Tài liệu How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America doc

The company haddivorced the reality of its business, abusiness in decline, from the profit-and-loss picture it presented to Wall Street.Breaking the most basic conventions ofaccounting,

One of Many

January 22, 2001, 5:30 P.M Darkness hassettled over the East Coast, but the mood

is sunny in the executive suites at the

Is l andi a, New York , headquarters ofComputer Associates The world’s fourth-largest independent software company hasjust released its quarterly earnings for thethree months ending December 2000, andthe report is a good one Sales and profitsare higher than Wall Street anticipated

No one will benefit from the news morethan Charles Wang, the chairman of

Computer Associates, and Sanjay Kumar,the company’s chief executive, goodfriends who have just bought the NewYork Islanders professional hockey team.Wang owns 30 million shares, more than

$1 billion, of the company’s stock Kumar,

a relative pauper, has about $200 million

in Computer Associates shares Thosefortunes will grow the next day, asinvestors bid Computer Associates’ stock

up almost 6 percent

After issuing the report, ComputerAssociates holds a conference call todiscuss its results with the Wall Streetanalysts who follow the company Kumarcan’t resist bragging Although thesoftware industry is in its worst downturn

in a decade, his company has

demonstrated its strength “We’reextremely pleased with the performance

we pulled off,” he says.1

If she had been on the call, that newswould have come as a surprise to MaryWelch Welch, a Computer Associatessales rep, had been fired by the company aweek earlier, one of three hundredemployees laid off as 2001 began Likemost of the fired employees, Welch wastold she would not receive any severancepay, because she had been dismissed forpoor performance Yet she had received apositive job review only two weeksbefore Welch and many other firedemployees believed that ComputerAssociates wanted to avoid payingseverance by disguising a company-wide

cutback as individual firings The layoffswere necessary because the company’ssales had plunged in the Decemberquarter, the fired employees claimed.

“They did a mass layoff,’’ Welch said

At the time, Welch’s complaints seemednothing more than the gripes of adisgruntled ex-employee After all,Computer Associates’ financial statementsshowed that business had been better thanever in the December quarter, with sales

up 13 percent and profit up almost third Surely the company couldn’t justmake up its results

one-But Mary Welch was right Thanks to anaudacious accounting trick, ComputerAssociates had found a way to rewrite its

financial statements The company haddivorced the reality of its business, abusiness in decline, from the profit-and-loss picture it presented to Wall Street.Breaking the most basic conventions ofaccounting, it was rebooking sales andearnings that it had already reported.

Computer Associates was not a pennystock operating in the shadows of themarket It had eighteen thousandemployees, tens of thousands ofshareholders, and a market value of morethan $20 billion, more than Nike orFederal Express Yet no one— not theanalysts paid to decipher the truth ofComputer Associates’ fortunes, not theaccountants legally required to certify itsbooks, not the mutual fund managers who

bought its stock, and most certainly not theregulators who oversaw the U.S.securities markets— had blown thewhistle on the company’s accountingmaneuvers.

There are fourteen thousand publiclytraded companies in the United States.Expecting all of them to be honest isunrealistic Like any town of fourteenthousand, the market is bound to have itsshare of grifters and shoplifters But thedeception at Computer Associates was

dangerous precisely because it wasn’t an

aberration By January 2001, all manner

of companies were abusing accountingrules to mislead their investors, seeminglywithout fear of being caught A strangemadness had gripped the market Even its

most solid citizens were running red lightsand breaking windows And the policewere nowhere in sight.

PC shipments Casino winnings in AtlanticCity and the Las Vegas Strip.

The figures roll out every day fromgovernment agencies and industry tradegroups and independent analysts.Watching them all is impossible; most

It makes intuitive sense that corporationsmust regularly tell their shareholders howmuch money they have made or lost.What’s your weekly paycheck? Did youget a bonus last year? All in all, how muchmoney did you make? You know theanswer, without much trouble Why

shouldn’t Exxon and General Motors?

