The U.S. Economy: A
Few Bad Apples or Tip of the Iceberg?
Keith W. Rabin and Scott B. MacDonald
In the face of massive
stock market volatility, wealth erosion and concern over almost
daily accounting and corporate governance scandals, there is considerable
discussion about the need to cull the few "bad apples"
that are giving U.S. business a bad name.
Many analysts and television talking heads note that Main Street
is demanding the culprits be apprehended and made to do hard time.
Congress is busy passing legislation to deal with corporate sleaze.
This thinking reflects the common perception that most corporations
are managed by honest people and that the main task at hand is
to root out the egregious examples of fraud that are shattering
investor confidence. Then, it is believed, market concern can
be alleviated and U.S. firms can return to what they do best -
make profits. With U.S. business refocused on profits (as well
as better corporate governance), the economic recovery will be
assured, the stock market will go back up, and the American public
will regain lost confidence in buying securities.
While it is true that most
managers are honest and indeed critical to make examples of executives
who commit criminal fraud, this type of thinking misses the boat.
Yes, the outright deception that characterized the Enron, WorldCom,
Tyco and other debacles are special cases, but the late 1990s
tendency to engage in highly aggressive accounting practices was
highly pervasive -- even though most firms remained within the
lines of ethical corporate behavior. It should be remembered that
following the Arthur Andersen debacle, there are now 2,400 ex-Andersen
accounts forced to reexamine everything that was reported over
the last several years. This will have a negative effect on earnings
moving forward as it is probable that at the very least a number
of firms will have to restate earnings - not a good signal to
an already highly sensitive bear market. Therefore, one might
view the current paradigm as more similar to exposing the tip
of the iceberg than the need to clean out a few bad apples.
As the late 1990s Internet
boom accelerated, traditional rules of business behavior and corporate
valuation were eroded. In the land grab that characterized this
era, growth of market share was seen by many to be more important
than profitability. Many concluded it was better to invest in
new, speculative firms who had little more than a business plan
and venture capital funding. These enterprises enjoyed massive
capital inflows without the need to endure the analytical rigors
and performance expectations imposed upon companies with real
revenues and operating histories. Emerging firms such as Amazon,
eBay and eToys quickly amassed market capitalizations that were
larger than many Fortune 50 corporations.
To remain competitive,
established firms turned to high-octane financial engineers. As
if by magic, they transformed balance sheets and income statements
in a manner that delivered the progressively improving performance
demanded by the financial community. Two exemplars of this trend,
Andrew Fastow of Enron and Scott Sullivan of WorldCom, were lionized
for their achievements and recognized as being in the forefront
of business finance. Each received "Best CFOs" ratings
in annual competitions by CFO Magazine. Corporate finance managers
recognized this change in sentiment and adapted their institutional
values accordingly. The message was clear. CFOs and controllers
who wanted to get ahead adopted an aggressive stance. Those that
maintained a conservative posture were viewed as old-fashioned
relics of the past.
Today, we are presented
with a very different dynamic. Many of the practices seen as highly
clever and cutting edge only a year or two ago are now viewed
as scandalous. Good, conservative accounting practices, which
could likely have been grounds for
dismissal in 1997-2000, are now seen as desirable virtues. Corporate
behavior is beginning to reflect this new reality. This in essence
is what is so troubling about the current "bad apple"
debate, which maintains that once the few fragrantly fraudulent
offenders are rooted out, the "silent majority" of good,
honorable companies can regain the valuations they deserve. Matters
are not so black and white nor is it a case of good versus evil.
Accounting is far more
art than science. As anyone who has engaged in the preparation
of complex financial statements can observe, numerous subjective
judgements are required as to how to classify and treat each and
every item. President Bush acknowledged this phenomenon in a recent
press conference. When asked about Harken Energy, he noted something
to the effect "in the corporate world, not everything is
black and white and sometimes there are honest disagreements on
how to account for complex transactions."
As the smell test of what
is normal and ethical shifts from overly aggressive to even mildly
conservative, it will have profound implications on the standards
that govern audits and the behavior of corporate finance professionals.
Most corporations - whether or not they have engaged in any fraudulent
behavior -- will be far more reserved in their accounting and
corporate profitability will inevitably suffer as a result. This
represents an obstacle that has not been sufficiently recognized
or factored into the expectations of many analysts and investors.
It therefore does not seem
realistic to imagine that even if the U.S. could show dramatic
2002 GDP growth beyond the 2-3% anticipated by most economists,
that we will see the earnings revisions that will lead to the
rapid upwards valuations needed to lift share prices.
Far more likely is a continuation
of the current scenario, in which we continue to slowly work off
the excesses of the dot.com era. Real growth and achievements
will be masked by a continual procession of announcements concerning
accounting and other
irregularities - not to mention the major uncertainties caused
by the continuing war on terrorism. In the end corporate America
will emerge all the stronger. However, a belief that we simply
have to uncover all the "bad apples" to rectify all
that is wrong with the current market environment will only delay
the ultimate resolution of these important issues.