Alex Berenson writes elsewhere in today's NYT:
So when Paul A. Volcker Jr., the former chairman of the Federal
Reserve, said last week, "Accounting and auditing in this country is
in a state of crisis," he was not just speaking to men in green
eyeshades, but to the millions of Americans who hope to pay for their
retirement or their children's educations by investing in stocks.
History suggests what could happen. After the 1929 crash, said
Charles Geisst, a finance professor at Manhattan College and author
of "Wall Street: A History," a series of Congressional hearings
revealed that companies routinely failed to disclose important facts
about their finances and that corporate insiders routinely profited
at the expense of small investors.
Scandal's Ripple Effect: Earnings Under Threat
February 10, 2002
Gretchen Morgenson
When Enron (news/quote) caved in last December, investors
with the good fortune to have none of the energy giant's
stock in their portfolios no doubt breathed a collective
sigh of relief.
But it has become increasingly clear in the two months
since Enron's bankruptcy filing that an investor did not
have to own Enron shares to have been hurt by the largest
business scandal in decades. Each revelation in the saga
has added to suspicion that Enron may not be an anomaly,
that much greater risk resides in stocks today than
investors had thought.
So it is not all that surprising that stock prices have
sunk since early December. Recent data has shown that an
economic recovery may be imminent, but the Standard &
Poor's 500-stock index has fallen almost 4 percent since
Enron failed, while the Nasdaq composite has lost almost 6
percent. Only the Dow Jones industrial average has held its
own, losing just 1 percent in the last two months.
If and when the Enron mess fades from view, stock prices
may well rebound, reflecting the expected economic
resurgence.
But Enron's aftershocks could instead have a more lasting
and deleterious effect, not only on the shares of companies
that are aggressive in their accounting, as Enron was, but
also on stock prices over all. In that new world, companies
may be forced to make adjustments that will hurt their
results. Among other things, they will incur higher
expenses and pay more to borrow - lowering reported
earnings. And earnings - the genuine, unadulterated kind -
are what shellshocked investors suddenly care deeply about.
In the broadest sense, Enron has shown investors that very
bad things can happen to companies that engage in
questionable practices to keep reported earnings up and
stock prices aloft. But during the bull market of the late
1990's, few investors cared about nitty-gritty details.
Little wonder that the current rush to examine corporate
accounts is turning up disturbing questions at several
companies, including Tyco International (news/quote), the
AES Corporation (news/quote) and the Elan Corporation. In
recent days, their stock prices slumped. Any company is now
suspect if it has used a lot of off-balance-sheet
financing, has made many acquisitions, has used joint
ventures to create revenue or has been a serial user of
restructuring charges.
"All of these mechanisms that were designed to present a
company's financial condition in the best possible light
are now going to meet a very much higher standard of review
and disclosure," said Jonathan Cohen, portfolio manager at
JHC Capital in Greenwich, Conn., and former chief of
software and Internet research at Merrill Lynch
(news/quote). "Undoing these mechanisms is going to take
air out of the dirigible that has been inflated over the
course of many years."
Investors hoping for a quick rebound in stock prices must
face another harsh reality, gleaned from history. Crises
that occur in the midst of bull markets typically wind up
delivering only short-term blows to stocks, but crises in
bear markets usually exacerbate the existing downturn. And
the bear market continues.
"People expect that the effects of a crisis will quickly be
overcome and the market will go up," said Stephan R.
Crandall, principal at Crandall, Pierce & Company, an
investment research firm in Libertyville, Ill., who has
studied market reactions to dire events going back to 1940.
"But there hasn't been a crisis yet, if we are in a bear
market that has lifted us into a bull market. The reality
is, you always come back to the fundamentals that were in
place prior to the crisis."
Ý
The Enron collapse, coming on the heels of a wild spike and
distressing decline in stock prices, has so angered
investors that they are forcing executives to change their
practices. "Up until very recently, management was rewarded
by engaging in certain types of bad behavior," said Howard
Schilit, president of the Center for Financial Research and
Analysis in Rockville, Md. "Now that reward structure has
been flipped 180 degrees. The market is saying, `We are fed
up with people not telling us the truth.' "
Companies that continue to operate in the old,
anything-goes mode will be punished by investors, Mr.
Schilit predicted. Other companies - those with simple
accounting, understandable businesses and internally
generated earnings growth rather than growth by acquisition
- will be rewarded by fresh investor appreciation.
Regulators are already mandating some behavioral changes.
Last Thursday, for example, the Securities and Exchange
Commission proposed new rules for analysts that call for
increased oversight of research department activities by
firms' compliance departments. This oversight would
increase costs and reduce profits at brokerage firms.
Executives at many companies, meanwhile, are scrambling to
meet new demands from investors for clarity and total
accuracy in financial disclosures. Some companies are being
forced to restate recent earnings to reflect a new, more
conservative approach to accounting.
Last Wednesday, the Cornell Companies (news/quote), an
operator and builder of prisons, said that it was examining
its off-balance-sheet transactions and that its past
financial reports, which had been audited by Arthur
Andersen, might have to be revised. Cornell's shares fell
43 percent on the news.
