Accounting is Broken - Investment Analysts Journal

Stern Stewart & Co.
I ronically some of the sharpest observers of stock market behavior–the so-called “eff i c i e n t ”
market theorists–do not find favor with this recommendation. They argue persuasively that
astute, price-setting investors look beyond re p o rted earnings and take into account all publicly
available information relevant to the valuation of shares. They think the aim of re f o rm
should simply be fuller information disclosure and re g a rd as folly the idea that one tru e
e a rnings measure can be defined. A recent Wall Street Journ a l editorial by regular columnist
Holman W. Jenkins, Jr. is indicative of this school of thought:
Studies galore show that stock prices already behave as if investors understand what options
cost them in terms of potential dilution of their ownership stakes. The issue has been fully
aired and the proposed rule, if adopted, would have no impact on share prices.
Much Ado About Stock Options–Act Tw o
By Holman W. Jenkins, Jr.
The Wall Street Journal
August 7, 2002
Although bookkeeping
entries are not real, re a c-
tions to bookkeeping are .
Jenkins and other like-minded souls are correct as far as the professional investor is conc
e rned but go awry in suggesting that the auditor’s definition of earnings is unimport a n t .
I ro n i c a l l y, the counter argument appeared the same day in a separate Wall Street Journ a l
a rticle (“What the New Option Rules Mean for Your Pay”):
As companies begin expensing options, they are almost certain to get stingier about handing
them out because it will hurt their bottom line. That will have major implications for how a
wide array of employees negotiate their compensation packages.
Although bookkeeping entries are not real, reactions to bookkeeping are. The media, re g-
ulators, unions, employees, and top executives all tend to take re p o rted earnings seriously
at face value. The press judges business leaders by the amount of earnings they book.
Labor unions base wage demands on disclosed corporate profits. Accountants are sued
when their profit re p o rts are alleged to be misleading. Most damaging of all, bonuses for
corporate top brass are almost universally tied to book income measures, and that distort s
almost every decision they make, including how they manage risk:
Reported earnings are
indeed of considerable
practical importance,
and a far better definition
is needed.
Enron’s risk manual stated the following: “Reported earnings follow the rules and principles
of accounting. The results do not always create measures consistent with underlying economics.
However, corporate management’s performance is generally measured by accounting
income, not underlying economics. Risk management strategies are therefore directed at
accounting rather than economic performance.” This alarming statement is representative
of the accounting-driven focus of U.S. managers generally, who are all too frequently have
little interest in maintaining controls to monitor their firm’s economic realities.
Testimony of Frank Part n o y
P rofessor of Law
University of San Diego School of Law
Hearings before US Senate Committee on Government Aff a i r s
J a n u a ry 24 t h , 2002
P rofessor Partnoy has fingered the smoking gun of the accounting scandals. It is the rank
f a i l u re of accounting to account for economic value. Reported earnings are indeed of considerable
practical importance, and a far better definition is needed.
The proposed re f o rms now making the rounds are way too timid for the task at hand. Ye s ,
employee stock options should be expensed, and pension fund gains should be eliminated
f rom income. But proposals such as those have more to do with appearances—forcing companies
to re p o rt lower earnings—than the real issue of getting out a more accurate and re l-
evant measure of earnings. The pundits are for the most part swatting flies when there are
s a c red cows to kill.
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