The Number, Alex Berenson (2004)

Foreword: Alex Berenson (author) The author believes that the stock market is broadly efficient that at any given time the Standard & Poors 500 index might be 30 percent too low or 50% too high, but that in the long run it reflects the performance of the American economy. (An efficient market is a market where the price of the stock is based on all the information that is available no information that can influence the price of a stock is secret or hidden from investors and the price of the stock reflects all of that information.) Foreword, Mark Cuban In 1990 Mark Cuban sold his company, MicroSolutions, to CompuServe. That gave him a bunch of cash. Originally he thought the markets were efficient that stock prices reflected any and all available knowledge about a company and that attempting to beat the market was a waste of time. But a friend convinced him that he could make money in the market by trading. The word trading is different than the word investing. In the early 90s he bought shares of a company called Gandalf. It climbed dramatically and then, in 1997, he got very lucky he sold it just before it went bankrupt. That gave him a lot more cash. In 1995 Mark Cuban started a company called Broadcast.com his partner was Todd Wagner. In 1998 they took the company public. In the process of trying to find and attract investors to buy the stock in the companys initial public offering, Cuban was shocked to discover that potential investors didnt understand or even care what his company was doing they only knew that a lot of people were talking about the company and thought they should possibly invest. All of them eventually place multi-million dollar orders for stock when the company went public. Mark believes that stocks dont go up or down because companies do well or do poorly. They go up and down simply because people do or dont want the stocks (supply and demand). He believes fundamentals such as price-earnings ratio (P/E ratio), price-sales ratio, the present value of future cash flows, etc, are just metrics (measures) that help stockbrokers sell stocks and give buyers confidence when buying them. Companies motivate people to come to work for them by offering them options to purchase shares of stock at a fixed, set price. The stock options may not be valuable when they are given to the potential employee, but if the employee works hard and the price of the stock goes up, then the employee can exercise his option and sell his stock for a profit. Mark Cuban believes the stock market used to be a place where investors who owned a part of a company actually had a say in how the company was managed. But now he says it is a market designed

to make insiders rich by allowing them to exercise their options when the price of the stock goes up. The options allow them to buy shares at a low, fixed price, that was set when they were originally given the options. Companies not only give options to new employees, but continuously issue new shares and give options to their managers without asking existing shareholders. Those managers then exercise their options and sell those shares and leak them to the market a little at a time. This has the effect of putting more shares in the market. If a company has 1M shares outstanding, then the shareholder owns 100/1,000,000th of the company. But if the company issues 500,000 new shares and gives them to its management in the form of options, when those options are exercised and the shares are sold there will then be 1.5M shares outstanding and the shareholder will now own only 100/1,500,000th of the company. Mark Cuban says If that isnt a scam, I dont know what is. You buy stock in a company and a few weeks later your stock is worth less and all of the missing money went to insiders, not to the company. No one asked your permission and you dont even find out that your ownership was diluted and by how much until 90 days later or longer. Cuban says that the stock market is not efficient it is inefficient and is as close to a Ponzi scheme as you can get. Ponzi scheme: A fraudulent investing scam that promises high rates of return for older investors by acquiring new investors. This scam actually yields the promised returns to earlier investors, as long as there are more new investors. The Ponzi scam is named after Charles Ponzi, a clerk in Boston who first orchestrated such a scheme in 1919. Cuban says that he got calls every day from people who owned his companys stock but the only thing they ever wanted to know was the number (earnings per share). Prologue One of Many In 2001, Computer Associates, the worlds fourth largest software company, reported its quarterly earnings for the three months ending December 2000. The report was a good one and very beneficial to the companys chairman, Charles Wang, who owned 30 million shares worth more than $1 billion dollars. But it turned out that Computer Associates was using accounting tricks to create false financial statements. In particular, it was posting sales and earning twice to make the company appear to be much more profitable than it actually was. By January 2001, lots of companies were abusing accounting rules to mislead their investors. Introduction System Failure Every three months, publicly traded United States companies report their sales and profits to their shareholders these quarterly reports include earnings per share (The Number). These reports are filed four times a year with the Security and Exchange Commission (SEC), the federal agency that is

