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CEOs, under increasing pressure from the investment community to meet short-term elevated expectations, in too many instances have been drawn to accounting devices whose sole purpose is arguably to obscure potential adverse results. Outside auditors, on several well-publicised occasions, have sanctioned such devices, allegedly for fear of losing valued corporate clients.

This situation is a far cry from earlier decades when, if my recollection serves me correctly, firms competed on the basis of which one had the most conservative set of books. Short-term stock price values then seemed less of a focus than maintaining unquestioned credit worthiness.

Value for corporate reputation: A change in behaviour, however, may already be in train. The sharp decline in stock and bond prices following Enron's collapse has chastened many of the uncritical practitioners of questionable accounting. Corporate reputation is fortunately re-emerging out of the ashes of the Enron debacle as a significant economic value. Markets are evidently beginning to put a price-earnings premium on reported earnings that appear free of spin. Likewise, perceptions of the reliability of firms' financial statements are increasingly reflected in yield spreads on corporate bonds.

Corporate governance has doubtless already improved as a result of this greater market discipline in the wake of recent events.

Limit on regulation: But the Congress is clearly signalling that more needs to be done. I hope that any legislative and regulatory initiatives will move to further realign current practice with the de jure governance model that served us well in generations past. Most success in that direction would seem to come primarily from changes in incentives for corporate officers.

We have to be careful, however, not to look to a significant expansion of regulation as the solution to current problems, especially as price-earnings ratios increasingly reflect the market's perception of the quality of accounting. Regulation has, over the years, proven only partially successful in dissuading individuals from playing with the rules of accounting.

Overdue changes: Some changes, however, appear overdue. In principle, stock option grants, properly constructed, can be highly effective in aligning corporate officers' incentives with those of shareholders.

Regrettably, the current accounting for options has created some perverse effects on the quality of corporate disclosures. This has, arguably, further complicated the evaluation of earnings and diminished the effectiveness of published income statements in supporting good corporate governance.

The failure to include the value of most stock option grants as employee compensation and, hence, to subtract them from pre-tax profits, has increased reported earnings and presumably stock prices. This would be the case even if offsets for expired, unexercised options were made. The Financial Accounting Standards Board proposed to require expensing in the early to middle 1990s but abandoned the proposal in the face of significant political pressure.Misused stock options: The Federal Reserve staff estimates that the substitution of unexpensed option grants for cash compensation added about 2.5 percentage points to reported annual growth in earnings of our larger corporations between 1995 and 2000. Many argue that this distortion to reported earnings growth contributed to a misallocation of capital investment, especially in high-tech firms.

Some have argued that the Black-Scholes option pricing, the prevailing means of estimating option expense, is approximate. But so is a good deal of all other earnings estimation, as I indicated earlier. Moreover, every corporation does report an implicit estimate of option expense on its income statement. That number for most, of course, is zero. Are option grants truly without any value?

Critics of option expensing have also argued that expensing will make raising capital more difficult. But expensing is only a book-keeping transaction. Nothing real is changed in the actual operations or cash flow of the corporation. If investors are dissuaded by lower reported earnings as a result of expensing, it means only that they were less informed than they should have been. Capital employed on the basis of misinformation is likely to be capital misused.

Critics of expensing also argue that the availability of options enables corporations to attract more-productive employees. That may well be true. But option expensing in no way precludes the issuance of options. To be sure, lower reported earnings as a result of expensing could temper stock price increases and thereby exacerbate the effects of share dilution. That, presumably, could inhibit option issuance. But again, that inhibition would be appropriate because it would reflect the correction of misinformation.

Dubious independence

In a further endeavour to align boards of directors with shareholders, rather than management, considerable attention has been placed on filling board seats with so-called independent directors. However, in my experience, few directors in modern times have seen their interests as separate from those of the CEO, who effectively appointed them and, presumably, could remove them from future slates of directors submitted to shareholders.

I do not deny that laws could be passed to force selection of slates of directors who are patently independent of CEO influence and thereby significantly diminish the role of the CEO. I suspect, however, that such an initiative, while ensuring independent directors, would create competing power centres within a corporation, and thus dilute coherent control and impair effective governance.

Character, the key: I should like to emphasise that a market economy requires a structure of formal rules — a law of contracts, bankruptcy statutes, a code of shareholder rights — to name but a few. But rules cannot substitute for character. In virtually all transactions, whether with customers or with colleagues, we rely on the word of those with whom we do business. If we could not do so, goods and services could not be exchanged efficiently.

Companies run by people with high ethical standards arguably do not need detailed rules to act in the long-run interests of shareholders and, presumably, themselves.

But, regrettably, human beings come as we are — some with enviable standards, but others who continually seek to cut corners. Yet there can be only one set of rules for corporate governance, and it must apply to all.

(Source: www.federalreserve.gov)

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