Academic journal article SAM Advanced Management Journal

Capitalism and Accounting Reform

Academic journal article SAM Advanced Management Journal

Capitalism and Accounting Reform

Article excerpt

Introduction

It has long been recognized that capitalism depends upon the rule of law and property rights. Without the enforcement of these two underpinnings of a free market system, capitalism does not operate efficiently. As Hayek (1960:159) put it: "When we obey laws, in the sense of general abstract rules laid down irrespective of their application to us, we are not subject to another man's will and are therefore free." Nevertheless, as business activities have become more complex, and as business interests have become more politically powerful, the laws and rules that underpin the capitalist economic model have come under increased scrutiny. The public perception is that some of these laws and rules are weak and foster "loophole mining" and a culture of business dishonesty. This is particularly so after the scandals of 2002 when companies such as Enron, WorldCom, and Adelphia were the focus of media attention and government legislation.

During the last century, capital markets became increasingly important for corporate financing and growth, particularly in a rising stock market. Attempts to align owners' goals (greater wealth) with management goals (company expansion/increased market power) led boards of directors to motivate executives with compensation packages tied to corporate stock prices, particularly stock options. Per Levitt (2002:2), "By 2001 some 80% of management compensation was in the form of stock options. But instead of aligning employees' interests with shareholders, options gave executives an incentive to use accounting tricks to boost the share price on which their compensation depended."

These incentives, however, fostered an environment that 1) sacrificed the long-term goals of sustainable company growth for short-term goals of increased profit, and 2) inflated measures used for financial purposes while simultaneously deflating numbers used for income tax purposes. A company might choose to optimize its stock position by being "honest" enough in its financial accounting to be perceived as a high-quality firm, while skewing tax numbers, using as many gray areas as possible, in the company's favor. Some might argue that managing earnings numbers is the best way to produce a favorable financial output on all fronts, thus protecting the investor. Others would say that while all financial statements contain some approximations, presenting extremely diverging stories to the government and stockholders likely prevents at least one of those stories from straying materially from the truth. Practically, the stakes can be high: two diverging stories were told to Enron stockholders and the IRS regarding Enron's 1993 and 1994 income tax returns. In 1998, an unnamed IRS appeals officer concluded that "the report to shareholders 'fooled' both investors and securities regulators about its financial condition" (Johnston, 2003, Section C, page 1). The unnamed appeals officer made strenuous attempts to persuade the IRS to reject Enron's position, asking in a memo "[s]hould the IRS condone this?" The IRS national office overruled the officer protests. (1) Theoretically, auditors should prevent material misstatements before audited financial statements are released, and where there is doubt as to accounting treatment, opt for the more conservative approach. (2) However, the audited companies pay public auditors, and that in itself creates an ethical conflict. Prior to recent scandals, IRS auditors had little incentive to perform beyond the basic level necessary to remain employed, but accounting scandals have highlighted the need for additional attention to the system to ensure complete disclosure.

This paper will identify economic problems with the U.S. capitalist model, propose possible solutions to the external structure, and discuss the pros, cons, and political realities of the proposed solutions.

Characterizing the Problem with the U.S. Capitalist Model

Is there a problem with the U. …

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