Prof. Ronald Dye

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 performance.

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 as auditors.

This emphasis 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.

It is 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.