It’s an old and repetitive story. Executives at HealthSouth massaged the accounting numbers so that they could make Wall Street happy. Analysts set expectations, and managers felt that they had to meet those forecasts of the quarterly earnings. They fibbed only a little bit -- after all, making up only $2.5 billion of earnings is so small that we have to consider it a white lie. It couldn’t hurt anybody. Until, of course, you remember that the compensation for these managers is a function of the numbers. What they receive in stock and stock options is very much dependent on these accounting constructions.
 
At this writing eight managers or former managers have pled guilty to charges such as committing securities fraud and falsifying the accounting books. More pleas are expected, as well as an indictment of Richard Scrushy, the former CEO of HealthSouth. Lawyers for Mr. Scrushy vigorously deny the allegations, claiming that he was set up. If true, stockholders should sue him for incompetence and nonfeasance. After all, any CEO who cannot keep track of $2.5 billion is unfit for the job.
 
Alex Berenson has examined this phenomenon in his new book The Number. This volume should be on the shelf of investors and creditors who would like to know what happened to them. It chronicles the misdeeds of the 2001/2002 era, but shows that these transgressions are a part of a larger history that unhappily promotes manias and market crashes through the accounting process. To change future events, one must change how managers are compensated and de-emphasize quarterly earnings.

 

Berenson provides a historical background in part 1 of his book, looking at the market crash of 1929 and the creation of the SEC, and later at such events as the blow up at Equity Funding. From there he moves to the present time and systematically critiques the greed of corporate managers and investment bankers, the complicity of the auditors, and the impotence of the SEC and other regulators. These topics of course lead him to investigate the frauds at Enron and WorldCom and Lernout & Hauspie and Tyco, as well as the games played at stalwarts such as General Electric and IBM.

 

In this framework he also examines the institution of quarterly earnings and the use of stock options with which to compensate corporate managers. The powerful and insightful analysis by Berenson demonstrates that these institutions have become insidious temptations for managers and other players in the economy to lie and cheat and steal. Until society addresses the iniquities conjured up by these institutions, we shall continue to see managers at HealthSouth and elsewhere attack the fabric of financial reporting to their advantage. In turn, these dysfunctional behaviors affect the economy as a whole. Unfortunately, I think Berenson is correct in his analysis.
 
Until the economic system is truly reformed, the SEC should require all registrants to place on their filings with the SEC in bright red letters: These financial statements may be hazardous to your financial health. That would furnish at least one nugget of honesty to investors and creditors. After all, the rest may be smoke and mirrors.
 

J. EDWARD KETZ is the MBA Faculty Director at the Smeal College of Business at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of the forthcoming Hidden Financial Risk, which explores the causes of recent accounting scandals.