& Tornado Alley
of Accounting and Auditing Practices
There are two related problems here. First, what should be the treatment of stock options for making accounting figures representative of the financial state of the company? Second, does the non-expensiving of stock options result in not only over-compensation of executives but also give them an incentive to go to any lengths to raise the price of the company stock even if it involves lying and cooking the books. As Richard Breeden, a former SEC Chairman (1989-1993) has said:
You have executives in many companies who have- measure their option packages in millions of shares, and sometimes tens of millions of shares. And with that, of course, grows a pressure to make the stock perform at higher levels.
When an executive has a portfolio of a hundred million stock options, they can make far more money by getting the stock to move a few dollars in response to false information than anybody could do in most insider trader cases.
So the size of the stock packages create a temptation for economic gain that is very corrosive and will lead some people to be willing to lie, to cook up false income, to not tell the truth about negative factors, and in Enron's case, to create an entire picture of a company that didn't exist.
This sentiment is echoed by Sarah Teslik of the Council of Institutional Investors:
At Enron the executives had the ability, by jacking up the stock price, to take hundreds of millions of dollars out of the company and keep them through the vehicle of stock options.
Stock options should be charged to earnings. They are often a massive cost of production, and they need to show up in the financials in a very clear way, so that someone investing in the company today doesn't miss the fact that a couple years down the line, their stock is suddenly going to be diluted massively and be much less valuable.
When the Financial Accounting Standards Board (FASB) ruled in 1993 that stock options should be expensed there was wide-spread corporate outcry particularly in the Silicon Valley. Hedrick Smith, in his Frontline Special Bigger Than Enron, remarked:
Corporate America was livid because making options a business expense would be devastating to the bottom line of many companies. At Internet dynamo Cisco, for example, a $2.6 billion profit one year would have been cut nearly in half. A Merrill Lynch study found that expensing options would have slashed profits among leading high-tech companies by an average of 60 percent.
But options were a hidden cost that never showed up on a company's balance sheet, and that made it harder for ordinary investors to gauge corporate performance.
The FASB thought that it was a clearcut matter of truth. As Jim Leisenring the Vice Chairman of FASB from 1988 to 2000 stated:
The costs are fairly significant, and we think that this is a credibility issue, that, in fact, financial statements are omitting compensation expense, for some companies very material amounts of compensation expense. So we thought and still believe that it's a matter of the marketplace deserves that information.
But the industry was not interested in the objective truth of the matter. It was a question of their pocketbooks that mattered. A grassroots compaign swept industry. As Mark Nebergall, a software industry lobbyist, described the situation:
People were signing petitions to the president saying, you know, "Please don't let them do this. Don't take away my stock options." People were hot under the collar.
People had on T-shirts with big stop sign on the front that said "Stop FASB" that they were passing out.
CEO's from all over American industry traveled to Washington to personally lobby their congressmen and senators. Sarah Teslik of the Council of Institutional Investors described the campaign:
It was one of the most impressive lobbying efforts on earth. It was protecting CEOs' pay packages.
I mean, there's nothing in CEOs' salaries that compares to the numbers of CEO stock options. It was protecting CEOs' pay package. They were out in force.
The campaign was effective. In May of 1994 the Senate voted 88 to 9 to condemn the FASB resolution. Jim Leisenring of the FASB described the nature of the Senate's action:
It wasn't an accounting debate. We switched talking from about whether, "Have we accurately measured the option?" to things like, "Western civilization will not exist without stock options," or that there won't be jobs anymore for people without job- without stock options. People tried to take the argument away from the accounting and over to be just plainly a political argument.
The Senate did not have the power to force the FASB to rescind their resolution but the Senators could take away the funding of the FASB. This was a serious threat to the functioning of the FASB. Arthur Levitt the Chairman of the SEC at the time got involved. He explained his actions as follows:
My concern was that if Congress put through a law that muzzled FASB, that would kill independent standard-setting. So I went to FASB at that time, and I urged them not to go ahead with the rule proposal.
It was probably the single biggest mistake I made in my years at the SEC.
The FASB relented and passed a much weaker rule that the cost of stock options need only be revealed in a footnote in corporate reports.
A complicating factor is that many companies count stock options as an expense for tax purposes but do deduct them in reporting corporate earnings.
Sunbeam was an old, well known maker of household appliances. By 1996 it had fallen on tough times. The major stockholder brought in Al Dunlap to manage the company. Dunlap was known as a turnaround artist with a record of rescuing failing corporations. He was given 7 million shares and options so he had a high incentive to improve the financial status of the company. That was the general idea but actually what his incentive was was to increase the stock price. By 1997 he reduced the number of Sunbeam appliance factories from 26 to 8 and sold off businesses that fit well with the core business. He claimed to have cut costs by $225 million a year. Wallstreet heard and believed. The stock price rose from $12.50 per share to $53.