supposed to regulate US stock markets. (In fact, it regulates them very poorly.) The first three of the four reports for the fiscal year of a publically traded US company are called 10-Qs and the final report for the fiscal year is called the 10-K or audited Annual Report. For traders and investors, earnings per share (The Number) is the most important number that determines a companys success or failure. However, the author says that The Number is a lie. Thats because earnings per share is actually just the result of thousands of guesses and financial statements are based on accrual accounting. Revenue is booked when the company makes a sale, not when it actually receives cash for the sale. And it books expenses when it agrees to buy something, not when it actually pays. Take the example of an airline that buys an airplane. The airline may pay for the airplane immediately but the financial statements spread that cost over many years the useful life of the asset as the value of the airplane depreciates. Accrual accounting can be abused. Companies that want to cheat have thousands of ways to do so. They can book sales to customers who wont ever be able to pay them. They can hide daily expenses as longlived assets that depreciate over time. They can shift research and development expenses to supposedly independent partner companies. They can make fake deals with other companies trade overvalued assets so both companies seem to make a profit on the trade, for instance. The SarbanesOxley Act of 2002 (Sarbox or SOX), is a United States federal law which set new or enhanced standards for all U.S. public company boards, management and public accounting firms. Before Sarbanes Oxley was enacted in 2002, most individual and professional investors didnt worry much about accounting. Investors believed that as long as a major accounting firm certified that a companys financial statements were prepared according to generally accepted accounting principles (GAAP), then the financial statements could be trusted. In reality, the SEC never had the budget or personnel to check company 10-Qs and 10-Ks for accuracy. Also, markets seemed to be growing continuously and investors didnt really have much reason to question companies quarterly reports The Number seemed to always be going up. But the growing market of the 90s turned into a bubble and crashed, Several big public companies admitted or were caught committing accounting fraud to make their financial statements look better than they actually were. Enron Qwest Dynegy Bristol-Meyers Squibb IBM Global Crossing Computer Associates Adelphia Communications AOL Time Warner Nvidia Halliburton Tyco WorldCom

Enron not only went bankrupt, it just seemed to disappear. The assets on its books didnt seem to exist at all.

Enrons auditor was Arthur Anderson. Arthur Anderson had 85,000 employees and had been in business for 90 years. When Enron went bankrupt, Arthur Anderson, went out of business after being criminally indicted for obstruction of justice.

PART I THAT WAS THEN . . .

Chapter 1 Boom and Bust 1920s economic boom. Everyone with any money owned stock. Money flowed readily and, for the first time, millions of Americans were able to afford electricity and cars. But there was a lot of fraud widespread stock price manipulation, financial reporters for the Wall Street Journal and the New York Times were discovered to have taken bribes to write good articles about stocks, financial information reported by companies was not reliable, in fact companies were not even required to report profits only a balance sheet once a year. Benjamin Graham (Warren Buffets professor at Columbia and mentor) is considered by this author to be the first stock analyst and the greatest stock analyst. Graham wrote that in the 1920s the stock market was like betting on a horse race. He said that in the 1920s people thought the value of a common stock depended entirely on what it was expected to earn in the future. It wasnt necessary to research the quality of a companys management or whether the stock was too expensive. If everyone else was buying it then it was thought to be a good stock no matter what it cost. Everyone thought that it was easy to make money in the stock market and that it was only necessary to buy stocks, no matter what the cost, and wait for the price to go up. Stocks were very cheap. The most basic measures of stock valuation are the dividend yield and the price-earnings ratio (P/E ratio). If a company trades for $100 per share and pays an annual dividend of $4 per share, then the companys dividend ratio is 4/100 = 4%. If the companys profits for the year are $8 per share then its price earnings ratio is 100/8 = 12.5. Over the last hundred years the P/E ratio of big American stocks has been about 15 and the average dividend yield has been about 4%. But in the 1920s the markets P/E ratio was below 10 and the dividend yield was above 6%. 1926 beginning of the economic bubble. Credit and buying securities on margin was easy. Buying on Margin borrowing part of the cost of stocks from your broker. If the price rises or falls, then the gains or losses are multiplied. Also, when the price falls the broker can demand that you put up more cash as collateral called a margin call. 1929 October 29 (Black Tuesday) the bubble burst stock market crash and beginning of the Great Depression. Most economists now believe the crash itself did not cause the Depression but that it was caused by President Herbert Hoover who thought the market would regulate itself and refused to increase federal spending when market demand had crashed.

