Enemies of Reform

SYNOPSIS: Without proper accounting standards for corporate profits, options give management the incentive to pump and dump

"I would suggest to you that the single most important innovation shaping [America's] capital market was the idea of generally accepted accounting principles." So declared Lawrence Summers, then deputy secretary of the Treasury, in a 1998 speech. Mr. Summers urged troubled Asian economies, then in the middle of a disastrous financial crisis, to emulate American-style "transparency and disclosure."

Now America has its own problems with corporate accounting, exemplified by Enron. So will we follow our own advice? Will we provide investors with the facts they need to make informed decisions? Probably not. And that's bad news, because Enron's case, though extreme, was by no means unique.

For corporate America as a whole, 1997 was a watershed year. According to government statistics, overall corporate profits grew rapidly between 1992 and 1997, but then stalled; after-tax profits in the third quarter of 2000 were barely higher than they were three years earlier. But the operating earnings of the S.&P. 500 that is, the profits companies reported to investors grew 46 percent over those three years.

There are technical reasons that these measures of profits need not grow at exactly the same rate, but they have historically tracked each other fairly well. So why did they suddenly diverge? Surely the main reason was that after 1997 companies made increasingly aggressive use of accounting gimmicks to create the illusion of profit growth.

You see, corporate leaders were desperate to keep their stock prices rising, in an environment where anything short of 20 percent profit growth was considered failure. And why were they desperate? In a word: options. The bull market, combined with ever-more-generous options packages, led to an explosion of executive compensation. In 1980 chief executives at large companies, according to Business Week's estimates, earned 45 times as much as non-supervisory workers. By 1995, however, the ratio had risen to 160; by 1997, it had reached 305. C.E.O.'s wanted to keep the good times rolling, and they did: by 2000, though profits hadn't really increased, they were paid 458 times as much as ordinary workers.

The point here isn't that top executives are overpaid, though they surely are; it's that the way they are paid rewards them for creating the illusion of success, never mind the reality.

Still, that's exactly the kind of thing that accounting standards are supposed to prevent. What allowed our corporate emperors to hide their nakedness was a combination of poorly crafted standards, which I wrote about last week, and compliant auditors. Major accounting firms were all too happy to be deceived by corporate smoke and mirrors, as long as they got lucrative consulting contracts.

Time for reform? Not according to some people. Today the Senate Banking Committee is scheduled to take up a bill drafted by Paul Sarbanes, the committee's chairman, that would take some modest steps toward accounting and auditing reform. The bill has been endorsed by some of the most respected names in finance people like Paul Volcker, the great former Fed chairman, and John Bogle, the famed investor. But Senator Phil Gramm, throwing his weight behind an all-out lobbying effort by the accounting industry, has made it clear that he will try to kill the bill.

I'd like to be nonpartisan here really I would. And there are indeed Democrats who have gotten large contributions from accounting firms. But the current effort to prevent any meaningful accounting reform is explicitly a Republican initiative, one directed from the very top: The New York Times reports that Mr. Gramm is "working closely with the Bush administration" in his efforts to block the Sarbanes bill.

Let me repeat what I said last time: Honesty in corporate accounting isn't a left-right issue; it's about protecting all investors from exploitation by insiders. By blocking reform of a broken system, the Bush administration is favoring the interests of a tiny corporate oligarchy over those of everyone else.

One final thought: This isn't just a question of treating American investors fairly. Like the Asian nations before their crisis, the United States relies heavily on inflows of foreign capital, inflows that depend on international faith in the integrity of U.S. markets. The Bush administration may believe that investors have nowhere else to go, that the money will keep coming even if we don't reform. That's what Suharto thought, too.

Originally published in The New York Times, 5.21.02