Sealing Cracks in the Capital Markets
Investors Will Pay Risk Premiums Until New Behaviors are Instituted
If the capital markets are to function safely and fairly, incentives need to be re-aligned so that neither terrorism nor fraud is rewarded.
Two major events shocked the world and exposed fault lines in U.S. capital markets during the past year. The first was the September 11 (9-11) terrorist attack on the World Trade Center. The second was the collapse of Enron Corporation.
Even though these are very different events, both expose risks that normally are obscured by social relationships that rely on incentives to be effective. The threat of terrorist acts may be reduced when potential supporters have little incentive to contribute to terrorist causes. Managerial greed may be held in check by compensation policies that take seriously the agency relationships between shareholders on the one hand and Boards of Directors and managements on the other. Auditor impropriety can be minimized if opportunities for future work are reasonably available.
Reasonable incentives and appropriate penalties may keep others from egregious acts, such as those at Enron, in the future. The current challenge is for social institutions to re-align incentives so that they will discredit terrorists, reward only verified managerial performance, and assure auditor independence and performance.
The impact of 9-11
Direct Costs: The 9-11 terrorist attack was important for many reasons, not the least of which was the human suffering involved. Nearly3,000 lives were lost. From the standpoint of the capital markets, however, 9-11 revealed two previously-ignored risks to capital market valuations: the actual costs for increased security, and the recognition of an increased chance of catastrophic loss. These risks will persist until mitigating actions are taken.
All businesses in the post 9-11 era will suffer additional costs, and thus lower profits and decreased valuation in the U.S. capital markets. Firms that may be targets for terrorist actions will be impacted most severely. They face increased costs for physical security as well as costs for more information and for planning and creating contingent operations. Costs of imported goods and exported goods will increase because of higher inspection fees and delays in transit. For all firms, travel costs will increase, not only directly from added security fees but also from productivity loss as employees and goods wait at airports for inspection or suffer delayed flights. Additional billions of dollars that before 9-11 would not have been spent at all will be spent on processing goods and delivering services in this new environment.
Security-cost-induced inflation will be a factor as well. Corporations will have to raise prices if they cannot somehow find new efficiencies to compensate for these other costs. Security costs may be necessary and may decrease the risk of catastrophic loss, but in the process they squander the wealth of a nation.
Indirect Impacts: The second and more important impact of 9-11 on the capital markets is the psychological impact on investors. The United States has long enjoyed a reputation for the safety of its capital markets relative to other markets worldwide. After last September, investors will never again believe that war cannot be brought to U.S. shores, or that the U.S. capital markets cannot be disrupted. The Dow Jones Industrial Average dropped 22% in the first two days the markets were open following the World Trade Center collapse. Five months elapsed before the Dow and NASDAQ shares regained the value they had prior to September. In just a few minutes, terrorists reminded a new generation that unimaginable domestic destruction is entirely possible.
This threat adds a risk premium that reduces the value of all securities, most notably those of global firms. Firms with a noteworthy foreign presence may become targets because of their U.S. symbolism. The result is higher costs of capital for all firms that trade in those markets. Any time a firm goes to market with a new issue, or any time a shareholder wants to sell shares, the price of the security will be a little lower than it otherwise would have been before last September to compensate investors for the risk of another attack.
Corporate and Government Actions: In order to restore the confidence of citizens, the U.S. government has engaged in a series of unprecedented acts to increase homeland security. The BU.S.h administration has asked Congress for $30 billion-money lost to economic development. Even so, it remains likely that some ingeniously diabolical acts, like those of 9-11, will recur. No amount of anticipation can fully stop a group bent on inflicting harm to others if the inflicting group is willing to pay any price to achieve its aims.