1933 J. P. Morgan, Jr. testified before the Senate Banking and Currency Committee about his companys behavior during the 1920s economic boom and the 1929 crash that followed. Morgan admitted that he and his partners hadnt paid any taxes in 1931 and 1932 when the Depression was at its worst. His reputation was ruined. (Morgans father, the original J.P. Morgan, was so rich that his bank controlled the market, helped end market panics, and helped the economy stay steady.) The Senate committee held hearings for two years. At first, the Senate committee focused on short selling because they thought that was the problem with the economy (short sellers borrow stock, sell it and promise to deliver the stock later, hoping to buy it back after the price has fallen and profit). But the committee turned their attention to the stock price manipulation, deception, and greed that had occurred during the 1920s. Chapter 2 Foundations The Senates hearings produced three laws: The Securities Act of 1933 requires companies to file registration statements with the government before they can sell shares. Corporate executives, investment bankers, and auditors are required to make sure the information in the registration statement is true and no important financial facts are omitted. The Glass-Stegall Act prevents financial institutions (like JP Morgan back in the 1920s and before) from both selling stocks and issuing bonds (investment banking also called underwriting like Goldman Sachs today) and taking deposits and making loans (commercial banking like Wells Fargo today). Financial institutions have to choose one or the other and cannot do both. The Securities and Exchange Act of 1934 created the Securities and Exchange Commission (SEC) to oversee the securities business. The Act limits short selling, gives the Federal Reserve the power to set margin requirements so brokers cannot lend people 80% or 90% of the value of the stock they are buying, forces board directors and corporate executives to report purchases and sales of their companies stock, and requires companies on the New York Stock Exchange (NYSE) to file audited annual reports of their sales and profits with the SEC. Financial institutions did not like these laws and went on a capital strike from 1933 to 1934 refusing to underwrite stocks and bonds. The New York Stock Exchange (NYSE) was also not cooperative and in 1938 its president even went to prison for embezzlement. In spite of the SEC Act of 1934, the SEC also never took the opportunity to become as powerful as it could have. The SEC only focused narrowly on the New York and American Stock Exchanges and small scale fraud instead of watching out for system-wide accounting and corporate governance problems. The first description of bookkeeping was written in the 1400s by Luca Pacoli, an Italian monk. The template for the modern balance sheet (total assets must always equal total liabilities including equity what I have equals what I owe plus what I am worth) was created in 1880 by Charles Ezra Sprague. Accountants are the plumbers of capitalism.

In the 1920s and 1930s, accountants were not truly independent. They were hired and paid by the companies that they audited and pretended that a conflict didnt exist. Also, they could certify that a company had properly followed the accounting rules that the company chose to use even when the company used the wrong rules. Accountants believed the responsibility for financial statements was with the directors and officers of the corporation, not the accountants. 1934 The foundations on which modern stock analysis is still based began in 1934 when Benjamin Graham and David Dodd wrote Security Analysis (the investors bible) which teaches investors how to think about what a stock is worth and how to go through financial statements to find hidden values and hidden traps. Graham was a value investor who looked for out-of-favor companies with steady earnings and dividends and that had hard assets greater than the value of its shares. Graham also believed that investors should not put too much weight on short-term earnings (The Number) trends, especially if they were strongly positive. 1938 John Burr Williams, a PhD student at Harvard, wrote The Theory of Investment Value in which he argued that stocks of a company are only worth the future cash (dividends) that they generate for their shareholders. This idea became known as the dividend discount model and states that a company with rapidly rising dividends will be worth more over time than a company whose dividends are flat or declining. Unfortunately, its difficult to put the dividend discount model into practice: Investors needs to figure out what future dividends will be Then they have to determine how sure they are of their predictions They have to choose a discount rate in order to figure out how much the future dividends are worth today

Williams dividend discount model can be used to justify just about any price for a stock. If a company is growing rapidly, will that growth continue forever? What if the economy changes or new competitors emerge? 1939 Faced with huge fraud by a company called McKesson & Robbins that had been audited by Price Waterhouse, the American Institute of Accountants issued new guidelines for auditing and required accountants to confirm that inventory and sales really existed and that the companys internal financial controls were correct. 1945 Helen Slade founded the Financial Analysts Journal which published articles about the best way to pick stocks and create portfolios that would outperform the overall market and minimize risk. The journal is still published today. 1949 the second great bull market of the twentieth century began. Investors engaged in profit taking and the market went through technical adjustments are words that Wall Street analysts use to say I have no idea why the market went down today. Chapter 3 Bubbling Under 1955 the SEC required that publically traded companies issue earnings reports twice a year (semiannual).

