Sort of a Symposium Issue: Fraud or Co-optation in the Practice of Smoothing Earnings?

Posted by Jeff Lipshaw

June Carbone (left) and Bill Black (right), both of UMKC, and I were trading e-mails two days ago, and to make a long story short, on pretty short notice, I filled in (to substitute for a cancellation) on a panel in the Section on Socio-Economics workshop here at the AALS meeting on Wednesday afternoon, moderated by June, and on which Bill was presenting.

The general theme of the panel was “norm-creation.”  Bill’s talk centered on a 2005 presentation by Michael Jensen, of SSRN and all sorts of other fame, about what Jensen now sees as “low-integrity relations” between firms and analysts on the subject of earnings smoothing.  I have written and posted on the relationship between law and business ethics, so I also was interested in the Jensen piece.

Since my quickly prepared presentation consists presently of what I scrawled at lunch on some LexisNexis note paper, I thought this would be a good place to preserve this somewhat impromptu “symposium” offering.

Jensen’s observations are thought-provoking, particularly if you have been on the inside of a corporation making decisions about how you report your earnings.  Bill is a criminologist, and his piece was about what the criminologists call “neutralization” and what I would call “co-optation, in this instance into the creation of norms under which the manipulation of accounting numbers was acceptable.

My limited goal was to take a deeper dive into how we decide something is manipulation worthy of the name “lie” or “fraud.”  Regular readers of this blog are, I believe, familiar with my long history as a GC at the corporate and divisional level in companies that aspired (because of the career history of the managers) to something resembling GE management style.  At AlliedSignal under Larry Bossidy, the mantra every year was “Make the Numbers,” a shorthand (I came to believe poorly worded) for the values of “fulfill your commitments, do what you promise, and do that for customers, employees, shareholders.”  So if that was one end of the continuum driving the development of internal norms of behavior, the unacceptable other end of the continuum would have been “Make Up the Numbers.”

There is an epistemological element to all of this, I’m sorry to say.  Accounting, in many respects, is about buckets of time, quarters and years, most of which are arbitrary (or at least as arbitrary as the fact of the Gregorian calendar and its divisions).  A goal of accounting (and I’m pretty sure I could pull up a basic accounting text on this) is to match revenues and costs properly in each bucket.  Smoothing is the phenomenon by which companies deliberately manipulate the revenues and costs in the various buckets so as to conform to earlier predictions, either from management or analysts, about the result in the time periods represented by the buckets.

More on this below the fold.

In the pre-Enron period, there is no question that analystsdemanded, and companies delivered, if they could, no surprises from what the companies issued as their own earnings expectations for future periods.*  Thatwas the point of smoothing.  Bill had an interesting thesis aboutthose days:  if the company’s stock was punished because it missed anestimate by a penny (out of saying several dollars per share ofearnings), it was because the market perceived that the company hadexhausted every possible “fraud and manipulation” and still couldn’tget to the number.  I disagree, on further reflection, with that causalexplanation.  I think the market expected you could always manipulateanother penny, so that if you missed by a penny, it was a deliberatebearish signal by management on the future prospects.

But the present question is what it means to put the terms “lie” or”fraud” as descriptors on that manipulation.  I want to put aside thestraw man of straight cooking the books in the manner by which I nowconfess I did my freshman chemistry lab reports:  if you don’t like thenumber, erase it and put in a new one.  Booking sales you never made isout and out fraud.  Simply changing entries you don’t like is out andout fraud.  Writing an earlier date on an option agreement and pretending it wassigned then is a lie.  Those cases, it seems to me, are too easy to beinteresting.

Here’s the epistemology.  If a lie is a sentence uttereddeliberately not to reflect reality, and with the intention ofdeceiving in the process, what does it means to lie about youraccounting when you are talking about manipulation that is not out andout falsification of a piece of data?  A financial statement is itselfa model seeking to represent another reality – the state of abusiness.  That reality is so complex that we need to reflect it inseveral ways, with a snap shot view at a moment in time (the balancesheet), and in flow over periods (income and cash flow statements). Lots of aspects of accounting conventions are precisely that:conventions that are proxies and do not themselves reflect reality.  Ifyou use a depreciation method, you are not really reflect the extent towhich the asset is used up; you are reflecting a model of that use. And sometimes, the accounting or tax rules sanction what seems like alie:  accelerated depreciation.  So what are truth statements in thecontext of accounting?

Moreover, the accounting conventions are subject to interpretationand judgment.  For example, is the cost fairly attributable to onebucket or more than one bucket (i.e., do you expense or capitalize thecost?)

