Corporate Scandals: The Epilogue

Approximately a year ago, before the Bush administration made the Iraq war its major priority, the nation was riveted by corporate scandals. At the time, Congress passed the Sarbanes-Oxley Act to stiffen regulation of the accounting industry. The Bush administration threw a little extra money into the Securities and Exchange Commission so that it could, ostensibly, pursue the job of enforcing corporate compliance with basic accounting standards.

Of course, these were only palliative measures. Conservatives argued forcefully that nothing else really needed to be done, because the market would regulate itself. Corporate officers would see the damage sustained by Enron and Worldcom and be driven to clean up their balance sheets before the same terrible fate hit their own companies -- or so the argument went.

A year later, however, little has changed.

The Sarbanes-Oxley Act established the Accounting Oversight Board, whose purpose is to keep an eye on accounting firms and set new standards for auditing public corporations. Setting up a new agency can be a slow process, but the Accounting Oversight Board faces unique hurdles.

The funding issue is the most critical. The board is currently operating on money borrowed from the US Treasury, because the Sarbanes-Oxley Act set aside no public funding source for the Accounting Oversight Board. Instead, the Act specified that the board itself would bill accounting firms and use those funds for its operations. But the board has yet to finish registering all the public accounting firms in the US and the foreign accounting firms that do business with US companies overseas (a contentious issue with the European Union), much less figure out rules for how much to bill them and how often. Should they impose an annual fee? Bill only those firms they audit? What ratio should they use in order to avoid over-taxing smaller firms?

More importantly, this raises the issue of whether the Accounting Oversight Board can be truly independent of the accounting industry if its main funding source is the industry itself, particularly the big firms that are responsible for the most egregious abuses.

In the same vein, the board is having trouble recruiting members and drafting rules for inspection and enforcement. Naturally, the pay is not as good as in private industry. Chairman William McDonough, however, makes half a million dollars per year -- more than the chairman of the SEC and the President of the United States make combined. No one, so far, has pointed out that this classic corporate pay scale might be counterproductive for recruitment purposes. Currently, after a year of recruiting, the board has only 60 members, while its goal was to have 200 by the end of this year.

New employees are being drawn from large public accounting firms and the industry's own trade group, the American Institute of Certified Public Accountants, which has been attempting to influence the standards set by the Accounting Oversight Board. This increases the risk of the board becoming a revolving door for the very industry it's supposed to be regulating, like so many other government agencies.

At least the SEC is on the case, right? Well, the added funding from the Bush administration has made little difference in the SEC's ability to review the thousands of financial statements filed by public companies in the US every three months. It's a Herculean task, an insurmountable mountain of paper, and the SEC has been historically (and still is) chronically understaffed, only able to check selected financial statements on a spot basis and with little depth.

For example, last year the SEC issued a rule that requires corporate executives to personally sign and certify the accuracy of their companies' financial statements. In the months since then, there have been many companies whose executives have failed to comply, including some who have simply refused to comply on principle, like Intel Corp. Qwest Communications, Gemstar-TV Guide, Footstar, and others have broken this rule repeatedly but have not received any fines or other sanctions from the SEC. In fact, only one company has been punished under this rule: HealthSouth Corp., whose officers signed financial statements that were so clearly incorrect as to be impossible to ignore.

Meanwhile, the notion that US companies would voluntarily stop abusing the system has been disproved by recent financial scandals, most of which have received little press coverage. For example, Freddie Mac has been recently caught incorrectly booking derivatives on its balance sheet in a effort to smooth out its earnings and make the company look consistently profitable from quarter-to-quarter -- an illegal move that got Microsoft and other companies in trouble with the SEC in the 1990s. The repercussions for the economy have been serious: Market analysts blame much of the increase in mortgage interest rates on the accounting scandal at Freddie Mac.

Another example: Ten banks, including Bank of America and Washington Mutual, have been forced by the SEC to close down proprietary mutual funds the companies set up in the mid-1990s. The banks transferred a number of loans to these mutual funds, and each fund only had one shareholder: the bank that set it up. The banks then reported the interest earned on the loans in these mutual funds to the IRS as tax-exempt dividends, and thereby avoided paying state and federal income taxes on billions of dollars of income from 1995 to the present. The IRS and the States of California and New York are also investigating this widespread scam -- set up by accounting firm KPMG LLP -- and are expected to levy heavy penalties. Naturally, the banks will have to pass this expense on to their clients in the form of higher fees and interest rates.

It's true that many companies have given up publishing and publicizing "pro forma" financial statements -- revised balance sheets that subtract certain expense and debt items and have the effect of making companies look more profitable or in better shape than they really are. However, other companies have learned new gimmicks for dressing up their finances. One popular route is the "net debt" calculation. Heavily indebted telecom companies, in particular, are pushing this iffy number as a way for investors and creditors to gage the soundness of their companies.

"Net debt" is simply a company's total debt minus its cash on hand. The problem is that cash on hand isn't always available to directly pay off debt. Cash may be needed instead to pay restructuring costs, buy back shares for stock option plans, pay off fired or retired corporate officers, pay legal bills or penalties, shore up under-funded pension plans, or pay for new acquisitions. And many companies, particularly those with heavy debt loads, are required by their creditors to keep a large amount of cash on hand for emergencies, effectively putting that money off-limits for paying down debt. The difference between "net debt" and total debt can run into billions and tens of billions of dollars.

Clearly, the subterfuge is continuing. So far the war in Iraq has served as the perfect smokescreen to cover up the abiding problems in corporate America. But the public's attention is turning back to the ailing economy, and it will soon become very clear that leaving the market -- and the Bush administration -- in control is an extremely dangerous game.

Maria Tomchick is a co-editor and contributing writer for Eat The State!

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