Mutual Funds (called Investment Trusts during the 1920s boom) allowed small investors to own a diverse basket of stocks at low cost. During the 1950s, Mutual Fund managers hired sales representatives to sell their funds to small investors. 1957 Gerry Tsai started and managed the Fidelity Capital Fund and became the most famous and respected mutual fund manager in the world. Largely because of Gerry Tsai, mutual funds became extremely popular with investors. But investors assumed that the fund managers were doing the due diligence on all of the stocks in the funds portfolio and actually knew what was going on unfortunately, that was not the case. Some investors think that since mutual funds own a lot of a companys stock, the fund manager can fight for better corporate governance. The author says this is not true. With only 5% or 10% ownership for instance, the fund cant actually control a company. A big problem with mutual funds is that when an investor buys shares of a mutual fund they are putting their own savings at risk, but the fund managers are not. Also, with so much competition among mutual funds, fund managers are encouraged to take big risks on high growth companies in order to hopefully show big returns. This may or may not be in the best interest of individual investors. Efficient Market Hypothesis academics argue that investors, both professional and individual, are wasting their time by trying to beat the market. The Efficient Market Hypothesis is a theory that says that stock prices always include all of the information that is known about a company at any given time. So no single investor, no matter how smart he is, can be smarter than tens of millions of people who have that same information. The Efficient Market Hypothesis says that the market is always right whatever the price of a stock is right now, that is what the price should be. And anyone who seems to be beating the market is actually just lucky. The author of this book argues that the Efficient Market Hypothesis is not correct. He acknowledges that index funds do beat actively managed mutual funds (which should prove that the EMH is correct). But he believes that beating the markets is hard but not impossible. The trick is to find inefficiencies in the market and trade on them and he cites Warren Buffett as an example of someone who has consistently done that for forty years. However, there is a weaker form of the Efficient Market Hypothesis which states that the price of a stock cannot be predicted by its previous prices. Notice, this version of the EMH isnt about all of the information about a company just its past stock prices. People who believe this version of the EMF are called Technical Analysts or Chartists. They chart stock prices and believe they can predict what the future prices will be based on their charts. The author of this book does believe this version of the EMH, that chartists cannot beat the market watching only prices alone. 1965 More than 20 million Americans owned stocks. Gerry Tsai quit Fidelity to start his own fund, the Manhattan Fund. Beginning in the 1950s, many businesses began growing into Conglomerates (large businesses that consist of many smaller businesses) which specialized in taking over other companies and increasing their profits, supposedly with superior management. One example, Ling-Temco-Vought (L-T-V) started in 1956 and grew to $3.8B by 1969.