So there is something of a gray area on that continuum, between”Make the Numbers” and “Make Up the Numbers,” in which we have tostruggle with questions of the very essence of truth.

Here are some very cursory hypotheses:

1.  Certainly pre-Enron, the rules of the manager-analyst gamerewarded present period “making the numbers” over long-term value, orat least that’s how companies perceived it.  Woe betide the R&Ddepartment in the fourth quarter of a company having a bad year.  Evenwithout manipulation of the accounting, as Jensen observes, there was adouble-think rationalization (in my view) of perfectly legal, buteconomically nonsensical trading of long-term value for short-termgain.  See Larry Ribstein for why this supports the thesis that firmsare turning to the private capital markets.

2.  There is moretransparency now than there used to be.  That is partly related toattitudinal shifts, and partly due to the Sarbanes-Oxley rules(Regulation G) requiring there to be a reconciliation in publiclyreleased financial statements between GAAP numbers and “as adjusted forcontinuing operations” numbers.

3.  The integrity issues related to smoothing were not restricted tothe relationship between the firm, on one hand, and securities markets,on the other.  In large and complex organizations there is gaming upand down the business:  business unit controllers game the division,and divisional controllers game the corporation.  Jensen has anotherpaper (only downloaded about 7,500 times) entitled Paying People to Lie:  The Truth About the Budgeting System.  Here is the abstract:

This paper analyzes thecounterproductive effects associated with using budgets or targets inan organization’s performance measurement and compensation systems.Paying people on the basis of how their performance relates to a budgetor target causes people to game the system and in doing so to destroyvalue in two main ways: 1. both superiors and subordinates lie in theformulation of budgets and therefore gut the budgeting process of thecritical unbiased information that is required to coordinate theactivities of disparate parts of an organization, and 2. they game therealization of the budgets or targets and in doing so destroy value fortheir organizations. Although most managers and analysts understandthat budget gaming is widespread, few understand the huge costs itimposes on organizations and how to lower them.

Mypurpose in this paper is to explain exactly how this happens and howmanagers and firms can stop this counterproductive cycle. The key liesnot in destroying the budgeting systems, but in changing the wayorganizations pay people. In particular to stop this highlycounterproductive behavior we must stop using budgets or targets in thecompensation formulas and promotion systems for employees and managers.This means taking all kinks, discontinuities and non-linearities out ofthe pay-for-performance profile of each employee and manager. Suchpurely linear compensation formulas provide no incentives to lie, or towithhold and distort information, or to game the system.

Whilethe evidence on the costs of these systems is not extensive, I believethat solving the problems could easily result in large productivity andvalue increases – sometimes as much as 50 to 100% improvements inproductivity. I believe the less intensive reliance on suchbudget/target systems is an important cause of the increasedproductivity of entrepreneurial and LBO firms. Moreover, eliminatingbudget/target-induced gaming from the management system will eliminateone of the major forces leading to the general loss of integrity inorganizations. People are taught to lie in these pervasive budgetingsystems because if they tell the truth they often get punished and ifthey lie they get rewarded. Once taught to lie in this system peoplegenerally cannot help but extend that behavior to all sorts of otherrelationships in the organization.

For what it’s worth, I watched this happen.  I am not convinced thatpeople respond so directly to compensation that changing the pay systemwould solve the problem, but I have no doubt that Jensen correctlyidentifies a corrupting influence from a “top-down” imposed budgetingsystem.  I have this intuition that the gaming is more complex than merely economic.  Once you set the rules of the game for success-oriented people, success-oriented people want to win.  Or they want to get an A and not a C.  Period.

* * *

This is about norms and integrity.  My guess is the number of people who walk into these situations with the preconceived notion they are knowingly going to scheme is fairly small.  That is, the set of true evil actors is relatively small.  The set of banal evil, of cooptation, or neutralization, as Bill Black put, seems to me is not only bigger, but more interesting and important.  And I’ve written about the dangers of the instrumental reasoning process by which we can delude or deceive ourselves into justifying the abuse, all of which can be exacerbated by a lawyer’s professional gloss (if not imprimatur) on the justification.

I don’t think the solutions are algorithmic.  I am suspicious of instrumental reason (or instrumental reason masquerading as pure practical reason).  I am aware of the mushiness of relying on intuition.  So it’s a mystery to me still how we resolve the intersection of legal rationalization with a moral and ethical sense.

*(The practice of issuing “guidance,” as it is called, has substantiallycurtailed since then, I think.  I saw some data just a few days agothat securities class action filings are down – that would beconsistent with less earnings guidance – the core of a archetypal suitconsists of company guidance and then a subsequent event that provesthe guidance incorrect.)