No Profit The craze to reform corporate accounting gets things exacly backwards
Bartley, Robert L.
Profit The Craze to reform corporate accounting gets things exactly backward. BY ROBERT L. BARTLEY HAT DO WE MEAN BY " PROFIT " ? That question became a national issue in the wake of...
...expect—and might demand—from a company's published accounts and annual statements...
...Last January, the SEC implemented the Sarbanes-Oxley directives by issuing Regulation G, effective in March...
...A new authority is chartered to police the accountants, making sure they don't let their clients get away with anything...
...Treasury general counsel now associated with the American Enterprise Institute, and G. Bennett Stewart III at Stern Stewart & Co, developers of the management tool Economic Value Added...
...There are only costs...
...However, with their book equity of about $2.9 trillion, a ten percent charge for interest on equity would come to $290 billion...
...SECURITIES ANALYSTS SUFFERED a considerable black eye in the recent market collapse, especially those who became television personalities...
...Risk was subject to actuarial determination, while uncertainty was not measurable...
...And also such pro forma concepts as operating cash flow per share or core earnings from ongoing operations...
...The purpose of capital markets is to direct scarce capital to its highest uses, and this is measured not by accounting profits but by economic profits...
...And thus greater rectitude about GAAP will restore investor confidence, both in the accounting profession and in the securities markets...
...Neither group wants an accounting system that shows many of these profits are in fact a loss...
...torically been paid out of the proprietor's share...
...1 SPECIALLY IN CONJUNCTION with the threat of class-action lawsuits, the practical effect of A this will be to restrict severely the use of such popular measures as EBITDA—earnings before interest, taxes, depreciation and amortization...
...It started, "One of the basic causes of poor performance on the part of analysts, investors and business managers is the yardstick they use to determine how a business is doing—'earnings per share.'" The only thing that measures, he pointed out, is taxable earnings—what remained after all the charges the tax collector accepts as deductible...
...But as far back as Adam Smith, more careful economists have recognized this as fallacious...
...Thoughtful commentators have continued to follow these careful distinctions...
...The House, initially hesitant, felt impelled to accede almost completely to the Senate bill...
...These manipulations have been widely used in "earnings management"—meeting earnings-per-share targets set by expectations of "The Street" or the company's own guidance...
...So in that ill-fated year, the nominal accounting profit disguised an economic loss twice that size...
...BY ROBERT L. BARTLEY HAT DO WE MEAN BY " PROFIT " ? That question became a national issue in the wake of the NASDAQ collapse and business scandals at Enron, WorldCom, Tyco and the rest...
...His first entry was entitled "The Delusion of 'Profits.'" Its sweeping conclusion: "[T]he essential fact about profit is that there is no such thing...
...Adam Smith pointed out the tendency of human nature to exaggerate the value of a small change of large winnings...
...ent explanation of our recent experience in B the securities markets...
...s THE BILL PASSED, the Wall Street Journal did publish one caveat...
...The nation's business must return to the lodestar of Generally Accepted Accounting Principles, as defined by the Securities and Exchange Commission and the Financial Accounting Standards Board...
...It's true of course that such calculations have not been standardized across companies, and are hence subject to abuse...
...Audit committees must include a "financial expert," with the definition of that term left unspecified and likely to be decided in class action lawsuits...
...Such a debate would be a valuable educational experience, not least for corporate executives and Wall Street analysts...
...30 THE AMERICAN SPECTATOR DECEMBER 2003/JANUARY 2004 NO PROFIT Chicago School of economics, published Risk, Uncertainty and Profit—in fact his doctoral dissertation, written a decade earlier...
...Various other charges have hisA few, so far lonely, dissenters have arisen to challenge the SarbanesOxley consensus...
...0N THE OTHER HAND, Wall Street has survived the revelation that most financial managers fail to beat the stock market indexes...
...firms reported aggregate net income of $96 billion...
...So part of his return is not "profit" but compensation...
...Knight distinguished between risk and uncertainty...
...Everyone understood that the problem at Enron, WorldCom and American business generally was that they and their accountants had strayed from the path of rectitude marked by GAAP calculations of earnings per share, which is to say, the accounting view of profit...
...This article is adapted from the RAND Corporation's 2003 Charles Wolf Lecture...
