of accounting scandals lie in incentive structure, not ethics
At a recent Kellogg
financial disclosures conference, a speaker reported that
during the previous few months there were more than 60 consecutive
days in which accounting issues made front page news. That
suggests an epidemic of accounting scandals.
To eliminate any
epidemic, we must first identify its root causes. While some
people contend the epidemic resulted because of a breakdown
in corporate ethics, I think changes in corporate ethics had
little to do with it. That prevailing view suggests corporate
ethics are fads that can change overnight, and it fails to
explain why some businesses caught the “ethics virus”
and others didn’t.
I propose we use
an economic perspective to explain the behavior. Economics
emphasizes changes in incentives or opportunities. The biggest
incentive change in the 1990s was the introduction of massive
stock options grants. Since most options are issued “at
the money” (i.e. their exercise price equals the market
price on the date the options are granted), options encourage
managers to disclose bad news just before the stock is issued,
and overstate good news just before options are exercised.
Moreover, since virtually no options are issued indexed to
market returns or a set of benchmark stocks in the same industry,
options often rise in value for reasons unrelated to the executive’s
It is not just
these qualitative features of stock options that compromise
their incentive effects. It’s also the number of options
that are awarded. Previously, egregious corporate misconduct
would have been tempered by a manager’s career concerns.
But when a manager can generate $100 million in profit by
exercising options, concern for reputation loses its power
as a tool of discipline.
The biggest opportunistic
change contributing to the accounting crisis came from the
increasing complexity of financial transactions. Most of the
financial sleight of hand has involved arcane transactions
— exotic swaps, special purpose entities, synthetic
leases. The proper accounting treatment of these transactions
is often vague — because GAAP cannot change as fast
as investment bankers construct new transactions. Ambitious
managers can exploit this vagueness. Also, complex transactions
often require the assistance of the firm’s accountants.
This makes it difficult for accountants to function subsequently
on incentives also helps explain what happened at Arthur Andersen.
Andersen’s problems arose as a result of its attempt
to respond to the revenue shortfall resulting from its consulting
arm (then Andersen Consulting, now Accenture) splitting from
its auditing parent. Andersen’s senior management seems
to have revised its partners’ compensation and performance
evaluation to encourage them to behave more like salesmen
and less like auditors, resulting in a lot of sloppy audits.
often said that what we witnessed were failures in corporate
governance. While boards of directors, internal controls and
auditors may have performed no worse than in the past, it
was not enough. To function effectively, all aspects of corporate
governance should have been upgraded as conventional bonus
schemes were replaced with huge options packages. When these
upgrades did not take place, it was inevitable that serious
degradations in the quality of financial reporting would occur
— and they did.