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Alok Ray

SKELETONS are continuing to tumble out of corporate cupboards in the US. The companies involved include such illustrious names as Enron (the biggest private sector energy company in the world), WorldCom (the second largest long-distance telecom major in the US) and Xerox Corporation (the inventor of photocopying machines).

The accounting firm involved in many of these cases is Arthur Andersen, till recently one of the top global auditing and consulting entities. The rot, no doubt, is deep-seated. Even the business history of the President, Mr George W. Bush, and the Vice-President, Mr Dick Cheney, is being dragged out by investigating journalists (including those in The New York Times) as examples of similar corporate wrong-doing.

Suggestions for overhauling corporate and accounting laws and practices are flying thick and fast. The US economic system, arguably, is facing the biggest crisis of confidence since the Great Depression of the 1930s. Has something suddenly gone wrong in the citadel of capitalism?

Not quite. Some theorists would consider these as typical examples of the so-called principal-agent and asymmetric information problems in corporate governance. Basically, everyone is not privy to the same information. Those who have the benefit of insider information can personally gain a lot by making use of such privileged information. The ordinary shareholders (`principal') cannot effectively control the behaviour of and the goals pursued by corporate top managements (`agents'). This problem has worsened since the late 1980s with the advent of the "new economy" business model.

The major change since then is that stock price has become almost the sole concern of managements in American corporations. Stock options became a major component of the pay package of managers and employees. In addition, the bonuses awarded to top company executives were directly linked to stock prices. This provided the incentive to jack up stock prices by hook or crook.

Since in many cases fraudulent methods were used to overestimate the profits and artificially boost stock prices, those with insider information knew that it would not last. So, they sold their stocks at inflated prices and increased their personal wealth. In this endeavour, they were helped by the auditors certifying the accounts.

Some people in the regulating agencies and politicians and their relatives in the corridors of power would also get advance warning about the impending fall in stock prices and would be able to unhoard their stocks before the truth comes out. Ordinary shareholders and employees whose retirement funds are invested in a company's stocks are generally kept in the dark about the fraudulent methods used. They would find themselves stuck with junk stocks.

Why would the auditors oblige? Several factors could be responsible. First, many of the supposedly independent auditors got lucrative consultancy assignments in the same company or related firms. This provided the incentive to look the other way.

Second, it was not clear ex ante when, if at all, the truth will be revealed. It is only when a company collapses or a disgruntled employee or insider blows the whistle that an investigation is ordered. So, it would be a calculated risk worth taking.

Third, no single fradulent method was used by all companies to inflate profit and stocks. It was not always obvious which trick is employed in a given case. So, it is possible that in some cases even well-intentioned auditors could not detect the fraud. That, of course, would imply inefficiency of the auditors, if not dishonesty. What kinds of tricks were used? Some misclassified operating expenses as capital expenditure. Capital expenditure is spread over several years. So, it artificially inflated current profits and stock price. Some others sold their product to basically fictitious customers and created fictitious profits.

Yet others entered into contracts with real customers but underestimated the cost of production, thereby overestimating profits, and then entered these projected future profits as part of current profits. All these and many more "innovative" strategies enabled bosses (and their accomplices, including some politicians, regulators and bankers) to sell their stock at highly inflated prices and pocket the gains.

What were the personal risks for the top brass? Very little. The companies had made heavy campaign contributions to all political parties. So, there may have been expressions of "outrage" by politicians but no real action. Nobody would go to jail. At worst, the chief had to resign or sack some of his finance people. New jobs would be arranged for the sacked officials in one or the other company. In any case, they got to keep their ill-gotten wealth.

Some of the questionable deals with political leaders may lie embedded in the files of company accounts — so they can be held to ransom. The reputation to the peers in the profession would not sink as many of them use the same questionable methods for personal advancement. It is part of the corporate game and prevailing ethos.

One would, therefore, underline greed — fuelled by the changed incentive system since the late 1980s — and the lack of independent regulation as the root causes. Regulators are mostly chosen by the political bosses and sometimes include close relatives of political bigwigs. The `independent' auditing firm is chosen by the company whose accounts are being audited. It is like the referee being appointed by the soccer team, rather than by FIFA. Moreover, the referee is being paid side money by the team management through consultancy assignments elsewhere.

Finally, the same referee is allowed to officiate indefinitely, so long as he remains in the good books of the soccer team — he will be replaced if his decisions go against the team appointing him. This arrangement makes sense for the coach, but certainly not for an independent referee.

Self-regulation by members of a profession cannot be very effective, unless it is a blatant case of proven wilful fraud. This is true of accountants, just as it is true for doctors or teachers.

Suggested remedies follow from the diagnosis. One suggestion is that auditors for a company be selected from a panel by some independent body. Further, the auditors must be rotated — say, every five years. No auditor would be allowed to do consulting for the firm whose accounts are being audited. The problem is: two apparently independent companies can still mutually arrange among themselves so that the auditor for Company A will be doing consultancy for Company B, and vice-versa.

Stricter conflict of interest restrictions for bankers, stock analysts and credit rating agencies is being emphasised. Some Senators in the US are even proposing confiscation of personal wealth built through insider information, a mandatory long jail term for officials involved in fraudulent business practices, and restrictions on sale of stocks by company bosses. It is yet to be seen whether all this tough talk by politicians will lead to concrete results.

Finally, how about India? There is no doubt that such practices also abound in India. Globalisation has caused American business practices, both good and bad, to spread to other countries. The incentives for fraud in India are even greater. Here, to do business, the company has to pay protection money to hordes of local politicians, criminals, police inspectors and tax-men, on a continuing basis.

Bribes have to be paid for winning government contracts and big loans from banks. Companies have to fudge the accounts to allow for these expenses. When such things happen, this provides an additional opportunity for managements to siphon a part of the slush money for personal gains. The line between company interest and private interest then becomes hazier than ever.

(The author is Professor of International Economics, Indian Institute of Management, Calcutta.)

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