One can either live in fear perpetually, or cap this risk by reducing the incentives for others to target the United States. Punishment — military or economic — will not entirely remove the incentive for others to do harm. Mutual respect and economic benefit need to replace empire building and poverty. BU.S.iness firms must respect the diverse cultures in which they operate and act within the ethical and religious norms of their host countries. The U.S. government must act diplomatically to advocate self-determination and free expression among citizens of all nations. Corporate and government behavior changes can reduce the incentives for others to target the United States and its corporations.
Enron and the Capital Markets
As the capital markets began recovering from 9-11, they were beset by Enron’s collapse. The Enron bankruptcy exposes a second, systemic chink in capital market valuations. Bankruptcies-even major bankruptcies-have been part of the American capital markets since they began. Enron’s bankruptcy is important not because of what, how, or when it happened, but because of why it happened. Enron’s operations were risky, but management’s actions hid that risk from investors. Enron’s management and accountants had incentives to distort the publicly-available information stream. Management and auditors benefited, at least temporarily, from this distortion. Enron shareholders suffered losses of over $50 billion in stock value, and share prices in other companies fell as investors recognized that they could be subject to the same distortions as Enron’s shareholders
Enron’s bankruptcy had the effect of further raising the cost of capital for all firms doing business in the United States because investors, who previously believed they could rely on the numbers in financial statements, came to question even the most basic financial statement disclosures. Uncertainty as to whether accounting numbers are correct and disclosures are adequate has led to higher perceived risk and lower share prices for all firms, especially those with unclear accounting practices.
Incentives that Distort: What caused the Enron problem? In a word, “incentives.” Management’s incentive was “the profit motive” gone awry. In 2001, a six-year old compensation plan was nearing terminal measurement for the determination of bonuses. Financial targets had to be met or years of employee and manager effort would go unrewarded. Management corrupted disclosure and performance measurement to surpass bonus targets. For their supposed diligence, managers and employees gained over $300 million in bonuses plus gains on stock without disclosure to the shareholders. External accountants failed to demur.
There is nothing essentially wrong with managers benefiting from the success of their company. People who create successful companies should benefit from them, and companies have instituted many ways for managers to benefit from the value they create, e.g., stock option plans. It is when managers benefit at the expense of investors, rather than from the economic success of their company, that regulators must enter the picture. This was Enron. Insiders at Enron gained while the other shareholders, the 401(k) holders, consumers, and creditors paid the price for those gains. The president of Enron has testified that he made nearly $70 million from his company at a time when other investors lost all of their investment in that stock.
The Role of Accountants: Who and what are to blame for enabling Enron’s insiders to gain? Clearly, there is enough blame to taint many parties, but a group that deserves special mention is the profession in which both of the authors are certified to practice, accountancy.
The public’s perception of accountants has been that CPAs are the guys and gals in white hats — incredibly honest, straight-laced and ready to do battle with evil wherever it is found. The CPA will tolerate no corner cutting or dishonesty. That is the reputation that the American Institute of Certified Public Accountants (AICPA) has been building for more than 100 years. Andersen failed themselves and the profession.
The accountants’ incentive was also “personal reward.” Enron was rich in fees, a secure, multi-year client. Furthermore, it held the possibility of future well-paid employment for former auditors at Enron. Disincentives were minimal. The accountant’s position could be supported by technical interpretation(s) of accounting and disclosure standards, malpractice insurance, infrequent license revocation, and peer review. Left to their own discretion, accounting partners pursued self-interest, at the expense of others, by not disclosing Enron bonuses or off-balance sheet transactions.
Enron’s chief financial officer, Andrew Fastow, was not reined-in by the external auditors from Arthur Andersen, CPAs. The audit firm’s consulting branch earned more than double the audit fee from Enron. Many former auditors left Andersen to become well-paid employees of Enron. Enron is about the systemic incentives that tempt weak individuals.
