Published in the Financial Post, April 16, 2004, p. FP-15.

When Regulators Run Loose
by
Pierre Lemieux

 

“Nortel Networks has been fully cooperating with the OSC,” the company said Tuesday. It doesn’t have much choice, and it used the same submissive formula on April 5, in response to the first investigation, launched by the U.S. Securities and Exchange Commission, OSC’s mentor. This praetorian activity follows Nortel’s announcements, first last fall and then last month, that it would restate its results for several years. The company also placed its CFO and controller on paid leaves. We don’t know what will come out of all this process, cloaked in mystery and secrecy. But we know something about the underlying incentives. The best of all worlds for a CEO is to overestimate earnings this year, and restate them downward next year. This way, he gets high growth in both periods ­ and in his bonus too. It is true that officially restating is a quite recent phenomenon, imposed by the Ministry of Truth -­ pardon me, by The Regulator. But I suspect that other methods have achieved similar results, like calculating profit growth including this year’s extraordinary revenues, and excluding these special items (from “core earnings”) when profit growth is calculated next year. At the very least, the management discussion and analysis will stress the right figures. The best of all worlds for a regulating bureaucrat is to go after the CEO, either because he has overestimated earnings, as at Enron, or because he restates them, as at Nortel. This happens when the bureaucrat can also catch executives whose very remuneration is deemed to pull earnings down, as at Tyco or Hollinger. The bureaucrats face little costs and get lots of benefits from witchhunts. All this would perhaps make some sense if there was an unambiguous way of measuring abstract quantities like asset values, goodwill, depreciation, provisions, etc. In 2003, for example, there is a $31-million difference in RBC’s net income depending on whether the company uses the Canadian or the American GAAPs (generally accepted accounting principles); and the gap, as it were, was more than $100-million in 2002. These small figures hide differences of hundreds of millions of dollars in revenues and expenses, depending on which set of conventions is used. Even income taxes ­ the sort of expenditure for which you would think they actually have to write a cheque ­ are not the same! The point is that accounting conventions are often just that: conventions. I don’t remember which economist said that accounting is like religion in that it provides neat answers to unanswerable questions. On the bottom line, net income remains a debatable accounting estimate until hard dividends are actually paid. Now, the best of all worlds for you and me would be to have no regulator and take what executives say with a healthy grain of salt until the dividend cheque is issued. This is how capitalism used to work. In the 19th century, and well into the 20th, there were virtually no legislated standards of accounting or financial disclosure, and no “regulator,” except the best of all regulators: The market. The first company to issue audited statements was U.S. Steel, in 1903. A firm signalled that its earnings were real simply by paying real dividends. As Wharton professor Jeremy Siegel found, the average dividend yield on stocks was 5.8% in the 19th century, compared to less than 2% today. We do need basic honesty in business, as in life in general, and there was a lot of that before The Regulator started running loose. Now, we seem to be drifting into a world where every regulated spoken word ­- and every unspoken insider word, too -­ is to be taken for cash, a Potemkin village where “enforcement” and “compliance” are the passwords. But if you literally believe every figure of style in job applicants’ résumés and every word spoken by sales reps, if you really think that business executives are going out of their way to reveal self-damaging truths and that the bureaucrats are self-sacrificing for the “public interest,” well … good luck!