They should, and they do Every quarterthey add up their sales and costs, andfigure out where they stand Then they tellthe world, in press releases andconference calls and most important inreports that they file four times a year withthe Securities and Exchange Commission,the federal agency that regulates U.S.stock markets To be precise: Threequarterly reports, or 10-Qs, submitted tothe S.E.C within forty-five days after aquarter ends One 10-K, the big one, theaudited annual report, to be filed less thanninety days of the end of a company’sfiscal year Qs and Ks, in Wall Streetshorthand

Qs and Ks are monuments to numbers.Revenue Selling, general, andadministrative expenses Operatingincome Interest paid Columns of hugenumbers, eight, nine, or ten figures long,fall down the page in black and white toland with a bang disguised as a whimper

at one small number: earnings per share

Earnings per share is usually no more than

a couple of bucks, an unprepossessing sumcompared to the giant figures above Butits small size is deceiving Multiply adollar or two per share by hundreds ofmillions of shares, and you have realmoney A stray penny on the 10 billionshares that General Electric hasoutstanding turns out to be $100 million

Even within a profit report, not allnumbers are equal For traders andinvestors of all sizes, earnings per share isthe ultimate benchmark of a company’ssuccess or failure Has it risen from theprevious quarter and the previous year?Has it met the “consensus”— the averageestimate of the Wall Street analysts whofollow the company? More than any othernumber, earnings per share determineswhether a company’s shares will rise orfall, whether its chief executive will berewarded or fired, whether it will build anew headquarters or endure a round oflayoffs.

On Wall Street, a place of little subtlety,earnings per share is known simply as

“the number.” As in “What was the

number for Pfizer?” Earnings per share isthe number for which all the othernumbers are sacrificed It is the distilledtruth of a company’s health Earnings pershare is the number that counts.

Too bad it’s a lie

Under the best of circumstances, thefigures in a quarterly report— earningsper share most of all— areapproximations, best guesses based on athousand other best guesses Earningsreports are about accounting, and theaccounting that big companies use tomeasure their financial health has as much

in common with the way you balance yourcheckbook as a five-alarm fire has with abackyard barbecue

If you’re like most people, your paycheck

is your main source of income Over thelast few years, if you work for a publiclytraded company, you may have gottensome stock options too Those are nice,but the local grocery store prefers cash, so

if you’re wise, you won’t figure options asincome, either, until you cash them in

Then there’s the other side of the ledger:spending and saving The distinction isusually clear, although the line blurs atyour mortgage payment, since part of that

is going to build equity in your home.Still, your personal accounting isrelatively straightforward You can easilycompare how much you’ve earned andhow much you’ve spent, because you get

paid in cash and you spend cash (or use acredit card, which you pay off within afew weeks).

But big companies measure their costs andrevenues in a very different way Instead

of simply counting the cash they aremaking and spending, they use somethingcalled “accrual accounting.” Underaccrual accounting, a company booksrevenue when it makes a sale, not when itactually receives the cash for the sale Itbooks an expense when it agrees to buysomething, not when it actually pays.Accrual accounting also recognizes thatcompanies invest in assets that will lastmany years, and it allows the companies

to spread the cost of those assets overtheir life For example, an airline doesn’t

expense the entire price of a new plane upfront Instead, it recognizes the cost of theplane over many years, as the aircraft’svalue “depreciates.”

In theory, accrual accounting makes sense.Cash accounting can make companiesappear to be losing money just when theirbusiness is ramping up and they’re makinglots of sales for which they’ll be paid inthe future *

But what makes sense in theory can beabused in practice Because they’re notsimply measuring cash inflows andoutflows, companies need to makehundreds of assumptions to calculate theirearnings each quarter They must estimateeverything from how much money they

will earn on their pension funds to howquickly their assets will lose value †With so many assumptions to make, evenhonest companies sometimes makemistakes Those that want to cheat have analmost infinite number of ways to do so.They can book sales to customers whowon’t ever be able to pay them They canhide ongoing, day-to-day expenses asinvestments in long-lived assets They canshift research and development expenses

to supposedly independent partners Theycan make sham deals with othercompanies, swapping overvalued assets in

a way that allows both sides to book aprofit on the trade

Used properly, accrual accounting isabout timing, not about creating profits

where none exists Over the long run, theprofits that a company reports underaccrual accounting should jibe with thecash it receives and spends Over the longrun, companies that make sales tocustomers who can’t pay will have toadmit that their clients are deadbeats.Over the long run, a company can’t hideoperating expenses as capital spending,because it will wind up with a balancesheet full of nonexistent assets Over thelong run, all the accounting and financialtricks in the world can’t turn a failingbusiness into a success.

But they can in the short run Andsometimes, with enough tricks, the shortrun can last a long time, long enough forexecutives to make tens or even hundreds

of millions of dollars selling stock whosevalue has been inflated by pumped-upearnings.