...If it could not, that was a signal that the company had run out of ways of adjusting its results to produce earnings growth, and that in turn suggested that its earnings had really fallen quite dramatically...
...If it could, that meant the company's earnings were probably growing, although not necessarily as stated...
...Movement of reporting and of investor interest away from accounting profits and toward economic profits must be a good thing...
...If a company's report includes "non- GAAP financial measures," it must also include a reconciliation of such figures with GAAP reports, as well as include a "statement of purpose" explaining how such figures help investors...
...Accounting conventions, he complains, cater to bankers rather than shareholders, stressing liquidation value—and therefore hard "As accounting has lost its anchor to value, it has forfeited its stature and authority...
...The notion that stifling the flow of information helps investors and improves the operations of financial markets is, to say the least, counterintuitive...
...Wallison cites numerous studies show that cash flow is a better predictor of share values than are earnings...
...And these bodies must enact higher standards, stamping out the sinful practices wayward corporations invented to avoid the path of righteousness...
...It also happens to satisfy their critics, who like to demagogue success, as in "obscene profits...
...Chief executives and financial officers must swear by their reports under penalty of jail...
...p 1 VEN MORE IMPORTANTLY, the proprietor contributes capital, without which no product or / jobs could be created...
...Knight, in his scholarly fashion, had taken up a similar point of distinction between economic profit—what really matters—and mere accounting profit...
...The accountant's view of profits makes it much easier for business executives to report rosy results...
...Intelligent and constructive securities analysis has always been the painstaking construction of a mosaic of factors, and if Washington and the SEC think they can construct one acceptable number to help people who won't bother to open the annual report, then they are setting people up for additional pain...
...That is something very different from profit...
...The main accountant's view of profit— including interest on equity in the "proprietor's share"—is a massive distortion of economic reality...
...With the current temper of the times, we seem to be headed entirely backward...
...But every enterprise has to compete for the capital pool...
...The key to averting "bubbles," we thus are told, is rectitude in accounting—the measurement of profit...
...From the standpoint of public policy, Knight lets the accountants off rather easily...
...This in turn is said to create "bubbles"—a word I persist in surrounding with quotation marks out of respect for the historic record of the capital markets in directing investment to good use...
...DECEMBER 2003/JANUARY 2004 AMERICAN SPECTATOR 35...
...The crude Marxist labor theory of value, for example, holds that profit is any income to a proprietor—the better to justify notions of class struggle...
...Peter Drucker noted the same phenomenon back in 1975...
...But it's also true that they are often attempts to translate accounting profit into economic profit, an effort by companies to give ordinary investors the benefit of at least part of the work done by securities analysts and sophisticated investors...
...In the 1970s, I persuaded management legend Peter Drucker to write an ongoing column for the Wall Street Journal...
...Another accounting earthquake Stewart proposes would capitalize investment in intangibles...
...OTH WALLISON AND STEWART start with a differ...
...The cruel reality is that the 'bottom line' for a Fortune 500 company in an accrual-based accounting system like the Generally Accepted Accounting Principles is the net result of a long series of guesstimates," warned an experienced investment manager, Jeffrey Bronchick of Reed, Conner & Birdwell, in Los Angeles...
...It was because of this that we saw the strange market phenomenon in which companies that missed their earnings targets by a penny or two saw 20 percent or 30 percent declines in their share prices...
...The former, for exam ple, asserts that even without cheating GAAP, corporate managers can manipulate earnings per share by changing assumptions about such things as reserves and depreciation rates...
...In its stead, Drucker proposed a reform focused on what really produces wealth: "The key figure for this is return on all assets (or on capital employed), related to cash needs, to cost of capital, to risks and needs...
...STEWART RECOGNIZES that his proposals would "rock the foundations of accounting," but his adjustments are instructive...
...Profit is the result of uncertainty—what's left after all the hired factors of production have been paid...
...This rather than the meaningless 'earnings per share' figure is what the public, the SEC, analysts and, above all, the stockholders should opment of modern finance, land could be put out to rent, which would not vary with the success of the enterprise using it...
...But no one was prepared to listen to such counsel...
...Like rents on land, opportunity cost is fixed, whether the enterprise succeeds or fails...
...American business...
...So interest on equity is not profit...
