SYNOPSIS: Standard & Poor's does what our government refuses to do

On Tuesday Standard & Poor's, the private bond rating agency, announced that it would do something unprecedented: It will try to impose accounting standards substantially stricter than those required by the federal government. Instead of taking corporate reports at face value, S.&P. will correct the numbers to eliminate what it considers the inappropriate treatment of "one-time" expenses, pension fund earnings and, above all, stock options — a major part of executive compensation that, according to federal standards, somehow isn't a business expense. S.&P.'s estimate of "core earnings" for the 500 largest companies slashes reported profits by an astonishing 25 percent.

Why does S.&P. — along with Warren Buffett, Alan Greenspan and just about every serious financial economist — think that current accounting standards require a drastic overhaul? And if such an overhaul is needed, why doesn't the government do it? Why does S.&P. think that it must do the job itself?

To see the absurdity of the current rules, consider stock options. An executive is given the right to purchase shares of the company's stock, at a fixed price, some time in the future. If the stock rises, he buys at bargain prices. If the stock falls, he doesn't exercise the option. At worst, he loses nothing; at best, he makes a lot of money. Nice work if you can get it.

Yet according to federal accounting standards, such deals don't cost employers anything, as long as the guaranteed price isn't below the market price on the day the option is granted. Of course, this ignores the "heads I win, tails you lose" aspect: executives get a share of investors' gains if things go well, but don't share the losses if things go badly. In fact, companies literally apply a double standard: they deduct the cost of options from taxable income, even while denying that they cost anything in their profit statements.

So how could it possibly make sense not to count options as a cost? Defenders of the current system argue that stock options align the interests of executives with those of investors. Even if that were true, however, it wouldn't justify ignoring the cost — no more than it would make sense to deny that wages, which provide incentives to workers, are a business expense. Furthermore, it's now clear that stock options, far from reliably inducing executives to serve shareholders, often create perverse incentives. At worst, they handsomely reward managers who run their companies as pump-and-dump schemes; executives at Enron and many other companies got rich thanks to stock prices that soared before they collapsed.

Options are only part of an accounting system in deep trouble. As David Blitzer, S.&P.'s chief investment strategist, recently wrote, "Financial markets are as much a social contract as is democratic government." Yet there is a growing sense that this contract is being broken, undermining the trust that is so essential to the operation of financial markets. Clearly, major reforms are needed. And bear in mind that this isn't a left-right issue; it's about protecting investors — middle-class and wealthy alike — from exploitation by self-dealing insiders. So who could possibly be opposed? You'd be surprised.

Harvey Pitt, the accounting-industry lawyer who heads the Securities and Exchange Commission, has clearly been dragging his feet on reform. And his boss, George W. Bush, has declared himself opposed to treating stock options as a business expense. Wouldn't it be nice, just once, to see the Bush administration oppose the interests of a privileged elite?

But the administration is not alone in its foot-dragging. In fact, perhaps the biggest foot-dragger of all is Senator Joseph Lieberman. Way back in 1994 Mr. Lieberman gave crucial aid to lobbyists trying to head off new accounting standards, which would have forced companies to recognize the cost of options; now he is once again defending the status quo, urging his colleagues to go slow.

Some politicians do see the problem; John McCain and Carl Levin have introduced legislation to reform America's accounting standards. But it seems unlikely that government will fix our dysfunctional accounting rules anytime soon.

Mr. Blitzer of S.&P. points out that in previous periods of corporate scandal, "legislators and prosecutors took the lead in tackling public concerns over the market." It is a sad commentary on our leadership that this time he feels that he must do the job himself.

Originally published in The New York Times, 5.17.02