Accounting High Jinks and Stock PricesPublished: February 27, 2002 in Knowledge@Wharton
By now they are something of a rogues gallery, symbols of maverick accounting in the new century – Enron, Tyco, Qwest, Computer Associates, Global Crossing. Many investors worry these firms may be the tip of the iceberg, just the start of what will become a relentless parade of accounting scandals that will dampen stock market returns for months to come, perhaps years.
There is some precedent. In 1973, Equity Funding Corporation of America, an insurance and mutual fund company, disintegrated amidst revelations of fraudulent financial reporting. The Equity Funding scandal was a major factor in the bear market that lasted a decade. While the 1970s were not completely analogous to the present, since they were a time of high inflation and slow economic growth, financial markets never benefit when investors grow distrustful of corporate earnings statements.
Enron-type accounting shenanigans do appear to be hampering the broad market, spilling over to undermine stock performance for companies that have not been subject to controversy, says Wharton finance professor Jeremy Siegel. "It’s definitely impacting the market. There’s no question about that. I think it’s accelerating a solution to a problem that had really been festering for a long time, which is the proper accounting for earnings."
Wharton accounting professor David F. Larcker agrees. "Clearly, the prevailing news story is that these accounting practices have cast a pall over the market," he says. "I think there’s some truth to that … People have made some adjustment for how risky their holdings are." Siegel and Larker note, however, that accounting scandals are not likely to sweep the corporate landscape. "It’s still my feeling that the vast majority of CEOs and CFOs are honest," Siegel says.
Meanwhile, Federal Reserve Chairman Alan Greenspan gave his own, somewhat reserved, vote of confidence in the economy during remarks February 27 before the House Committee on Financial Services. In addition to predicting a modest recovery from the current recession, Greenspan said the Enron scandal was "not a significantly negative event" and might even result in more corporate accountability and transparency. He also noted, however, that the scandal, and others like it, could adversely affect the economy by creating uncertainty and loss of confidence among investors.
In terms of the market, both Larcker and Siegel predict that the worst stock-price damage probably will be concentrated in so-called new economy companies – high tech and financial-services firms which, like Enron, deal in products and services that are not easily understood or valued. These companies are hard to evaluate even when they keep honest books, and many are in new industries in which it is hard to apply traditional accounting standards or to gauge performance against well-established yardsticks. As Siegel says, "There’s going to be a cloud over those sectors for a little while."
Global Crossing, once a high-flying company that laid fiber optic cable, filed for bankruptcy in January amidst accounting irregularities that, as at Enron, inflated earnings and concealed debts. A year ago the company’s shares traded above $20; today they’re worthless. Qwest, a money-losing phone and data-services provider, is mired in problems involving the way it recognized revenue and accounted for "bandwidth swaps." It trades at around $8 a share, after trading above $40 a year ago.
Computer Associates, an e-business software company, has been accused of double-counting some revenue. In the past month its shares have fallen from nearly $40 to about $17. Tyco, the international conglomerate, has been hammered by criticisms it has not disclosed enough detail about $8 billion in investments. Tyco shares have fallen by half to around $30 since the start of the year.
Despite all this, the Dow Jones Industrial Average has been surging in the past month. The S&P 500 is about 15% higher than it was when the Enron and other accounting scandals began last fall. Even the Nasdaq Composite, brimming with money-losing high-tech companies, is nearly 30% higher than it was when Enron began to unravel last fall, though this index has fallen about 10% this year.
Of course, the market might have been doing even better if not for the shadow cast by accounting and disclosure problems. "The short- to medium-term impact might not be so good, because it might be awhile before we have all this figured out," says finance professor Andrew Metrick. "I don’t think there will be many as nasty as Enron, but it’s not clear how much is lurking out there."
While there may be new controversies, he says, the broad market has already adapted. "You can think of accounting risk as being an extra kind of business risk." But Wall Street analysts and sophisticated investors already have accounted for this risk in pricing stocks at the levels they are at today, he adds.
Siegel notes, however, that the spotlight on accounting is causing many companies to take the conservative approach on earnings, revenue or debt figures that fall into gray areas. As a result, reported earnings may well be lower this year than forecasters had expected before the scandals broke, even if business does as well as the experts had predicted. "The truth is, earnings numbers do affect stock prices," he says. Lower earnings mean lower prices.
Metrick, Larcker and Siegel all say, however, that the broad market could benefit if companies adopt better practices and government strengthens regulations. Many companies are voluntarily adopting more conservative reporting standards because they expect investors to reward such behavior by bidding up prices of companies that clearly disclose data that other companies obscure, Siegel points out.
Still, it’s likely to take some time for the post-Enron environment to evolve, Larcker adds. Setting new accounting standards, he cautions, is difficult. "The problem is that standard-setting is inherently political. Experts have a hard time agreeing on what new rules should be and, even when they do agree, there inevitably is opposition from groups that would suffer if the rules change. The way you keep score affects the numbers. Depending on how you choose to do these things, the numbers can go up or down. A lot of people weigh in on these things."
After looking at Enron, for example, many argue that companies should be required to disclose "off-balance sheet" transactions with subsidiaries, partnerships and other "special purpose entities." Enron used such transactions to conceal massive debts. But many other companies used such transactions for perfectly legal purposes. They won’t be happy about any rule change that would suddenly make their businesses look less profitable, or which would force them to disclose dealings they had agreed to keep confidential. "I think what’s going to happen is that we are going to see some expedited way for developing standards," Larcker predicts.
Ultimately, says Siegel, accounting for earnings will be more standardized than it is today and corporate activities that have been kept hidden will be revealed. "This is long overdue."
Adds Metrick: "It looks like we might end up with more and better disclosure. Ten years from now we might be glad this happened."