Comment/Pearse ColbertThree years ago, the US Nasdaq Index stood at 5,048; this week it registered 1,307. Over the intervening period the collective losses of investors have been horrendous. In many cases personal capital has been wiped out and pension provisions have vanished.
The collapse of investor confidence in these markets is a serious matter. The absence of immediate credible alternatives to equities creates a special problem for investors in the pensions industry. There is a clear need to earn long-term returns to meet their obligations.
Given that our best hope lies in market solutions, the restoration of investor confidence is imperative. We must be clear about the factors that precipitated the market declines in the US.
Firstly, bloated and unrealistic expectations had taken hold of the market;
Secondly, investment, particularly in the newer sectors of the economy, began to slow down;
Thirdly, the financial reporting and corporate governance systems failed in a number of high-profile disasters.
There was also clear evidence that the reporting and governance issues extended across many companies.
In late 1998 the chairman of the Securities and Exchange Commission, Mr Arthur Levitt, drew attention to the aggressive earnings management behaviour of scores of companies. Accounting rules were bent or stretched to the limit to achieve management targets. Reported earnings were often aspirational rather than grounded in economic reality.
Corporate management became embroiled in a numbers game as they sought to meet analysts' expectations in reporting quarterly results.
Exceeding anticipated results brought handsome rewards in positive share price fluctuations.
There was, however, another factor driving management to produce the most positive earnings data. Stock options had become an important mode of management remuneration. They did not require the sanction of shareholders and the generosity of option provisions created the opportunity for management to create substantial personal wealth at the expense of other shareholders by virtue of the dilution of share capital.
Between December, 2001 and December, 2002 there was a series of corporate bankruptcies in the US. It experienced eight out of 12 of its biggest bankruptcies in corporate history. Five of the corporations were found to have engaged in corporate fraud on a grand scale.
The largest collapse was WorldCom but the one that attracted most attention was Enron, being the first in the period. Consequently it was subjected to extensive investigation by an array of government agencies.
Their collective reports were damning. The verdict was one of catastrophic systematic failure. In particular they cited the failures of the "gatekeepers", namely the board, audit committee and auditors.
It would be wrong to merely focus on Enron's failure to protect investors. There was clearly a problem of misbehaviour among numerous companies. Government agencies reported escalating numbers of companies being obliged to restate their accounts. In October, 2002 the General Accounting Office reported that one in 10 US companies had been obliged to restate their accounts over the preceding five years.
The failure of corporate governance was a focal feature of the major collapse. For many it was the failure of the key "gatekeeper", the auditor, which was most disturbing.
A number of reasons have been advanced but a key factor was the way in which the auditing profession, with its very specific expertise and ethos, had given way to the accounting industry.
The revenues derived from auditing became less important. It became increasingly apparent over time that in many cases the combination of services provided by audit firms threatened the integrity of the audit.
In general the American accounting profession also attracted criticism. It was found to have extremely weak oversight and disciplinary jurisdiction over its constituents. It was not surprising that reforms, when they came, should address this issue.
A fundamental question to be asked in the wake of a crisis is the scale of government response. In the 1930s the stock market crisis precipitated major intervention and regulation. Excessive regulation, however, imposes additional costs and may curb business initiative.
The American response to the current calamity is evidenced in the Sarbanes-Oxley Act signed into law in July, 2002. The scale of the crisis as perceived by the administrator is reflected in the speed with which legislation was enacted and the bipartisan nature of the final outcome.
Overall, it lays a heavy hand on corporate America, with draconian penalties for misdeeds. Above all, the regulation of corporate activities is substantially expanded.
How does all of this activity help to restore investor confidence?
One way or another, the role of the "gatekeeper" must be strengthened. On the face of it the US legislation certainly addresses this issue. On the other, the new highly regulated environment may have an adverse impact on the overall conduct of business.
The second point concerns the accounting and reporting model. Mainly associated with the 1930s, it is imperfect, more art than science and has become increasingly stretched as the economic environment becomes more complex. Clearly the task of communicating relevant information to shareholders becomes more problematic and we may see greater use of narrative data to fill the gap.
What are the ramifications of all of this for Ireland? The Corporate Enforcement Agency is already in place. The Companies (Auditing and Accounting) Bill 2003 is in train. A consolidated Companies Act is in prospect.
The combined impact of all of these measures must be evaluated to ensure that we do not create a strait jacket of regulation that will only serve to inhibit the conduct of business in our economy.
Pearse Colbert is the Horwath Bastow Charleton Visiting Professor of Accountancy at Trinity College Dublin. On March 12th Prof Colbert will deliver a presentation on Financial Reporting and Corporate Governance Reform, a Global Perspective in Trinity College.
