Monthly Archives: July 2006

Yesterday, the SEC bought the first criminal charges against a Gregory Reyes, the CEO of Brocade Communications, the company’s CFO, and Brocade’s VP for human resources for options backdating. This is the first criminal action brought with regard to the growing option backdating scandal. The SEC also indicated that at least 80 companies are under investigation. On Wednesday, the Wall Street Journal had an article on how the big law firms are generating huge fees as companies prepare for investigations into their options practices. So, this seems like a good time to review what the problems are here.

There are two problems: lying and theft, as to be discussed after the break.

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I am in the process of relocating my home office from the dining room to a bedroom, so today’s post will be sorta short. Fortunately, there is a development in the papers worth a brief note. Today, the Wall Street Journal reported that it is likely that the SEC will withdrew a proposed rule that would have required companies to disclose the compensation of up to three non-management employees, if they are paid more than management. This proposal became called the “Katie Couric clause” for obvious reasons.

This seems like a bad thing. Admittedly, the principal reason for disclosing employee comp is to make sure that management is not ripping off the shareholders. But, there is another reason. As I have been arguing, investors in the new economy need a variety of non-traditional information to evaluate a company. Mega-star employees like Katie Couric and Howard Stern are key resources. The value of these resources depend upon what they cost. Hence, this comp info would be very useful to investors.

Shawn, in a comment, said that Generally Accepted Accounting Principles (GAAP) are satisfactory to compare apples to apples. That is not the case in the new economy. For example, during the tech bubble, GAAP was unable to distinguish a winner high-tech start-up from a loser. Here is another.

For more, let me give you a link to my favorite accounting blog AAO Weblog

I want to go down a tangent a bit and talk about accounting for taxes. This topic is in the media this week because on July 13 the Financial Accounting Standards Board changed the rules, effective next year. (It is funny that the interpretation released on July 13 says right on the the front that it was issued in June. Backdating may be in the air these days.)

Accounting for taxes is tricky for two reasons: First, the accountants want tax expense shown on the financial statements at the same time that the associated pre-tax profit is reflected. For a number of reasons, tax payment timing varies considerably from the timing of accounting profits. Second, the concern here, a company’s ultimate tax liability is uncertain. Firms take favorable positions on returns and then end up paying more after audit, and perhaps after having to go to court against the IRS.

Whether companies show low tax expense on their financial statements based on aggressive positions and force investors to gamble with the tax man is discussed below.

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I have been arguing that investors need more than just raw financial data. (Of course, CEOs like rah, rah data…) Investors also need financial statements that analyze, organize, and compress all of this information. But, I am not arguing that we should let accountants do all of the valuation work. That is “mark-to-market” accounting, which was the most important factor in Enron’s problems. [Haters of early 1990s pop music insert Funky Bunch jokes here.]

Under mark-to-market accounting, all of a business’ assets (and liabilities) are revalued (“marked”) to fair market value. Any increase (decrease) in the net value is added to (subtracted from) any profit distributions to shareholders (like dividends and share buybacks) in determining the business’ profit or loss. (Adjustments also are made for share issuances and the like.)

In theory, mark-to-market gives investors the most useful information, since it presents management’s stewardship of all of the busines’ resources, not just of financial transactions. In reality, however, matters are much different.

Reality is in the footnote.

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I want to supplement prior discussion at two points: First, Michael was kind enough to email me from the ether to call my attention to a post 2 days ago on Brad DeLong’s blog, at DeLong Post He discusses an experiment that tested smart people’s ability to make simple investment decisions. They do not do well. An article quoted concludes that most people cannot be trusted to invest their own money and should hire investment advisors. If so, one legal regime would require small investors to use an advisor, as current law does (or at least used to when I did these deals in practice) if they want to buy a private placement. Then, accountings could be written for investment advisors. Accounting reform still would be needed, as everybody getting snookered by Enron suggests.

CFO below.

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