an asset price bubble caused by Internet hysteria and unrealistic stock valuations.

    In the July 1st New York Post, business reporter Christopher Byron recounts the way America Online (AOL) Chairman Steve Case approved the very same accounting sleight of hand in the 1990s that WorldCom used the past 2 years. Under pressure from analysts and accountants, in November of 1996, AOL took a $385 million charge to earnings for erroneously booking expenses (in this case, subscriber acquisition costs) as capital investments. This $385 million wiped out 75 percent of AOL’s retained earnings, which is essentially the same percentage involved in WorldCom’s restatement. Of course, instead of unraveling and facing potential criminal liability, AOL’s stock soared as investors overlooked accounting gimmickry in favor of growth potential.

    The lesson to all of this is that there have always been crooks in business and irregularities in accounting and there always will be. Only when equity losses mount and investors retrench do these misstatements and SEC investigations turn into headlines of corporate greed and corruption. And once the media become transfixed and pundits opine how capitalism has been betrayed, voters begin to notice. And it is precisely this voter sentiment, embodied in polls, that serves as a starting point for policy discussions on the topic.

    With the market going up in 1996, politicians felt no reason to be “outraged” at little-known AOL’s financial misstatement. But now, with investors jittery and polls indicating that voters favor stricter enforcement, politicians would be working against their own self-interest to not get “out in front” of the “corporate crime wave” and propose new legislation to win voter support and allay investors’ fears.

    But making people feel safer is not always a good thing. In 1975, economist Sam Peltzman of the University of Chicago released a study on the effect of legislation mandating seatbelts, penetration resistant windshields, and other safety equipment on auto fatality rates. His study found that the safety features decreased the percentage of drivers fatally wounded in accidents, but increased the number of overall accidents leaving the overall number of driver deaths unchanged. The reason was that, on the margin, the safer a driver feels, the more chances he is willing to take behind the wheel. As a result, speeding, reckless driving, and pedestrian deaths caused by cars increased, leaving the benefits of the legislation more than offset by its cost.

    The same could be true of new legislation aimed at curbing “corporate abuse” and “accounting irregularities.” Now that investors have been reminded that the market bears considerable risks, their behavior will account for that more fully. Investors will likely be more prudent and take the time to understand the companies they are investing in, diversify their portfolio, and turn to real estate and other investments. Similarly, when corporations know that if they do not provide unbiased, privately verified information to investors, they risk being unable to raise money in the capital markets, their disclosure practices will change rapidly to meet demands.

    No politician has been more honest about the accounting scandals than New York Mayor Michael Bloomberg, who was head of Bloomberg financial news empire before moving into Gracie Mansion. In his weekly radio program the Mayor said: “People who were buying stocks in the stock market at multiples that never made any sense should look at themselves in the mirror…They’re as responsible, I think, as those that actually committed the crimes of misstating earnings and fudging the numbers.”

    As to be expected, Bloomberg’s honesty was rewarded with excoriation by the press. But the point that Bloomberg tried to make is that investors were the ones who made numbers meaningless when they invested in ways that robbed the numbers of any meaning. In August of 1999, the capitalization of the U.S. stock market was 160 percent higher than U.S. GDP. This figure was 60 percent higher than the previous record capitalization-to-GDP ratio reached just before the stock market crashed in 1929. In April of 2000, Cisco Systems was valued at $450 billion even though its REVENUES for the fiscal year were only $12 billion. When stock prices are not tied to financial numbers in any meaningful way, the crimes of misstating earnings do not seem quite so serious.

    Such crimes should seem serious to independent auditors responsible for verifying corporations’ books, but it has become obvious from all of the earnings restatements that accounting firms, in their current manifestation, are a vestigial appendage of America’s system of corporate finance. Government requires corporations to undergo an annual independent public audit, but leaves the auditors to be paid by the corporations themselves. Thus, accountants have no incentive to act as “whistle-blowers,” lest they rat-out their clients and guarantee they don’t get new audits in the future.

    Congress or the SEC could make a very positive contribution to the debate by eliminating the perverse incentive system that rewards auditor complicity, siphons untold billions from consumers and shareholders, and fails to provide investors with reliable and readily available financial data.