The last thing markets needed when they were already reeling from the Enron disaster was WorldCom and there may be more creative accounting scandals in the pipeline. What does it mean for the investing public and professionals alike and can we learn any lessons?
Well, Andersen's reputation is in tatters and the auditing process in general will come under intense scrutiny. The reputation of corporate America is in turmoil, prompting President George Bush to remark: “There is a need for renewed corporate responsibility.” Investor confidence has been dented and capital markets have been undermined, with an immediate impact on share prices. Unchecked greed and corruption is a dangerous cocktail.
Such events should push investors to consider the merits of companies with identifiable cash flow, easily understandable business models and visible earnings. A company's accounts will be the key factor for analysts and investors to digest – as they should always have been.
An accountancy guru once stated: “Cash is fact, everything else is a matter of opinion.” How can a company not generate cash and yet report profits year after year?
Clients may be reluctant to invest in companies with high debt or those that have grown rapidly via acquisition. Analysts will have to watch for companies hiding costs in the balance sheet and look at exceptional items and a host of other clues which may uncover discrepancies. Tim Steer at New Star has produced some very helpful guidelines on factors to look out for in the annual report and accounts.
On a more positive note, the vast majority of companies follow prudent and proper accounting policies. However, we will see auditors being extremely vigilant in future, so some benefit can arise from these debacles.
So far, the problems have been US based and, although there could be contagion, the UK is generally regarded as having tougher corporate governance standards. For example, following the Cadbury report, the roles of chairman and chief executive are usually split in the UK. After all, Kenneth Lay at Enron and Bernie Ebbers at WorldCom were all-powerful. However, we cannot be complacent, given the pressures linked to bonus packages and remuneration, which could lead to senior executives engaging in “aggressive earnings announcements”, particularly in a period of falling share prices.
In short, there needs to be more transparent accounting, enhanced corporate governance and less boardroom arrogance. This goes beyond simply auditors, in that all those financially involved, including directors, analysts, regulators and lawyers, need to be aware of their responsibility and be receptive to improvements.
We do not have to confine our analysis to US accounting scandals. Public mistrust is heightened when they read that the chief executive of Tyco is being indicted for tax avoidance and prominent individuals are accused of insider trading. We have witnessed Merrill Lynch agreeing to pay up when some of its research analysts were caught hyping shares they thought were next to useless.
If chief executives are coming across as greedy, self-interested individuals, then the public's faith in our system will be stretched. I sincerely hope that these scandals will have a silver lining in that the US, in particular, will demonstrate much more robust and reliable accounting policies, leading to a restoration of public confidence.
Some of these issues are, of course, part of a wider problem which is not just confined to the financial sector.
You must have leaders who can display integrity and an ethical society needs individuals responsible for their own actions. We seem to have lost sight of what is unacceptable behaviour but that is another story.
Michael Owen is joint managing director of Plan Invest Group