Ethics and good business sense correlate. The market accords a transparency pre- miumto the share price of companies who are willing and able to provide clear,
consistent, and informative disclosure about their operations and financial results.
Such disclosure must go beyond the general line of how the company works, to:
● Include the risks that are taken
● Provide an accurate understanding of economic drivers, and
● Accurately describe the detailed financial results of the business.
Creative accounting negates each one of these three points. In fact, the term is a misnomer because what takes place is neither ‘creative’ nor is it ‘accounting’ in the sense defined by Fra Luca Paciolo (see Chapter 2). The practice of changing the numbers in company books to hide losses, beef up profits, or otherwise man- icure financial statements is:
● Corrupt
● Quite often patchily done
● Eventually leading to abysmal results, and
● Always demonstrating a disregard for business ethics.
Ethics means virtueand as Socrates once said virtue is knowledge that cannot be taught. It is knowledge that is constantly evolving and often goes beyond formal legal and regulatory requirements, though these help to sustain business ethics.
Market discipline, one of the three pillars of Basel II, means growing demand for more responsible personal and corporate behaviour (see section 7).
It is part of the ethical stance of top management to ensure that within each reporting period disclosure is consistent and comparable. Also, that between reporting periods the books are always kept in accordance with rigorous accounting standards. It is also top management’s responsibility to see to it that financial information is presented in as simple a manner as possible, consistent with readers’ ability to understand the company’s performance.
Unbiased reporting standards are all-important in substantiating a strong commit- ment to corporate responsibility, recognizing the demands placed by different stakeholders: shareholders, bondholders, employees, regulators, and the general public which patronizes the company’s products and services. A frequently encountered problem, however, is that corporate responsibility means different things to different people. The best way to tackle this issue is to press the point that:
● Core corporate responsibility starts and ends with ethical corporate gover- nance, and
● The guardians of ethical corporate governance are the directors, CEO and CFO.
Corporate ethics make good business sense, as events in the early years of the 21st century demonstrate. Unable to depend on financial statements and unwill- ing to take risks, investors pulled more money out of equity mutual funds in June and July 2002 (after WorldCom’s bankruptcy) than they did in the weeks after the tragic events of September 11, 2001.
Weary of the lack of corporate accountability and failures of judgment, before buying stocks again many investors want to see CEOs effectively sign off on their books and assume personal accountability for what is being reported. The US Congress has aptly passed the Sarbanes–Oxley Act and the Bush Administration has been right in its decision to hunt down culprits.
● Doubling prison terms for CEOs guilty of financial fraud
● Freezing improper payments to corporate executives
● Forcing managers who benefit from creative accounting to forfeit their gains, and
● Setting the Securities & Exchange Commission to ban convicted chief exe- cutives from ever serving on a board.
The capital market, too, became more cautious. Securitization of corporates with scant disclosure of embedded risk is one of the practices that contributed to the widespread after-shock of the big bankruptcies. Many banks exposed on loans to Enron, WorldCom, Parmalat, and other defunct firms sold securitized products to institutional investors and to their retail clients. Also, experts say, to recoup some of their losses, they went short on these companies’ equity, essentially using inside information in making their moves.
The good news is that the scams which shook business, industry, and the mar- kets during the past ten years have had the effect of issuing a wake-up call. The new mood reflects a recently prevailing notion that the culture of a corporation can produce malfeasance. Eventually, the consequences for an accused com- pany can be severe. As an article in The Economistsuggested, in the aftermath of Enron:
● Many clients have deserted Andersen, the accounting firm
● Thousands of employees have lost their jobs, and
● The whole international network of one of the Big Five has crumbled.2 Like an auditor, a financial entity or any other business that operates under the scrutiny of regulators might find it difficult to survive a criminal probe. Bankers Trust paid dearly for its derivatives scams. Its indictment became its death warrant.
Yet banks and other financial companies sometimes act in a way that invites regu- latory action, if not outright public wrath.
This policy of cheating through creative accounting and other murky deals is simply senseless, and something is needed to save managerial wrong-doers from themselves. Cooking the books is a criminal act – though a government prosecu- tor might choose a civil over a criminal charge because it carries a preponder- ance of evidence rather than proof beyond reasonable doubt. While penalties imposed in a civil case are less severe than those in a criminal one, reputational riskis roughly the same, and so is the aftermath.
The events that took place in the go-go 1990s, and came to light after the stock market bubble burst in 2000, document that many players are no longer in charge of their actions. Pessimists say that the system itself has been corrupted and needs urgent repair. This requires a long list of changes going deep into the busi- ness community and its practices.
● Self-regulation might have been preferable, but does not seem to be doable.
● Therefore, legal measures are needed to redress the balances of business ethics. The letter of the law is the only alternative to a runaway system.
Firms must meet the public demand for transparency and ethical behaviour all of the time, not just in sporadic cases (see section 4). They must take their responsi- bilities seriously, and put shareholders’ interests first. This is not happening today, as a myriad of examples documents. We will study some of them in this chapter.
A strategy of personal and corporate accountability needs to show results for the efforts being undertaken in a clear and unambiguous manner. Measuring ethical performance is therefore essential, and it should be done through comprehensive and generally accepted criteria and standards. Both IFRS and Basel II have con- tributed a great deal in this direction, but the best example of legal framework is the Sarbanes–Oxley Act in the United States.
Moreover, while the written law is important, it is not everything. Only jurispru- dence, which will take years to develop, will establish tolerance levels for viola- tors, and will answer questions regarding assertions about effectiveness of management control. In the meantime, however, the regulators must provide some interpretations that could help to reduce the cost of compliance without diminishing the effectiveness of the law.
While only a few years old, Sarbanes–Oxley is already having a positive out- come. A near-consensus on Wall Street is that the new legislation succeeded in
improving stock market performance of large American companies. A noted
‘plus’ in financial disclosure has come in spite of growing complaints from cor- porate America that the pendulum has swung too far, resulting in excessive com- pliance burdens. Looking for factors that gave investors greatest transparency in judging behaviour, a mid-2004 study by Governance Metrics International (GMI) confirmed academic studies showing a link between share price performance and adherence to best practice in corporate governance.