...This would be entirely familiar to Peter Drucker and Frank Knight, if not Adam Smith: unless a corporation earns more than the going rate of interest, it is destroying value even it reports earnings as measured by GAAP...
...The And tellingly, Stewart reports that for 2001, the 1,000 largest U.S...
...It will not help confidence in the capital markets to enshrine a misleading number as the Holy Grail of investment, and it certainly will not help the capital markets direct money to its highest uses...
...If non- GAAP measures are released orally or in presentations to analysts, the reconciliation is to be included on a specified company website...
...It has degenDECEMBER 2003/JANUARY 2004 AMERICAN SPECTATOR 33 ROBERT BARTLEY earnings by making EVA-type information available to investors...
...This might shake the underpinnings of assets—over the ongoing value that brands, management skills and other intangible assets typically carry in a knowledge-based economy...
...The most substantive challenges I've found come from Peter J. Wallison, a Washington lawyer and former U.S...
...It might bruise the egos of CEOs—itself probably no bad thing...
...The economist is interested in the forces of production, while the accountant "is interested in proprietorship...
...facts in the psychology of the case are familiar....The behavior of men in lotteries and gambling tables is the most striking fact...
...And half a century before that, Frank Knight reported that while the available evidence was inconclusive, he was "strongly of the opinion that business as a whole suffers a loss...
...Risk is an ongoing expense—the cost of insurance...
...By far the most important is to deduct a charge against income for the use of equity capital...
...Such things as training expenses, new product promotion, and research and development would not be charged against current income, but depreciated over their estimated economic lives...
...Today it's possible to hire capital, either by borrowing or by issuing equity...
...To translate the accounting profits reported by business into the economic profits that determine values, we have evolved a whole new discipline, called securities analysis...
...Congress has even made this conventional wisdom the law of the land, with the Sarbanes- Oxley Act...
...Knight starts by surveying the various ways economists have treated the subject over the years...
...Even before the develDrucker's initial column was quickly followed by a broadside entitled "Measuring Business Performance...
...The question, he notes, "has tended to constitute an issue between accountants and economic theorists...
...Lenders charge interest, while providers of equity have an opportunity cost—what they could earn elsewhere, typically measured by the prevailing rate of interest...
...So it's not surprising that a few, so far lonely, dissenters have arisen to challenge the SarbanesOxley consensus...
...Profit The Craze to reform corporate accounting gets things exactly backward...
...But shareholders would be better informed, and society's capital would more easily flow to its most productive uses...
...Stewart says his EVA calculations track share values more closely than do conventional earnings per share...
...A proprietor typically provides an enterprise with management, for example—a task as deserving of a wage as the sweat of the workman on the factory floor...
...Robert L. Bartley is Editor Emeritus of the Wall Street Journal...
...Senate...
...Instead of trying to force the flow of corporate information into GAAP's Procrustean Bed, we should be encouraging the development of measures more closely aligned to economic profit...
...In other words, a purely arbitrary figure that has little to do with business performance...
...None has been indicted, perhaps because society has evolved the alternative punishment of pursuit by 32 THE AMERICAN SPECTATOR DECEMBER 2003/JANUARY 2004 ROBERT BARTLEY a pack of tort lawyers...
...Would that we were headed that way...
...There's no need to decide between Wallison's cash flow and Stewart's EVA to conclude that Sarbanes- Oxley has taken policy in exactly the wrong direction...
...Wallison describes . . . a game in which analysts and investors were testing the quality of a company's started earnings by determining whether management could hit its targets...
...These issues were scarcely discussed as Sarbanes-Oxley swept to a 97-0 victory in the US...
...Stewart put it more succinctly: As accounting has lost its anchor to value, it has forfeited its stature and authority...
...But he concludes that the debate is "entirely uncalled-for," because "the difference in opinion is a matter of obvious difference in standpoint...
...But at their best, analysts convert earnings per share into numbers such as rates of return and discounted cash flows, which determine share values and direct capital to its best uses...
...The conventional wisdom blames it all on cheating in reporting profits—accounting gimmicks used to inflate earnings per share and thus hype stock values...
...So I suspect the corporate world would survive the revelation that, in economic terms, most businesses operate at a loss...
Vol. 36 • December 2003 • No. 7
