Options and Other Accounting Scandals

Enron has ended the belief that American markets are "safe." Safer than most, yes. But at the end of the day, Enron took advantage of U.S. accounting rules to disastrous results. Investors are now terrified of the next Enron, and punishing companies with even a hint of accounting irregularities. This is a good thing.

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By Bill Mann (TMF Otter)
February 1, 2002

Right now, the greatest thing that I have seen happen in investing since Regulation Fair Disclosure is happening. Companies that have played fast and loose with their accounting are getting massacred in the market as people fear holding on to "the next Enron."

In fact, I did just call this a great thing, and it's not because I don't care about the shareholders' money in Tyco (NYSE: TYC), Elan (NYSE: ELN), WorldCom (Nasdaq: WCOM), or any of the other companies that have been torn asunder in the last two weeks. I care a lot. I care deeply about the workers and shareholders who got reamed at the hands of Enron. I care that people have been bilked by people playing fast and loose with accounting over the past few years at Waste Management (NYSE: WMI), Cendant (NYSE: CD), and MicroStrategy (Nasdaq: MSTR). But finally, in Enron's collapse, something so egregious has come along to make Joe Bloggs investor on the street really leery of loose accounting.

As such, the companies that have hid, shaded, and otherwise bent the rules (if not completely broken them) to their own benefit are having their heads handed to them. I can't say that every company that has played fast with the truth is being punished, nor can I say that any of the companies -- including those I named above -- are in FACT dirty. The problem is that they look like they are dirty, and investors are not sticking around to find out the hard way.

Good. Finally, one of accounting's dirty little secrets is being exposed, and there's nothing like a little sunshine to uncover and embarrass those who wish to deceive or shade the truth. I am reasonably certain that every single company out there is looking at its past filings to see if it has a liability for "Related Party Transactions," off balance sheet financing, and mark-to-market asset valuation. They had better be, because investors are scared out of their wits.

GAAP is not exact
There are a few problems with generally accepted accounting principles (GAAP) that need to be fixed. But more importantly, investors need to understand that GAAP, like any other language is not precise. GAAP is subject to interpretation, and if you think that there are some "what does 'is' mean" conundrums in the English language, GAAP is much, much worse. And it will remain so, because the Financial Accounting Standards Board, for all of its efforts to ensure that GAAP is accurate, can never, ever account for people who are willing to skirt the rules.

In one way, I think that British GAAP has a nice advantage over America's version. In Britain there is an override that states that not only must each line item comply to GAAP, but the overall information must be an accurate presentation of the company's performance. In other words, you can shade each line item and still remain within the law, but if the big picture is not accurate, then the company is out of compliance. This is a good thing, and it would have placed Enron on the wrong side of the law a long time ago, because even had it technically followed GAAP under each account, there is NO WAY that the total presentation was giving investors an accurate picture.

Does it walk like a duck?
Look at Enron, look at Tyco, look at Waste Management. We have the power to say that if a company does not make its accounting as clear as possible, then we are going to put our money elsewhere. Call it the "walks like a duck" penalty. Companies may be following the letter of the rules, but if they even smack of hiding the reality of their businesses, then we won't invest.

There are a few other issues that are coming to light. The first of which is 401(k) reform. I don't really agree with the limits on corporate stock as a percentage of the whole. I do agree that it is the height of cynicism that people who now have to manage their own retirement accounts can be issued restricted stock from their employers. This has got to stop. If individuals are charged with managing their retirements, then they must be able to do so.

There are many who are questioning how the senior executives sold hundreds of millions of dollars in Enron stock while the rank-and-file were not able to. The reason they could, of course, was that the executives were issued stock under options plans, while the other employees' stock was under their 401(k)s. I don't think this is the important question, actually, outside of taking restrictions off the employees. I do have a big problem with the amount of options that Enron was issuing its management in the first place -- more than a billion dollars worth in the last five years.

Enron was a company famous for doing anything it could to increase its bottom-line profits, even if the details of how it got there were obscure. But the company, per GAAP rules, could issue all of the options it wanted with only nominal impact to the bottom line, because options do not have to be expensed. This is an absolute outrage.

Here would be my question to Ken Lay at the Senate hearing on Monday: If Enron was forced to expense those options paid to you and other executives, so shareholders could plainly see how much money you were making, would you have paid yourselves that much, even though the damage to the bottom line would have been severe?

Without options expensing, companies like Enron could enrich executives for the job of making shareholders think things were better than they were. I never again want to hear the argument for options of "aligning the interests of management and shareholders," because Enron has exposed it as being complete hot air. How many executives from failed companies are walking away with millions of dollars? We have situations where the executives who ran companies into the ground are more creditworthy than the companies they ran, and the process by which they got that way is opaque to investors. This is WRONG.

I believe that options should be expensed on the income statement at face value. Any unused options can be credited back at a later period of time. No complicated Black-Scholes method. Just treat it as money spent at the time of issuance, and treat it as a credit later on. GAAP already has a similar treatment for tax liabilities, where "deferred taxes" are treated as a liability, even though a company may have no interest at all in ever selling the appreciated asset that has generated the liability.

Mechanics aside, it is time that GAAP and its application be changed to improve the clarity by which it presents company performance. A "total accuracy" override would be a good start. Expensing of options would be great as well. But investors should also vote with their feet. Think your company is doing something shady? Sell it, and send their investor relations a note and tell them why. When accounting games, or even the appearance of such have investors running in fear, it will no longer be in the company's best interest to play them.

Finally, Enron has wiped away the myth that the U.S. markets are "safe." When Enron exploded, and the truth came out, it didn't just hurt Enron investors, though they obviously got the worst of it. It hurt all of us, because suddenly people finally understood that Wall Street is self-interested and dirty, companies are willing to bend the rules, and there is a really good chance that the managers who actually did the bending will not pay a sufficient price for their misdeeds. This has been true for a long time, but finally, Enron has given us a disaster that cannot be ignored or washed away. The hearings for Enron are coming, but other companies had finally better understand that in the public markets, they are guilty until proven innocent. Just ask Tyco.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Langston Hughes, Bill Mann's favorite poet, would have been 100 years old today. Bill does not own any company in this article. Please see the Motley Fool's disclosure policy.