Given the importance of the number, andthe ease with which it can be manipulated,you might expect that investors wouldlook at earnings per share with a skepticaleye You might think they would carefullyread the footnotes buried at the bottoms of

Qs and Ks, and examine a company’s cashflows to see whether its profits have anybasis in reality

But you’d be wrong As a rule, before

2002, most individual and professionalinvestors didn’t worry much aboutaccounting As long as a major accountingfirm certified that a company’s financial

statements were prepared according toGAAP, or “generally accepted accountingprinciples,” shareholders took them atface value Investors held as an article offaith that the quality of corporate financialreporting in the United States was betterthan anywhere else Watched over by theSecurities and Exchange Commission andindependent accountants, Americancompanies had no choice but to tell WallStreet the truth U.S markets were thefairest and most honest in the world.

Like most deeply held beliefs, thisshibboleth overlooked inconvenientrealities The S.E.C had never been given

a budget large enough to check everyfinancial statement for irregularities.Accountants had always had to balance

their responsibilities to investors withtheir paychecks, which came from thecompanies whose books they audited.

Still, if history was any guide, investorshad reason to be confident Thecombination of mandatory corporatedisclosure and federal oversight seemed

to have worked since its creation in 1934.Sure, the concept behind the number—that public companies could preciselycalculate their earnings each quarter—was a lie But as long as companiesprepared their financial statements in goodfaith, it was a white lie Companies mightnot always be able to calculate theirprofits exactly, but if they made honestestimates they ought to be close And fortwo generations they had been close

Aggressive accounting gimmickry hadbeen uncommon, and overt fraud rare.Most financial statements were reasonablyaccurate There had been exceptions,especially during the 1960s, but theynever caused investors to question themarkets’ overall integrity In fact, in someimportant ways, markets appeared to begrowing fairer as the twentieth centuryprogressed Outright manipulation ofindividual stocks faded, and the S.E.C.aggressively pursued insider tradingcases.

But as the bull market of the 1990s turnedinto a boom and then a bubble, a fewregulators, short-sellers, and journalistswarned that the accuracy of corporatefinancial statements, the core of the

system, was slipping Accountinggimmickry had grown widespread andincreasingly dangerous, they complained.The number of earnings restatementssoared in the late 1990s, and several bigpublic companies admitted or were caughtcommitting accounting fraud.

“We are witnessing an erosion in thequality of earnings and, therefore, thequality of financial reporting Managingmay be giving way to manipulation;integrity may be losing out to illusion,”Arthur Levitt, chairman of the S.E.C., said

in a prophetic 1998 speech in New York

“Today, American markets enjoy theconfidence of the world How many half-truths, and how much accounting sleight-of-hand, will it take to tarnish that faith?”

But with the Nasdaq and Standard &Poor’s 500 index setting new highs onwhat seemed a daily basis, Levitt’sspeech, and similar grumblings, weremostly ignored Wall Street, theaccounting industry, and corporateexecutives insisted the system of oversightand disclosure was as solid as ever Mostindividual investors were inclined toagree, pouring money into mutual fundsand their retirement accounts WallStreet’s complacency about the quality ofearnings persisted even after the Nasdaqbubble burst in the spring of 2000— and,amazingly, even after Enron collapsed inthe fall of 2001 By March 2002, the S&P

500 index, the most important barometer

of the overall market, stood at 1,170,

compared to 1,130 when Enron filed forbankruptcy in December.

To be sure, at 1,170, S&P 500 had fallenabout 24 percent from its peak two yearsearlier But that loss was concentrated intechnology and telecommunicationscompanies, which had been crushed by theslowdown in demand for computers andInternet services Most other stocks hadhardly fallen; many had risen from theirlevels of 2000 Considering that theUnited States had endured both arecession and a terrorist attack theprevious year, stock prices in March 2002reflected extraordinary investorconfidence, a confidence seventy years inthe making

In a matter of months, that confidencedisappeared During the spring of 2002,dozens of cases of serious accountinggimmickry came to light at blue-chip,Fortune 500 companies Qwest, a gianttelecom company, said that it hadimproperly overstated its profits by $1.6billion Dynegy, an energy trader,admitted that it had inflated its cash flow

by hundreds of millions of dollars.Bristol-Myers Squibb, one of the world’slargest drug companies, acknowledgedjuicing its sales figures by encouraging itsdistributors to buy more product than theyneeded I.B.M was discovered bookingprofits from asset sales— which by theirnature are one-time gains— as operatingearnings Every week seemed to bringanother disaster, another S.E.C or

criminal investigation of accountingirregularities: Global Crossing ComputerAssociates Adelphia Communications.AOL Time Warner Nvidia Halliburton.Whole sectors of the market, most notablycable and telecommunications companiesand energy traders, found themselvesunable to sell new stock or bond issues atany price, so deeply did investors distrusttheir financial statements Enron’s auditor,Arthur Andersen, which had eighty-fivethousand employees worldwide and aninety-year history, broke apart andcollapsed after being criminally indictedfor obstruction of justice.

