INSIDE OUT: Even if some of what the fallen Enron did turns out to be illegal, much of what other companies did to inflate earnings was legal

INSIDE OUT: Even if some of what the fallen Enron did turns out to be illegal, much of what other companies did to inflate earnings was legal - Larry Summers, then US treasury secretary, looked sheepish. It was a couple of years ago and I'd asked him whet

by ROBERT PESTON, editorial director of Quest, www.csquest.com;e-mail: rpeston@csquest.com
Last Updated: 31 Aug 2010

Larry Summers, then US treasury secretary, looked sheepish. It was a couple of years ago and I'd asked him whether it was a problem for a centre-left politician such as him that the remarkable growth in the US economy appeared to be fuelled by the ability of corporate executives to earn egregious sums of money.

The fashionable theory of the time was that greed was the power behind US economic surpremacy. Entrepreneurs would 'go that extra mile' to squeeze maximum productivity out of their businesses if they could earn a few tens of millions of dollars rather than just a few million. If Summers had uttered a word of reservation about all this, it would have been political suicide. It would have looked like sour grapes from the unreconstructed left. So he simply shrugged.

Well, the consensus has finally shifted. The collapse of Enron and Global Crossing, and the financial difficulties of a host of other giant businesses (such as Nortel and Tyco), has raised questions about whether the financial pressures on directors to succeed are simply too great.

There are three issues here. One is about the quantum of rewards available.

Another is about the 'jam today' culture of financial markets. And the third is about yardsticks for measuring corporate success.

Or, put another way, what has turned out to be lethal has been the requirement on companies to produce earnings growth every quarter. Investors have insisted on it. Executives who delivered it were given the funds to buy their ranches and ski chalets. And their stock prices soared to ever more absurd levels.

The system was irrational. It was simply impossible for all firms to sustain 20% earnings growth over the longer term at a time of falling inflation, even if the US economy was growing at 5% per annum for a period.

What happened, as we now know, is that executives used the latitude afforded by accounting rules to manufacture earnings growth out of thin air. Even if some of what Enron did turns out to be illegal, much of what other companies did to inflate earnings was legal, although the picture of success presented turns out to be misleading.

This was not just an American phenomenon. The flaws in the relationship between providers of capital and users of capital are just as apparent here. Analysts at securities houses and finance directors at big companies form an unhealthy alliance. There is a kind of mating dance between them, in which the analyst talks out loud about the kind of growth that would allow a recommendation of the stock and the finance director does his or her best to oblige.

The big company CEOs then set very demanding short-term performance targets for their subsidiaries, in the hope that they'll be able to deliver this growth. Since executive bonus and share option schemes are often linked to earnings growth and share price performance, failure can't be countenanced.

There can be at least two deleterious consequences. First, subsidiary management make rash decisions to meet unrealistic budget targets. And second, as the accounting period draws to a close, top management frequently resorts to accounting ruses to cover up any shortfall in performance by a subsidiary.

With relatively steady economic growth and buoyant stock market conditions, a company can get away with this for quite a time - often long enough to make substantial stock option profits. But when the economy slows down, many of the accounting fixes come back to haunt it. The reason is that almost all the accounting devices involve a company effectively booking profit in advance of revenues arriving. So if the revenues never arrive, either because a customer has run into difficulties or costs categorised as an investment fail to produce a proper return, the company has a problem.

This is why the most helpful reform that could take place in the culture of markets and boardrooms would be for cash to supplant earnings as the benchmark for judging corporate success. It is much harder to fiddle the cashflow than to manipulate earnings.

Now I am not pooh-poohing the DTI's recently launched reviews of conflicts of interest in the accounting industry and the effectiveness of non-executives.

They will lead to an interesting debate on issues relevant to the confidence of investors in the stock market. But they may miss the big point: that 'cash should be king'.

Surprising evidence of this is provided by the leveraged buyout industry.

When companies are taken off the stock market and loaded up with debt, a surprisingly small number go bust. Part of the reason is that their managers are no longer interested in 'earnings'. All that matters is that they generate sufficient cash to pay off the interest and capital on their egregious borrowings.

This is not an argument that all businesses should load up with debt.

Many would collapse under the strain, or be deterred from making sensible long-term investments. But it shows that managers who concentrate on generating cash rather than earnings are less corruptible.

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