The problem with conglomerates was that any company with a high price-earnings ratio can cause that ratio to rise by simply buying another company with a lower price-earnings ratio and combining the second companys stock with its own. No management skills were needed to do this, but eventually it became impossible to find takeover targets they were all taken. So many conglomerates resorted to accounting trickery to keep the illusion that they were growing alive. The conglomerate boom ended in 1969 when the bull market ended, the market went down, and it became hard for conglomerates to issue the new debt to borrow money or sell the stocks necessary to get the cash they needed for acquisitions. All of a sudden conglomerates were faced with actually having to manage the second rate companies they had acquired. From 1969 to 1971 the stocks of ten major conglomerates fell an average of 86%. Throughout all of this, the SEC was understaffed and underfunded. It couldnt hope to oversee hundreds of thousands of accountants, mutual fund sales people, stock brokers, and financial analysts. For cases more complicated than simple fraud, the SEC hardly existed at all. There was a bull market in the 1960s but it never became a bubble. So there was never a crash, only a bear market that began in the late 1960s. Chapter 4 The Death of Equities Boiler Room high pressure brokerage firm that sells worthless stock over the phone. The Big Board another name for the New York Stock Exchange (NYSE). The Big Eight the eight major accounting firms that dominated the profession from the 1960s through the late 1980s Arthur Anderson, Arthur Young, Coopers & Lybrand, Ernst & Whiney, Deloitte Haskins & Sells, Peat Marwick, Price Waterhouse, and Touche Ross. Note that several of these have combined and evolved into the biggest firms today now called the Big Four: Ernst & Young, PriceWaterhouseCoopers, Deloitte Touche Tohmatsu, and KPMG (which absorbed Peat Marwick) . The only one of the original Big Eight that is completely missing is Arthur Anderson they were Enrons auditor and went bankrupt. 1972 Equity Funding, formerly the fastest growing diversified financial company in the United States, collapsed. The company sold insurance policies and allowed customers to borrow against the value of their policies to buy mutual funds. But it turned out that hundreds of millions of the insurance policies were fake and the company had printed fake stock certificates and carried them on its books as assets. The Equity Funding scandal showed that audited financial statements are not always what they seem to be and that the certification of the financial statements by auditors may very well be meaningless. 1973 The organization that sets standards for the accounting industry, the Accounting Principles Board, is abolished and the Financial Accounting Standards Board (FASB) is put in its place. However, neither board did much more than protect accountants from outside inspection. The members of the board were all people from the accounting industry. The author considers the FASB to be like a goldfish in a bowl of sharks. Its main mission, he says, is to make big accounting firms happy and not to crack down on aggressive accounting practices. 1973 The SEC forces the New York Stock Exchange (NYSE) to deregulate commissions on trade. Formerly, commissions charged by brokers buying and selling stocks for their investors were fixed at 7% of the amount of the trade. Now brokers could compete on price. Consequently, many small

brokerage firms went out of business since they were unable to compete on price. Discount brokers like Schwab charged far lower commissions on trades than full-service brokers like Merrill Lynch. Investors could use discount brokers to buy and sell stock. Full-service brokers charged higher commissions but they also performed financial analysis, issued reports on companies, and gave advice. 1978 A Senate subcommittee report finds that The Big Eight firms are more concerned with serving the interests of corporate managements who select them and authorize their fees than with protecting the interests of the public. A bill is introduced in the House that would create an independent federally chartered commission to oversee accountants and increased the potential liability of accountants for bad audits. The bill, titled the Moss Bill, never got out of the house. 1979 inflation is at 13.3%, the highest level in United States history. Policymakers decided to increase interest rates to hopefully drive down inflation. High interest rates cause consumers and businesses to cut back on borrowing. When business cant borrow, they raise prices and workers demand higher pay. Eventually, inflation falls and the interest rates can be lowered, but the process is extremely painful. 1979 to 1982 The Federal Reserve raises short-term interest rates that the Federal Reserve charges banks to as high as 18%. The rate that banks charges their best borrowers rises as high as 21.5%. Inflation rates fell but the high interest rates threw the United States into a deep recession.

PART II . . . THIS IS NOW

Chapter 5 Countdown 1982 the biggest bull market in history began and lasted eighteen years. Corporate Raider - An investor who buys a large number of shares in a corporation whose assets appear to be undervalued. The large share purchase gives the corporate raider significant voting rights, which is then be used to push changes in the companys leadership and management. This increases share value and generates a massive return for the raider. Leveraged Buyout (LBO) When corporate raiders put up only a small amount of capital and borrow the rest to buyout or takeover a company. This puts the acquired company into more debt than before. Since interest payments on debt are pre-tax expenses, corporate raiders argued that more debt was good. And since profits that are paid out to shareholders as dividends come out of after-tax income, corporate raiders argued that too much equity was bad. LBOs changed corporate America and forced corporate executives to pay more attention to their shareholders and their stock prices in order to keep from being raided and being bought out. CEOs learned a lesson from the corporate raiders high stock dividends were no longer a sign of corporate strength. Instead, high dividends signaled that the company was generating cash that could be used to pay interest on debt that could finance a takeover. So many companies cut back on dividends. Before the 1990s, dividends were the primary way that firms could show that their earnings were real. But because of the corporate raiders companies cut back on dividends or paid no dividends at all. This allowed companies to more easily abuse accounting rules and inflate their profits and opened the way for companies like Enron and WorldCom to report billions of dollars in fake paper profits.

