Unintended Consequences of Earlier Reforms Bite Market Hard

Article excerpt

Byline: Paul Craig Roberts, THE WASHINGTON TIMES

Alex Berenson is a New York Times business reporter, who sniffed out a couple of the accounting scandals

that investors and Wall Street analysts failed to spot. In "The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America," Mr. Berenson capitalizes on the public's interest in the accounting scandals that have contributed to investors' disappointed hopes in equity performance during these first years of the new millennium.

The book consists of two parts. The first is a journalistic history of previous booms and busts and the reforms and regulatory responses they provoked. The second part is a journalistic account of the long bull market beginning in the early 1980s and the subsequent bust of the past three years. There are two brief appendices that illustrate with simple examples how executives can fudge their financial statements.

Mr. Berenson's unifying theme is the focus that analysts, investors and executives place on quarterly earnings as a company's success indicator. He shows how this focus intensified over time and concludes that quarterly earnings became a cult on the altar of which were sacrificed the ethics of executives and accountants and the caution of analysts and investors.

The introduction of price competition among the Big Eight accounting firms combined with the use of stock options as a major source of executive compensation to unleash incentives to fictionalize the quarterly earnings number. In some instances misleading earnings reports were created without violating Securities and Exchange Commission rules by pushing accepted accounting practices to the point that they became misleading. In other instances, fictional reports were cases of outright fraud.

Mr. Berenson separates cases of accounting gimmickry from fraud as he takes the reader through scandals that led to investor disappointment in Lucent, Lernout & Hauspie, Cendant, Computer Associates, Enron, Tyco, WorldCom and Green Tree Financial. In some of these cases executives took fortunes out of companies by exercising options on the basis of fictional earnings. Clearly, there are executives who value money more than reputation, or perhaps they believe money is reputation.

Mr. Berenson believes that the legislative response (Sarbanes-Oxley) to the scandals is insufficient and that Wall Street and the accounting industry have succeeded in blocking measures that would have strengthened the Securities and Exchange Commission.

"The Number" is readable and succeeds on one level. However, it fails on another. A reader could come away thinking that quarterly earnings and stock options are devices designed by Wall Street and corporate executives for the purpose of enriching themselves through corrupt accounting. A reader could also come away with the belief that accounting firms broke up their cartel with price competition in order to be able to sideline straight-laced partners and chase the fast buck.

What Mr. Berenson fails to tell us is that the very factors that produced the scandals -focus on quarterly earnings, stock options, and price competition between accounting firms - are themselves the reforms of yesterday, reforms that were supposed to increase investor protection. Without realizing it, Mr. Berenson has explained the recent accounting scandals as unintended consequences of previous reforms.

Quarterly earnings reports are the result of reform that aimed at providing investors with more timely information about the profitability and financial condition of public companies.

Stock options resulted from reforms that sought to tie executive compensation to shareholder return as measured by the company's stock price. Another reform capped executive salaries at $1 million. Compensation above this amount must be paid out of after-tax profits or justified by performance. …