Other companies may be compelled by their auditors to bring
debt that had been shunted off to so-called special-purpose
entities back onto their balance sheets. That would cause
problems for many companies. Not only would companies face
severe limits on their future borrowing capacity, they
would also increase their interest expenses and reduce
their earnings. Lower earnings would mean less money to
finance operations or research and development. And it
would mean fewer dollars to buy back shares, an activity
that has helped many companies keep their stock prices up
in times of poor performance.
Because they are hidden from view, off-balance-sheet
obligations at companies are impossible to assess fully.
Certainly, banks and brokerage firms are heavy users of so-
called structured financing methods, as are companies that
have financing arms to help customers buy their goods -
like Ford Motor (news/quote), General Electric (news/quote)
and I.B.M. (news/quote)
Andrew Smithers, who runs Smithers & Company, an economic
consulting firm in London, offered one way to judge the
size of off-balance-sheet debts: look at total debt in the
financial sector, which has been rising faster in recent
years than that of businesses and households. As recently
as 1996, financial debt amounted to 32 percent of total
debt in the private sector. Now it stands at 36 percent.
Some financial debt is household obligations, like
automobile leases, Mr. Smithers said. But he thinks most of
it represents off-balance- sheet debts of corporations.
"U.S. companies are already highly leveraged," he said. "It
is unlikely that they could take on balance sheet much of
their off-balance-sheet debt without many companies being
in breach of their debt covenants." If, for example, just
half of all financial debt were moved onto corporate
balance sheets, the leverage would jump to 163 percent of
companies' net worth, based on replacement cost of assets,
Mr. Smithers said.
If their balance sheets are hobbled by such crushing debt
loads, companies will no longer be able to tap debt markets
for capital. They will instead have to go to the equity
markets. That won't help investors, though: a jump in the
supply of shares could also depress stock prices over all.
Another hit to earnings, though probably not in the
immediate future, involves the current accounting for stock
options. Now, companies take tax deductions when their
workers exercise options, but if three senators have their
way, those companies will be forced to compute the costs of
options grants and deduct them from revenue. Most companies
do not do this, referring to the costs of such grants only
in footnotes to their financial statements.
As a result, companies benefit from options grants in two
ways. First, the grants make companies' earnings look
better than they would if options were deducted from
revenue, as are other employee costs. Second, companies
receive a tax benefit equal to the difference, known as the
spread, between the strike price of an option and the price
of the stock when an employee exercises it.
Because option grants have become so huge in recent years,
changing the way companies account for them could put big
pressure on earnings. According to Sanford Bernstein &
Company, a brokerage firm in New York, the value of such
grants at the nation's 2,000 largest companies rose to $162
billion in 2000 from $50 billion in 1997. Bernstein
estimates that if the nation's 500 largest companies had
deducted the cost of options from their revenue, their
annual profit growth from 1995 to 2000 would have been 6
percent instead of the 9 percent that was reported.
In recent years, companies that are heavy users of options,
including Microsoft (news/quote), Cisco Systems
(news/quote) and Dell Computer (news/quote), have erased
much if not all of what they owed in taxes. But when it
became clear that stock option deductions had helped to
wipe out more than $625 million in taxes that Enron owed to
the government from 1996 to 2000, concern about
preferential treatment of corporate stock options got new
life.
The three senators - Carl Levin, the Michigan Democrat;
John McCain, the Arizona Republican; and Peter G.
Fitzgerald, the Illinois Republican - are expected to
introduce legislation this week requiring companies to
deduct stock option costs from their revenue if they intend
to take the tax deduction for options that are exercised.
"With Enron, you saw excessive incentives within that
company to pump up their per-share earnings to keep their
options in the money at all times," Mr. Fitzgerald said. "I
am concerned that overuse of stock options could promote
further the pump-and-dump syndrome that we've seen from
companies like Global Crossing."
As a matter of course, corporate lobbyists will mount a
feverish campaign to defeat such a bill. But after the
Enron collapse, misleading accounting - an accurate
description of the current treatment of stock options - is
a no-no, and the lobbyists may be beaten back.
Enron-related pressure on earnings comes as corporate
profits are already declining. According to Moody's
Investors Service, profit margins sank in the third quarter
of 2001 to 7.5 percent, the lowest since the 7.4 percent at
the end of 1982.
Ý
That is all the more reason for investors to obsess about
earnings and the true value of a company rather than its
share price.
John C. Bogle, founder and former chairman of the Vanguard
Group, the mutual fund giant, sees another implication from
the Enron mess. "There will also be a much more rigorous
focus on what realistic growth for a company can be," he
said.
That would indeed be a tectonic shift for investors. For
years, the corporate fabulists were in charge. Now, it's
the realists' turn.Ý
http://www.nytimes.com/2002/02/10/business/yourmoney/10WATC.html?ex=1014375348&ei=1&en=e26a115e3c914851
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