Greenmail (from the word blackmail) a raider buys a minority interest in a company and then demands to be bought out at an increased price in return for an agreement to not start a takeover fight. 1989 the Junk Bond market crashed. Junk Bonds (as opposed to Investment Grade Bonds) are corporate bonds with high interest rates. Corporate raiders often borrowed money to finance their takeovers by having the takeover company issue high interest (junk) bonds. As more and more takeovers occurred and takeover targets became fewer and fewer, junk bond interest rates became higher and higher. When the economy slowed down in 1989, the junk bond market crashed. Dozens of companies that had been bought with high interest junk bonds were unable to make their interest payments and went into bankruptcy. 1990s the biggest bull market in history continued and telecommunications, technology, and biotechnology stocks became the focus of investors. High tech companies like Microsoft made their stockholders millions of dollars but never paid a dividend. Chapter 6 The Number is Born Before the SEC forced the New York Stock Exchange (NTSE) to deregulate commissions in 1973, stock brokers all charged the same fixed rate (7%) on trades and were forced to differentiate themselves from their competitors by providing superior research information and financial analysis of companies for its investors. By the late 1960s, research competition was fierce. Trading commissions provided over half of the revenue for brokerage firms and they were highly motivated to provide the best research possible. But by 1990 research no longer generated enough commission revenue to pay for itself and investment banking (underwriting stock and bond offerings) became the most important source of revenue. And since underwriting stock and bond offerings paid their salaries, financial analysts wrote more and more positive reports. Consensus Estimate the average earnings forecast of all the analysts who report on a particular company. This consensus, this average quarterly earnings forecast, quickly became the standard for judging the success or failure of a companys quarter. A company whose earnings fell short of the consensus could experience a huge drop in their stock price. Individual analysts used to estimate earnings estimates in a range such as $1.90 to $2.00 a share. This gave companies some leeway. But consensus estimates came to be calculated to the penny and companies faced increased pressure to match the estimate or beat it. Earnings Guidance Typically provided on a quarterly basis, earnings guidance is information that a company provides as an indication or estimate of its future earnings. Guidance reports estimating a company's future earnings have some influence over analyst stock ratings and investor decisions to buy, hold, or sell the security. With companies reporting earnings guidances every quarter analysts were discouraged from performing research. Why conduct research when the analyst can just call the CFO and ask for the estimate? The focus on quarterly earnings estimates (The Number) encouraged Wall Street to focus on companies short-term results rather than long-term trends. The focus on quarterly earnings results motivated CEOs and CFOs to meet their estimates any way they could.

Chapter 7 Stock Options Stock Option gives the owner the right to buy a stock for a set price, called the Strike Price, any time before the option expires. When the option is cashed in, or Exercised, the owner receives the difference between the price of the stock and the strike price. If the Strike Price is lower than the current market price, then it would be foolish to Exercise the option and the option is said to be Out of the Money. Options are typically given to key employees, particularly executives, as incentives to stay with the company as it grows. A typical employee option has a ten year term and vests (becomes the property of the employee) over a four year period. Employees who quit before the option vests lose the portion that hasnt vested yet. This seemed to solve the corporate governance problem and aligned the interests of executives and shareholders. Accountants have traditionally viewed options as costless for two reasons: they do not require a cash outlay and their value is uncertain. Companies can create options whenever they like and valuing options accurately seems to be impossible since there is no way to know how much it will be worth if it is ever exercised. So companies never recorded a cost for issuing options as long as their exercise price was set equal to the companys stock price on the day they were issued. So companies could give away as many options as they liked with no impact on their earnings options seemed to be free. Black-Scholes Equation In 1973, two finance professors, Fischer Black and Myron Scholes, figured out how to value options and, consequently, otions can now even be traded on exchanges and bought and sold by investors. So using the Black-Scholes equation, companies can easily determine the fair market value of the options they are distributing. And since options can be valued and can be sold and a company can theoretically raise money by selling options to outside investors, a company actually does incur a cost when it issues options. Options are not free. Warren Buffet and his mentor, Benjamin Graham, were firmly opposed to issuing options to employees. They argue that options have a clear cost to shareholders. Also, by creating new shares options reduce the value of the shares that already exist. The author of this book says that just because the cost of options is subtle does not mean that the cost is not real. The exercise of options transfers value from a companys investors to the employees who exercise them. Like inflation, options are a hidden tax. Beginning in 1978, most accounting firms agreed that options should be expensed but the accounting rules didnt require it. So companies continued to hand out as many options as they wanted. 1993 the FASB, under pressure from Congress, recommended that companies be required to expense the cost of options. 1994 three thousand high-tech workers in San Jose, California, protested the FASBs decision in what became known as the Rally in the Valley. (The San Jose area was known as Silicon Valley computer chips are made from silicon and the Silicon Valley was the center of the US technology boom.)

