Restoring trust in Corporate America

As the U.S. economy is continually beset by instances of corporate accounting irregularities, the confidence of many domestic and foreign investors in the American business model has been shaken. Insider trading, misuse of stock options, accounting fraud and stock price manipulation have elicited the typical responses from politicians, industry executives and financial houses, as all have offered suggestions for reform, many of which are quite prudent. However, as it is likely that these episodes of irregularities will continue – due to the scandal that broke last week, WorldCom laying off close to 18,000 employees – it is important for legislators to expeditiously enact reforms to reverse the declining cycle of mistrust in the corporate world.

The firm first exposed in this recent trend of accounting irregularities was Enron, which overstated its profits through a delicate accounting calculus that simply exaggerated its revenues and underestimated its expenses. Enron fabricated “partnerships” with other, smaller energy companies to hide expenses and create new sources of revenue, some of which produced entirely illusory instances of profit. The company sold units of energy in long-term contracts – some as long as 30 years – while calculating these future sales as current sources of revenue.

Communications giant WorldCom used a simpler method of miscalculating real expenses as capital expenditures. The difference is that capital expenditures, as investments in a company’s resources, are considered to be assets, and not temporary operating expenses. WorldCom was able to accomplish this by paying other telecom companies for the use of their utilities, such as lines and switchboxes. Such transactions, however, are not actually purchases but fixed-term rental agreements. An analogy that illustrates this distinction is the difference between renting a house and purchasing it; a rented house does not legally belong to its occupant, while a house that is owned does, despite any remaining balance.

The irregularities at WorldCom were part of a pattern. In March, shareholders sued the board of directors for loaning company founder Bernie Ebbers several hundred million dollars. The following month, the company became the subject of a class action lawsuit alleging it inflated values of the telecom firms it was acquiring, thereby artificially increasing the company’s stock price. Additionally, there have been recent accusations that some clients were overbilled.

Several other companies have also recently been involved in similar scandals, and though the methods used were different, the intent remained the same. Dynegy, an energy company, made agreements for phantom sales with rivals without actually performing any real transactions. Such sales, though, did materialize on the books, increasing the company’s market capitalization, which is the value of a company’s sales. Adelphia also sought to artificially increase its prominence in the marketplace in a manner similar to that of Dynegy.

Because of the increasing awareness of these practices, there have been several demands for reform. Some of these irregularities have been blamed on corrupt accounting practices, specifically those of industry giant Arthur Andersen, which has been accused of complicity in both the Enron and WorldCom scandals. At Enron, Andersen acted as both the auditor and the consulting firm, resulting in an obvious conflict of interest. At WorldCom, Andersen stated that it did not discover the irregularities that were later found by an auditor hired by the new chief executive officer.

Strict new accounting standards, as well as enforcement of existing accounting laws are, of course, fundamentally necessary to prevent such abuses. However, several additional measures must be taken to ensure that corporate financial information is entirely accurate.

First, the obvious conflicts of interest must be prohibited. Companies that are involved in consulting cannot also act as impartial auditors of a company’s finances. Second, the existing business model whereby the CEO is responsible for the validity of the company’s financial information must be reevaluated. As an alternative, such responsibility should be deferred to the chief financial officer, who would in turn be compensated with a salary that does not include any of the company’s stock as options.

Finally, and most importantly, the institutionalized practice of compensating CEOs with stock options must be significantly reduced, as it is entirely unlikely that the political will exists to eliminate this practice entirely. While such options, whereby employees of a company are guaranteed the purchase of the company’s stock at a certain below-market price by a certain date, are useful for lower-level employees, they pervert the incentives for CEOs. Because these executives receive compensation in the form of their company’s stock, they have the incentive to increase the stock’s price and not necessarily boost the company’s performance.

Fortunately, though, because of the impetus for reform, several political, industry and regulatory officials have eagerly proffered suggestions. President George W. Bush has promised to “restore faith in the integrity of American business” and that the “federal government will be vigilant in prosecuting wrongdoers.” Several legislators have introduced bills proposing accounting reform and limits on insider loans to former chief executives. Securities and Exchange Commission Chairman Harvey Pitt said “people are going to pay heavily” and that political connections are irrelevant to any investigation, an implicit reference to the SEC’s investigation of accounting practices at Halliburton in 1998, during which Vice President Dick Cheney was chief executive.

It is easy to be pessimistic about the near-term effects of these instances of irregularities. They have become so pervasive that even the doyenne of modern American homemaking – Martha Stewart – might also be charged for an improper sale of 4,000 shares of the biotechnology company IMClone, the day before its cancer drug was rejected by the Food and Drug Administration. However, while many of the recent cases have been high profile, it is important to understand that there are 12,000 publicly traded American companies, only a few of which have been involved. Many of the necessary reforms do have popular support and have been suggested for several years. However, as business cycles take time to turn, it is important that these reforms are immediately enacted in order to begin restoring confidence in the marketplace.