Repairing broken trust
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.
Operating vs. capital costs
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.
Faith in markets
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.
Canadian Coalition for Good Governance
On June 27, the Canadian Coalition for Good Governance 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, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at email@example.com
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