Then, at the beginning of June, Manhattanprosecutors indicted L DennisKozlowski, the chairman of Tyco

International, a huge conglomerate that formonths had angrily denied allegations ofaccounting gimmickry, on criminalcharges of sales tax evasion (Prosecutorswould later expand the charges, accusingTyco’s three top executives of stealinghundreds of millions of dollars from thecompany.) Tyco’s stock, which had stood

at $60 in December 2001, fell as low as

$8 The drop cost investors $100 billion,more than the collapse of Enron And onJune 25, the telecommunications giantWorldCom admitted that it had outstatedits profits by $4 billion Less than a monthlater, WorldCom filed for Chapter 11, thelargest corporate bankruptcy in history.For many investors, the revelations atWorldCom and Tyco were too much to

bear The scope of the fraud at WorldComwas unprecedented, while the chargesagainst Kozlowski put in high relief thegreed that corporate chieftains had shownduring the 1990s boom Kozlowski hadbeen one of the most highly regardedexecutives in the United States only a fewmonths before, fawned over by WallStreet analysts and the subject of a rave

Business Week cover article in May 2001.

Now he was being arraigned in aManhattan courthouse among petty thievesand drug pushers Could any chiefexecutive or any financial statement betrusted? Was the spectacular growth that

t h e U.S economy and companies likeGeneral Electric had shown during the1990s real or a mirage?

Between March and October of 2002, theDow Jones industrial average fell morethan 2,000 points The S&P 500 dropped

by about one-third, closing on October 9

at 777, its lowest level in five years Inseven months, $4.3 trillion in stock marketwealth—$15,000 for every American—simply evaporated From its March 2000high, the S&P 500 had fallen nearly 50percent, the worst bear market since theDepression

The crash was particularly difficult forolder Americans who had counted onstocks to finance their retirements “Ididn’t want to become one of thosedoddering old professors who can neverafford to leave,” John Saxman, aColumbiaUniversity professor, said in

July “Now I’m sixty-three, and every time

I try to think about a specific retirementdate, I look at my quarterly reports andrealize I can’t.”1 But the pain was notconfined to a few or a few million unluckyinvestors U.S economic growth, whichhad been very strong during the firstquarter of 2002, stalled as companiespulled back on new hiring and newinvestments in plants and equipment.Osama bin Laden had hardly slowed theAmerican economy; Dennis Kozlowskiand Bernard J Ebbers of WorldCom andKenneth Lay of Enron brought it almost to

New York Times, I had seen plenty of bad

accounting and corporate fraud Still, Iwas stunned to see a company as large andsupposedly as profitable as Enronimplode in a matter of months Sure, bigcompanies had gone bankrupt before Butusually there were plenty of warningsigns, and the problems were easy tounderstand, if not to fix A labor war haddestroyed Eastern Airlines; heavy debtfrom a hostile takeover had forcedFederated Department Stores, the owner

of Bloomingdale’s and Macy’s, intobankruptcy Enron, however, had justdisappeared The assets that it listed on itsbooks didn’t seem to exist at all

So I was taken aback when the marketignored Enron’s collapse As I began

writing in the spring of 2002, I expected Iwould have to offer lots of specificexamples to convince readers that theproblem of bad accounting had becomepervasive But Tyco and Global Crossingand the rest of the rogues made that casebeyond a reasonable doubt The mostimportant question now is not whathappened at WorldCom or Enron orArthur Andersen or any individualcompany or accounting firm It is why thesystem as a whole failed, why accountingand financial reporting at so manycompanies became criminally shoddy.

The answer has many threads The ethicalcollapse of the accounting industry, vastincreases in executive pay, and severebudget problems at the S.E.C contributed

to the crisis The decline in Wall Streetresearch, the extraordinary growth ofmutual funds, and investors’ insatiabledemand for Internet stocks also played apart Even the falling cost of tradingstocks can be counted as an indirect cause.And in the final two-thirds of this book,I’ll offer a comprehensive look at thechanges of the last two decades.

But to truly understand what happened atthe end of the 1990s, investors need tolook back further than the beginning of themost recent bull market in 1982 The realanswer requires a (brief) explanation ofthe history of accounting and Wall Street

in the twentieth century, beginning with theboom and bust of the 1920s and thecreation of the S.E.C in 1934 For the

seeds of the system’s failure were presentfrom the very start.

Part I

That was Then