By 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.