Standard & Poor’s 500 Shades of Grey

Image of a man climbing a ladder out of a cement pit

As Ivey Business School Professor Gerard Seijts notes in an IBJ Insight entitled “Why We Should Thank Enron’s Former Chief Financial Officer,” the Mike Duffy affair highlighted the fact that reputable people often fall into the trap of simply accepting that it is appropriate to use technicalities and loopholes to break the principles behind rules when they think they can get away with it or if someone else says they can get away with it.

According to former Enron CFO Andrew Fastow, this is a problem approaching epidemic proportions. And as someone who was a willing participant in one of the largest corporate frauds in U.S. history, he knows what he is talking about.

For those of you who don’t recall, Fastow went to jail for, basically, bending accounting rules to the point where a court of law saw his actions as criminal — something the married father of two did not imagine possible, which is why he is now actively telling his tale to business students around the world, hoping to teach future business leaders the lessons he learned the hard way.

In an Ivey Business Journal interview with Seijts, Fastow raises the alarm over how easy it is to go too far when faced with grey-area decision-making.  He sees principle-breaking everywhere — in business deals, political fundraising, tax avoidance, etc. “The narrative that was spun after the downfall of Enron pointed to a few bad apples doing some things that no one else knew about. The board supposedly just wasn’t paying attention,” he notes. “But that isn’t accurate. All the deals that constituted fraud at Enron were approved by top management and the board of directors because they were deemed technically legal.”

“We all do this,” Fastow says. “We rationalize and say, ‘This is OK because technically I haven’t broken any rules.’ We do it at work and we do it in our personal lives, especially when filing taxes. We don’t break rules… we get around rules. Even presidential candidates do it with their super PACs, which serve the same purpose as off balance sheet financing. Think about it. Super PACs are ostensibly separate and independent organizations that technically can’t coordinate with a candidate, but somehow they do exactly what the candidate wants all the time. My point is that it is still common for people, businesses and politicians to follow rules in ways that undermine their principles. So when you ask about corporate governance, the real question is, ‘Are misleading deals still being done?’ And the answer is yes. In fact, the exact same kind of deals are being done today, and by the way, some of them make me blush — and I was the CFO of Enron.”

Sponsored by the Ian O. Ihnatowycz Institute for Leadership, Fastow recently gave a presentation to Ivey students on the ethical traps faced when making grey-area decisions. According to Chris Sturby, an Ivey Lecturer in Managerial Accounting, the important takeaways included:

  • There can be a contradiction between “doing what’s right” and “doing what the rules permit” and it is easy for leaders to rationalize inappropriate behaviour by citing “the rules,” especially when adherence to the rules is deemed acceptable by third parties.
  • It is important for managers to understand where judgement needs to be applied in financial reporting, keeping in mind that the use of differing accounting estimates and policies can result in a high degree of variation within financial results.
  • Leaders need to always consider the alignment between an organization’s long-term strategy and its incentive systems.

“The most memorable speakers are those who provoke thought and discussion long after their presentations have ended,” Sturby notes. “The range of people’s reactions to Mr. Fastow has been immense, both immediately following the presentation and in the days since. Regardless of one’s personal views towards the man, his presentation has incited a number of points on which to reflect.”

And despite the harm caused by the numerous accounting scandals that followed Enron’s collapse, not to mention the global financial crisis, the need to reflect on the lessons contained in Fastow’s story isn’t just for students — it still exists in too many boardrooms where accounting games continue to be played.

When it comes to misleading numbers in the marketplace, Jack Ciesielski, publisher of The Analyst’s Accounting Observer in the United States, says it is important not to confuse “accounting” with “reporting.” After all, until major accounting blowups occur, nobody really sees how much tomfoolery goes into pulling the wool over regulatory eyes when corporations file financial statements that are supposedly in accordance with accounting rules. “The state of official regulatory filings may or may not be worse than it ever was,” Ciesielski says.

According to the accounting industry expert, when it comes to dealing with regulators, things have probably somewhat improved on the accuracy front since Enron failed. But what happens after all the official accounting is done is another matter. Indeed, Ciesielski’s research indicates that the spinning of results reported to the market after official filing requirements have been met has really gotten out of hand.

Simply put, Ciesielski says it is common for companies to file their official earnings using the rules designed to ensure accuracy, then back out all kinds of charges to reach a more attractive “core” earnings figure that is then reported to investors. There can be legitimate reasons to do this, but because what is legitimate is open to interpretation, the door to all sorts of foolishness has been opened. And the limit of what is acceptable is being creatively pushed like never before, at least in the United States, where Ciesielski notes the Securities and Exchange Commission can’t really regulate free speech.

How widespread is the practice? An analysis last year of results from 500 major companies by The Associated Press warned that the gap between the so-called “adjusted” profits that analysts often cite when advising investors and actual bottom-line earnings, which companies are legally obliged to report, has widened dramatically in recent years. In one out of five cases examined, adjusted profits were higher than net income by 50 per cent or more. And in some cases, adjusted earnings indicated that money-losing companies were profitable.

A more recent study conducted by The Analyst’s Accounting Observer found that 90 per cent of the companies listed in the Standard & Poor’s 500-stock index used non-GAAP results when reporting results to the market last year, a significant increase since 2009.

What needs to be done? Simple. Board members should start seriously minding the GAAP, meaning asking tough questions whenever official result figures vary significantly from the numbers used to entice investment. Or as Fastow puts it, it is time for directors of companies with creative number crunchers to get “their heads out of their butts. Stop worrying about personal liability and start worrying about shareholders and other stakeholders by looking at the real risks and dealing with them, instead of looking the other way and being happy not knowing what is really going on.”