Recommendations for Change: The auditing failure at Enron appears also to be fixable without significant government intervention, although the political realities of the situation probably require such intervention for the public to have confidence in the solution. All recommendations should be taken in the climate that auditors need to be committed to their clients’ interests– and the recognition that the ultimate client is the U.S.er of the financial statements, not the officers of the company being audited. The seven recommendations listed below should improve public confidence in accounting numbers:
1. Publicly-traded companies must change audit firms every five years. It is not sufficient to rotate partners within the same audit firm. The entire auditing firm must be changed
2. The audit firm shall be hired by a body independent of management (e.g., the audit committee of a Board of Directors).
3. No auditor may have a consulting relationship of any kind with a firm it audits. The auditor may perform the business firm’s audit and prepare its tax filing and compliance reports. Period.
4. The partner(s)-in-charge of a business firm’s audit may not accept employment with that client firm (or subsidiary) sooner than three years following the most recent audit.
5. These rules may not be subverted by allowing audit firms to set up “subsidiaries” or “affiliates.”
6. A division of the Securities and Exchange Commission shall be empowered to review auditor compliance with standards.
7. Only Certified Public Accountants shall be eligible to be partners in CPA firms.
These simple actions will remove much of the incentive for auditors to establish cozy relationships with the officers of the firms they audit. They implore the auditing firm to focus on its true customer, the shareholders and other users of the financial data of the audited firm.
In the current media frenzy, the profession’s actions alone will not be adequate to restore public confidence in financial reporting. The SEC, Congress, or other public body must endorse and supplement the accounting profession’s efforts to restore investor confidence. Executive branch review of auditor performance would suffice.
An Inappropriate Recommendation: One must be cautious, however, of further governmental intervention. One such proposal would require firms to report to their shareholders on the same measurement basis that they report to the Internal Revenue Service. Like many of the proposals made in the heat of the moment, this one deserves rejection.
Accounting reports differ in objective from tax reports. Accounting reports provide financial information useful to investor and creditor decisions; they focus on information that is useful in predicting future performance. Academic researchers have verified much of the profession’s success in providing future-looking information. Tax law is passed by Congress to gather tax money from past activities. The scope of tax returns is less complete than that of accounting reports. There are no studies to validate the usefulness of tax information in predicting future performance of the firm. The differences in objective between accounting reports and tax reports have resulted in two sets of measurement standards that justifiably differ.
The shareholders’ problem with Enron is similar to that faced by the U.S. government’s attempt to prevent future 9-11 events: No amount of anticipation or controls can fully stop a group bent on achieving its aims if significant incentives remain. Put another way, the human mind is infinitely creative. Those bent on distorting information that will allow themselves to profit at another’s expense will do so. They will always be able to perform those acts before they are caught. One must alter the incentives first.
American memory tends to be relatively short. Few people remember many specifics of the junk bond trading “scandal” of a few years ago, or even the lessons that finance professors tell U.S. should be remembered from it. Both Enron and the terror of 9-11 will pass. But, it is important to remember that societally inappropriate incentives create risk for investors. They expose fissures in U.S. capital market valuations.
In the case of 9-11, one major lesson is that other cultures view Americans differently than Americans view themselves. Americans are doomed if they disrespect others, insult their cultures or religion. Without the support of others, the fanatics that perpetrated 9-11 would not have had the resources to band together, train, and act.
In the case of Enron, the lesson is that greed is a powerful motivator. Manager incentives should be controlled and administered by the shareholders’ board of directors. Auditor incentives should reward independence from management. Shareholders are the ultimate clients.
This paper has offered seven recommendations to help solve the problems of the auditing profession. Ultimately, accounting practices must provide better disclosure of financial information to investor-users, a task at which the accounting profession has 100 years of experience. If it chooses to act, the accounting profession will do a better job of solving the problems of financial disclosure than will any political solution to the problem.
About the Author(s)
Bruce Samuelson, DBA, CPA, is a seasoned professor of accounting at Pepperdine Unversity. His broad experience includes having been a military finance officer, U.S. GAO auditor, certified public accountant, CFO, union pension investment manager, and member of boards of directors.