Self-regulation
key to regaining trust
The past
six months have been littered with stories of corporate fraud, executives’
blinding greed, and negligent auditors. A handful of corporate America’s
biggest players have been at the center of controversy but the end result in
each case is the same – big losses for individual investors. That and the
fraud-driven failures of companies once thought to be invincible are testing
the trust investors have in the entire capital markets system.
Some of the fraudulent accounting at
the heart of the recent corporate controversy has to do with how expenses are
treated. Generally, there are two types costs – capital and operating expenses.
Operating expenses are recurring costs
that are incurred in the course of business – i.e. rent, maintenance, repairs,
salaries, office supplies, etc.
Capital expenses occur less
regularly and are usually associated with purchasing items that are not
“consumable”. For instance, costs incurred to buy paper clips and notepads
(supplies) would be considered operating expenses. In contrast, dishing money
out to buy filing cabinets, computers, and desks (equipment) would be
considered capital expenses.
Operating expenses are fully
deducted from income when incurred. Capital expenses, while they usually
involve bigger dollars, are deducted gradually over time (i.e. depreciated).
So, $1,000 spent on office equipment might reduce this year’s income by $200;
while the same $1,000 spent on office supplies would reduce income by the full
amount spent. While a firm spending $1,000 incurs the same cash cost regardless
of the cost classification, accounting rules will result in different “net
earnings” figures depending on how costs are classified.
Some companies have been incurring
regular operating expenses, but treating them as capital costs (i.e.
capitalizing costs). The result is an overstated earnings figure because the
financial statements aren’t showing all of the expenses they should.
If this treatment isn’t disclosed
anywhere, nobody will know there’s anything wrong. In other words, we rely on
management to act in good faith; on accountants to do their due diligence as
auditors; and on money managers to smell the poop. If any one of these things breaks
down, we become vulnerable to scandals.
Like most
things economic, a “system” only works if the participants have faith in its
capacity to operate ethically. When we go shopping, our currency is only good
because retailers accept it as good and legal tender. If they didn’t, we’d
start losing faith in the value and usefulness of our currency. In other words,
currencies themselves only work because we have faith in the system. The same
is true of capital markets.
If we were
convinced that public markets for stocks, bonds, and other investments were
riddled with fraud and we had no chance of making any real money, we’d steer
clear of them altogether. Without the faith of the people participating in
capital markets, there is no system. But what is needed to restore the somewhat
damaged trust of individual investors?
I believe
the answer is improved self-regulation. Sure, U.S. President Bush vowed to step
in with regulatory measures. And yes, the Securities and Exchange Commission
has asked 1,000 top U.S. executives to personally vow for the quality of their
firms’ respective financial statements. However, that’s only part of the
solution. The only way for confidence to truly be restored is for the larger
participants and the corporate world itself to want to make a change for the
better – and do it voluntarily.
If you
think about it, it’s kind of like that rebellious teenager. The kid keeps
sneaking out to meet with their significant other, to drink, or worse to
consume some other dangerous substance. Trust is broken between parent and
child. But locking a child in his/her room doesn’t restore trust – that’s just
taking control. Open communication and some gestures from both sides are
necessary to restore a genuine level of trust and confidence.
Extending
that line of thinking, having government toss its heavy weight around to put
things back the way they should be isn’t going to solve the problem. In
addition, public companies must improve disclosure. Brokerage firms that sell
research but also make money from investment banking must implement firm
policies that minimize potential conflicts of interest for their stock
analysts. The industry must voluntarily take steps to protect investors and
money managers so that faith is rebuilt to previous levels.
On June 27, the Canadian Coalition
for Good Governance (http://www.otpp.com/web/website.nsf/web/CoalitionforCorpGov)
was created. Formed by Canada’s largest pension funds and money managers
(controlling an aggregate of $500 billion), they will share information on
governance and regulatory issues regarding public companies. Initiatives
include monitoring who sits on boards of directors; insisting that board
committees have mainly independent members; supporting executive compensation
that more closely aligns the interests of management and shareholders; and
helping to strengthen securities legislation.
While Canada hasn’t gone through the
same level of confidence-shaking corporate fraud that our U.S. counterparts
have; it’s good to see steps being taken before a few of our largest public
companies collapse due to plain old greed.
Don’t lose faith in capital markets.
Aside from this new coalition, the Investment Dealer’s Association has drafted
new regulations regarding disclosure and stock analyst standards. In the U.S.
the SEC has made its intention clear to clean things up and the Association for
Investment Management and Research (AIMR) has been in constant contact with
political figures making reform recommendations. Add to that the public
companies that have already taken steps to improve disclosure and it becomes
clear that the combination of pending legislative changes and self-imposed
higher standards will strengthen the industry. Besides, we’ve had accounting
scandals before. We got through them then, as we will this time around.
Dan Hallett, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.