Category: Accounting

Penn State Scandal: Could a Corporate Compliance Model Have Prevented It?

The Penn State scandal has become ever more shocking with each new revelation. My colleague Kathleen Boozang argues that it is time for higher ed to learn from other large enterprises about the importance of compliance:

It appears that even now, Penn State lacks a compliance program, the creation of which Special Investigative Counsel Freeh’s Report recommends. Previously limited to financial fraud and HR issues, a June 21, 2012 posting by Penn State’s internal auditor announces a poster redesign advertising its hotline number, to which any ethical or legal concerns can now be reported.  Important will be training throughout the university regarding the law’s protection of whistleblowers, about which, according to Freeh’s Report, top university leaders were unaware.

While it is stunning that, even now, Penn State has not advanced further in setting up these protective measures, it is fair to say that much of higher ed has been slow to adopt compliance best practices common to the healthcare sector and most business entities.

In related news, the Institute of Internal Auditors met in Boston last week. It looks like they will need to play an increasing role in the higher education setting, especially if internal compliance methods are not mere “rituals of verification.”

Pascal on Power and Justice (A Thought for the New Year)

The past few years I’ve tried to find an inspiring quote for the New Year for the blog. There’s a rich vein of insight to be mined from the Carnegie Council podcasts, which I recently discovered on iTunes. One speaker I particularly enjoyed was Krishen Mehta, a former partner with PricewaterhouseCoopers who is now the co-chairman of Global Financial Integrity’s advisory board. Asked about what motivated him to try to stop the shocking abuse of tax havens and mispriced trade by oligarchs, he said the following:

It really is a war against the poor. The inequity that has existed in the past is going to continue unless civil society is informed, asks the right questions of its government, of its business leadership, and asks for more responsibility. One of my favorite writers is Blaise Pascal, who said that “justice and power must be brought together so that whatever is just may be powerful and whatever is powerful may be just.”

A recent study concluded that, “For a salary of between £75,000 and £200,000, tax accountants destroy £47 in value, for every pound they generate.” Mehta, by contrast, is not only creating value, but doing so for the most vulnerable people. How appropriate that a thinker admired by both mathematicians and philosophers would inspire him.

Image Credit: Augustin Pajou. As described on Wikimedia Commons: “Blaise Pascal (1623–1662) studying the cycloid, engraved on the tablet he is holding in his left hand; the scattered papers at his feet are his Pensées, the open book his Lettres provinciales.”

7

Will in Insolvency

In this week’s New Yorker, Nick Paumgarten, in the Talk of the Town, kindly draws on my work  about the cultural contingency of financial reporting; he quotes me on the need to update the idea of insolvency.  Usually defined as the ability to pay debts as they come due, or assets exceeding liabilities, there has always been a strong objective thrust to the notion.  The emphasis is on measured financial activity reduced to a verifiable expression of ability. 

But as Nick notes, equally important is a debtor’s will to pay.  The differences appear in the contrast between the United States and Greece.When  Standard & Poor’s recently lowered its credit rating of the U.S. Treasury by one notch, it registered doubt not so much about the country’s ability to pay its debt, but the will of its incumbant political class to do so. In contrast, Greece’s political elite seem committed to finding ways to meet that country’s debts; alas, its resources compared to its obligations raise real doubt about their ability to do so. 

Another example of the difference between the ability and the will to pay debts arose in the September 2008 tussle over what to do about American International Group. It was then the world’s largest insurance company and shortly before the crisis  boasted a market capitalization of $180 billion. Much of its trillion-dollar balance sheet was securely housed in walled-off insurance subsidiaries.  Read More

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Accounting for Power

Recent revelations in Japan suggest just how important an understanding of accounting may be.

In a post in late March, I related that many Japanese were willing to give the benefit of the doubt to TEPCO, the operator of the damaged Fukushima Dai-Ichi nuclear plant, in the days following the March 11 earthquake and tsunami. The most common excuse in the language, “Shikata ga nai” (“It can’t be helped”), struck most people as apposite, given the historical rarity of 9.0 earthquakes and 15-meter killer waves.