But all was not as it appeared to be. Much of the supposed turnaround came from taking an exaggerated writeoffs for the year 1996 in which Dunlap took over, $336 million. This writeoff turned $100 million of earnings into a loss of $230 million for the year. That made it easy to appear to have improved the fortunes of the company. This was combined with dubious accounting ploys. In fact, however, the company was not really doing better. In 1998 the general councel for Sunbeam met with several members of the Board of Directors. John Byrne reported in Business Week that the counsel told the board members:
Al [Dunlap] didn't tell you the truth. The quarter is coming in horribly. The numbers are a disgrace- new products that have no sales, inventory issues, accounting issues." And the board decides to fire both Al and the chief financial officer.
The price of the stock subsequently collapsed, not back to the $12.50 a share that it had been at before Dunlap came in, but to less than $1. The SEC brought charges against the Arthur Andersen auditor that failed to blow the whistle on the flaws in Dunlap's accounting. The case may still be pending because of limitations on the resources of the SEC. One was the regulated industries try to cope with regulation is to use political influence to have legislatures deprive the regulatory agencies of funding.
Waste Management is a familiar name around America because in many cities it is the company that collect the trash and garbage. Its name is blazoned on the big trash trucks that roam the cities. Waste Management bought up smaller trash-collecting companies and established a record of high growth in earnings simply from those acquisition. When it was no long feasible to boost earnings by buying more trash companies because they were not that many left the company resorted to accounting ploys to inflate earnings.
Companies compute depreciation because depreciation is deductible for tax purposes. High depreciation reduces the profit tax and thus enhances the cash flow of the corporation. The after-tax profit is lower when depreciation is higher. Usually corporation want to expense capital goods over as short of a period as allowed. Apparently Waste Management began extending the depreciation period on its equipment to increase its current after-tax profits even though this action reduced its cash flow. When new members joined Waste Management's board of directors they found that the company had inflated its earnings by $1.7 billion by such accounting ploys. Waste Management's auditor Arthur Andersen had not objected to the company's accounting practices and the SEC fined Arthur Andersen $7 million and had the accounting firm sign an agreement that it would not sanction such accounting in the future. However some of Arthur Andersen' clients were paying as much as $100 million per year in fees for auditing and consulting so a $7 million fine was not much of an incentive to stop doing the things that its clients wanted it to do.
In Enron's case the accounting ploy was the creation of partnerships so that corporate debt could be taken off the balance sheet in order to make the company look better financially than it really was. Its accounting firm, Arthur Andersen, not only did not object to this strategy in its audits, it helped create the strategy. There were staff members at Arthur Andersen, such as Carl Bass, who did object to the accounting ploys buts the client, Enron, demanded that Bass be taken off their audit program.
One of the vice-presidents of Enron, Sherron Watkins, who was a former professional employee of Arthur Andersen, warned the CEO Ken Lay that Enron was on the verge of financial collapse but nothing was done. Later Watkins notified Arthur Andersen of the accounting problems and when the accounts were corrected Enron's net worth was reduced by $1.2 billion. Subsequently the stock price collapsed and the company went folded.
The CEO of Andersen Worldwide, Joseph Berardino, had a witty comment on the situation. He said,
You know there's been so much pain that's coming out of this Enron situation- stockholders, their employees, now our employees. People always ask me, "How do you sleep at night?" And I say, "I sleep like a baby. I wake up every two hours and cry."
In an interview for the Fontline Special Bigger Than Enron Hedrick Smith had the following exchange with Lynn Turner, who was the chief accountant with the SEC but formerly had been a partner in the accounting frim of Coopers & Lybrand.
LYNN TURNER: In my prior life, we [Coopers & Lybrand] actually had a retainer arrangement with each of the major Wall Street investment banking firms under which we would help them financially engineer or structure hypothetical transactions for, you know, finding financing, keeping it off balance sheet, making companies look better than, quite frankly, they really were.
HEDRICK SMITH: You mean, doing the kinds of things that Enron and Andersen did.
LYNN TURNER: Yes. Exactly.
HEDRICK SMITH: So there's a whole system that does this.
LYNN TURNER: There is a system that turns around and does it. Every one of the big accounting firms have such a group.
HEDRICK SMITH: And all the big investment banks have that.
LYNN TURNER: Yes, investment banking groups. In fact, they make good money trying to figure out how to structure these transactions.
HEDRICK SMITH: So we haven't, in Enron, just stumbled into something that may have happened. This isn't way off, an odd-ball thing. We've run into something that is a fairly common practice.
LYNN TURNER: This is day-to-day business operations in accounting firms and on Wall Street. There is nothing extraordinary, nothing unusual in that respect, with respect to Enron.