By now, the situation has almost been integrated into the everyday, at least for those of us far from the reactor. People speculate whether the government nuclear agency’s lead spokesperson is wearing a wig, and a cable news channel has a daily segment, “Kyou no genpatsu kiiwaado” – “Today’s nuke reactor keyword”. Any goodwill toward TEPCO has long since evaporated, thanks to its management’s sloth in apologizing, its spokespersons’ frequent misstatements and evasions in daily press conferences, and sympathy for the thousands displaced from the evacuation zone, their livelihoods derailed (and their pets and livestock reluctantly left behind to starve, an aspect of the story that has mobilized many activists here). But it turns out that even the initial goodwill was probably misplaced.
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From “Qui Pro Domina Justitia Sequitur” to “Elite Frauds Go Free”

Should they change the motto at the Department of Justice? John Ashcroft modestly covered a statue of lady justice during his tenure as AG. But a series of reports suggests that, at least when it comes to financial heavyweights, Domina Justitia has left the building.

Consider first Morgenson & Story’s article, “In Financial Crisis, No Prosecutions of Top Figures:”

As the crisis was starting to deepen in the spring of 2008, the Federal Bureau of Investigation scaled back a plan to assign more field agents to investigate mortgage fraud. That summer, the Justice Department also rejected calls to create a task force devoted to mortgage-related investigations, leaving these complex cases understaffed and poorly funded, and only much later established a more general financial crimes task force.

To be sure, the DOJ has talked a good game here, unleashing Operation Broken Trust to catch the small fry. But even in December of last year, Andrew Ross Sorkin was ringing alarm bells:

To hear Eric H. Holder Jr. tell it, the Justice Department is aggressively cracking down on financial fraud. . . . But after you get past the pandering sound bites, a question comes to mind: is anyone in the corner offices of Wall Street’s biggest firms or corporate America’s biggest companies paying any attention to Mr. Holder’s “strong message”? Of course not. (I actually called some chief executives after Mr. Holder’s news conference, and not one had heard of Operation Broken Trust.)

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Finance’s Revolving Door: Perfected or Passe?

Washington’s revolving door is legendary. Everyone knows the connections between lobbyists, members of Congress, staffers, and favored firms. They’ve been mapped in health care, oil, agriculture, and many other industries. Finance journalists chronicle a superclass shuttling from beltway to bourse and back. Yves Smith and Matt Taibbi post on “sleazewatches” and $2,200-a-ticket conferences where the regulated schmooze with the regulators.

But what if the revolving door is the wrong metaphor? What if, instead, there has been a fusion of state and corporate authority in the banking sector? What if Peter Orszag never left the government when he dropped the OMB Directorship to make at least ten times as much as a vice chairman at Citibank? Gabriel Sherman suggests as much when he describes a lucrative cursus honorum for DC elites:

The close alliance among Wall Street and the economics departments of the major universities and the West Wing of the White House is the military-industrial complex of our time. That it has an effect on our governance is beyond question. How pernicious and distorting these effects are, how cynical many of its participants might be, and what might be done to change the system are being fiercely debated in Washington. In fact, to the layperson, the most surprising thing might be the degree to which people like Peter Orszag see the government and Wall Street as, essentially, parts of the same industry.

Conservative Kansas City Fed President Thomas Hoenig has already argued that “big banks like Bank of America Corp and Citigroup Inc should be reclassified as government-sponsored entities.” Texas Republican Randy Neugebauer has called eight banks “TSEs,” or taxpayer-supported entities. And at a recent conference on macroeconomics, Steve Randy Waldman made a legal point fundamental to all the economic dilemmas discussed.
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Law & Econ’s Influence on Law & Accounting

The hottest book of the century, on corporate law, is in production, thanks to editors Brett McDonnell and Claire Hill, both of Minnesota. As part of a series investigating the economics of particular legal subjects, overseen by Richard Posner and Francesco Perisi, this Research Handbook on the Economics of Corporate Law, promises a comprehensive canvass of the broadest definition of this field of law as it has been structured by economic theories over the past forty years.

My contribution addresses the influence of law and economics on the sub-field of law and accounting, which I suggest takes the form of “two steps forward one step back.”  You can read a draft of my chapter (comments welcome!), available free here, accompanied by the following abstract:

Theory can have profound effects on practice, some intended and desirable, others unintended and undesirable. That’s the story of the influence the field of law and economics has had on the domain of law and accounting. That influence comes primarily from agency theory and modern finance theory, specifically through the efficient capital market hypothesis and capital asset pricing model. Those theories have forged considerable change in federal securities regulation, accounting standard setting, state corporation law, and financial auditing. Affected areas include the nature of disclosure, the measure of financial concepts, the limits of shareholder protection, and the scope of auditor duty.

Analysis reveals how agency theory and finance theory often but not always point to the same policy implications; it reveals how finance theory’s assumptions and limitations are often but not always respected in policy development. As a result, while these theories sometimes produced policy changes that were both intended and desirable, some policy changes were both unintended and undesirable while others were intended but undesirable.  Examination stresses the power of ideas and how they are used and cautions creators and users of ideas to take care to appreciate the limits of theory when shaping practice. That’s vital since the effects of law and economics on law and accounting remain debated in many contexts.

Other contributions to the book similarly available in draft form are by Matt Bodie (St. Louis), David Walker (BU) and Charles Whitehead (Cornell).  The following scholars are also contributing chapters: Bobby Ahdieh (Emory), Steve Bainbridge (UCLA), Margaret Blair (Vandy), Rob Daines (Stanford), Steve Davidoff (Ohio State), Jill Fisch (Penn), Tamar Frankel (BU), Ron Gilson (Stanford/Columbia), Jeff Gordon (Columbia), Sean Griffith (Fordham), Don Langevoort (GT), Ian Lee (Toronto), Richard Painter (Minnesota), Frank Partnoy (SD), Gordon Smith (BYU), Randall Thomas (Vandy), and Bob Thompson (GT).

Creating Value

I’ve talked in previous posts about a “closed circuit” economy among the wealthy. A plutonomy at the top increasingly circulates buying power (be it luxury goods, real estate, gold, or securities) among itself. The middle class used to dream that a rising Wall Street tide would lift all boats; as Felix Salmon shows, that hope is fading. Whatever innovations arise out of these companies aren’t doing much for average incomes.

On the other hand, financial innovation has done wonders to extract purchasing power from the broad middle into the closed circuit at the top. Here, for example, is how one of our leading firms created enormous value in 2006:

Consider the tale of Travelport, a Web-based reservations company. [A] private equity firm and a smaller partner bought Travelport in August 2006. They paid $1 billion of their own money and used Travelport’s balance sheet to borrow an additional $3.3 billion to complete the purchase. They doubtless paid themselves hefty investment banking fees, which would also have been billed to Travelport.

After seven months, they laid off 841 workers, which at a reasonable guess of $125,000 all-in cost per employee (salaries, benefits, space, phone, etc.) would represent annual savings of more than $100 million. And then the two partners borrowed $1.1 billion more on Travelport’s balance sheet and paid that money to themselves, presumably as a reward for their hard work. In just seven months, that is, they got their $1 billion fund investment back, plus a markup, plus all those banking fees and annual management fees, and they still owned the company. And note that the annual $100 million in layoff savings would almost exactly cover the debt service on the $1.1 billion. That’s elegant—what the financial press calls “creating value.”

The corporate geniuses at Boeing offer another display of modern-day business acumen.

The more stories like this you read, the more you realize that massive unemployment isn’t a bug in our economic system; it’s a feature. A country can’t have legal rules that permit these moves without expecting to hemorrhage jobs. All the Michael Porter homilies in the world can’t put this Humpty Dumpty back together again.

5

What Damages Can E&Y Afford and Survive?

Probably $1 billion, but not much more.   Let’s explore.

Global banks are settling US government lawsuits for what looks like big money. Goldman Sachs earlier this year settled a securities fraud claim for $550 million. UBS recently settled tax fraud charges for $750 million. And Deutsche Bank will now fork over $553 million to settle a similar case.

These are large nominal amounts but they will not remotely break the banks. These firms are financial titans, each commanding some trillion in assets and boasting bountiful annual revenue: Goldman Sachs $52 billion; UBS $44 billion; and Deutsche Bank $37 billion. Payments such as those are significant but not crippling.

The same cannot be said of similar amounts if they had to be paid by the world’s global auditing firms. Those firms (Deloitte, Ernst & Young, KPMG, and PWC) command financial assets trivial compared to those of the global banks, with firm value residing primarily in personal and professional reputation (so-called “human capital”). Revenues are much less than at banks too, about $20 billion for E&Y and KMPG and $25 billion for Deloitte and PWC.

That revenue costs more than bank revenue too and is spread across a far larger employee base. E&Y and KMPG employ about 140,000 apiece and the others about 170,000 each. By contrast, Goldman has a mere 35,000 employees, with 65,000 at UBS and 82,000 at Deutsche Bank. In addition, those financial firms have access to insurance to cover at least certain kinds of losses arising from legal liability, whereas the auditing firms lack that resource and instead self-insure.

Even so, the auditing firms have absorbed considerable payments in legal liability claims in the past decade. Each firm incurs up to a dozen or so settlements in the modest range of a few to ten or so million dollars in any given year. Occasionally larger payouts occur, with nine to date exceeding $100 million: $110 million, $125 million, $200 million, $217 million, $229 million, $250 million, $335 million, and $456 million. All those but the last involved single-company frauds—the latter, the record to date, is KMPG’s settlement of tax fraud charges akin to those Deutsche Bank and UBS likewise settled.

No doubt, those figures sting, but are affordable. It’s easy to infer that E&Y, roughly of equivalent capacity to KMPG, could pay $500 million or more, perhaps twice that, if it had to settle the case involving Lehman Brothers.  But amounts exceeding that could be crippling given the comparatively small asset base, fractional revenue, huge payroll,  and reliance on self-insurance.  The risk of a larger demand is realistic too, given the larger size of the  Lehman fraud  compared to the previous single-company cases the firms have settled.

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Cuomo Sues E&Y: Auditing Profession At Risk

Ernst & Young, one of the Big-4 auditing firms left in the world, faces a grave lawsuit filed a couple of hours ago by New York’s Andrew Cuomo, the incoming governor’s last major act as state attorney general.  The lawsuit is based on fraudulent accounting committed by Lehman Brothers, the failed investment bank, that E&Y either overlooked or condoned, as I explained last March.  

The AG seeks unspecified damages the audit failure caused, certainly running to the hundreds of millions and easily reaching into the billions.  Given that E&Y does not have external insurance to cover such losses, but self-insures, the lawsuit could put the firm’s survival at risk.   Even so, settlement talks, going off-and-on since March, failed, suggesting that the firm is banking on being exonerated.  That is quite a gamble. 

As I told the New York Times and readers of this blog in March, if the case impairs E&Y’s viability as a going concern, a corporate financial reporting crisis should be expected.  It would be acute compared to the modest scramble that corporate America faced after government prosecutors a decade ago drove from the profession the Big-5 firm, Arthur Andersen, auditor of Enron Corp.   Then, 1/5 of companies needed to find a new auditor and most were able to count on one of the remaining four with little trouble. 

Today, 1/4 of public companies would be obliged to find a replacement auditor; thanks to rules stated in the federal response to Enron, the Sarbanes-Oxley Act of 2002, about 1/3 of those would be unable to engage any of the 3 remaining firms because of conflicts of interest (those other firms provide internal control or tax advisory services making them ineligible to render financial audits).   Amid such a crisis,  and with only 3 available firms, the existing structure of the auditing profession would be unsustainable.     

It would be reassuring if the Securities and Exchange Commission could tell the nation that is has foreseen this contingency and developed plans for addressing it, as urged last March and in 2006.  Alas, I am not sure that it is prepared to do either.