Under pressure from Congress and major accounting firms, both of which had changed their minds, the FASB was told to back off and accept a compromise the cost of options would not have to be expensed but companies would have to disclose the actual cost in a footnote to their annual reports. More and more options came to be granted. By the end of the 1990s some executives received as many as one million options a year. In 2000, Larry Ellison, the chairman of Oracle, already owned a billion shares but took an option for forty million more. This hurt investors in several ways. First, since the actual cost of the options were not being expensed, company profits were overstated. With companies issuing millions of options annually, profits were often misstated by 10% or more. For instance, in one year Microsoft gave $3.3B in options to its employees one fourth of its pretax profit. Second, the FASBs credibility and independence was destroyed when it was forced to reverse its initial 1993 ruling on options accounting. The FASB has always been financially dependent on the companies it was supposed to oversee and its members came mostly from inside the accounting industry. But it had tried and failed to be completely honest and impartial when it came to options accounting. Third, because option grants became so large and because the granting of options pushed up salaries and bonuses as well, executive pay came to have little connection with performance. According to the author, the options system which was originally intended to motivate executive performance became one which was simply designed to make the executives rich. Fourth, huge option grants gave executives huge incentives to cheat. By simply creating a short-term boost in profits, a companys stock price will certainly increase, and the executive can take home a fortune. But the incentives are all one-way. Executives lose nothing if their options expire out of the money (worthless), but shareholders actually lose their hard earned cash if the stock price falls. So, for executives, options represent the chance for a reward without the threat of a loss and encourage executives to take risks that may not be in the best interest of the shareholders. Under these circumstances, executives have little reason to build companies with long-term staying power and every reason to get their stock prices up as quickly as possible. And as the 1990s bull market turned into a tech-stock boom executives quickly figured out that the fastest and easiest way to get their stock prices up was to show strong, steady increases in The Number (quarterly earnings per share) by any means possible. Nearly all of the biggest frauds of the 1990s were run by executives who earned $100M or more from options along the way. Options provided the motive for the financial crimes of the 1990s, but changes in the accounting industry and the weakness of the SEC actually made the crimes possible. Chapter 8 Accountants at the Trough In the 1970s, the stereotypical accountant working for a Big Eight accounting firm was a boring, middleaged white man, country club Republican, more diligent than talented, hardworking, sincere, Protestant, intelligent but colorless, competent but unimaginative, honest but highly competitive, wore glasses,

balding, slightly overweight, had three children, rather pale, preferred gray or dark brown classic business suits. The Big Eight were the only firms big enough to audit multinational companies. They frowned on competition with each other and did not have to worry much about competition from smaller accounting firms. By the mid-1970s, clients of the Big Eight accounted for about 95% of the sales and profits of all the companies on the New York Stock Exchange (NYSE). 1977 The American Institute of Certified Public Accountants (AICPA) and state CPA associations had always prohibited members from advertising or actively soliciting each others business. However, in 1977 the Federal Trade Commission (FTC) and the Justice Department began to investigate whether the accounting industrys bans on advertising and marketing were anticompetitive. Facing the threat of an antitrust lawsuit, the AICPA dropped many of its prohibitions. As a result, competition heated up and firms began to compete with each other on hourly rates and the time to complete audits. In 1985 the chairman of Deloitte said: Five years ago if a client of another firm came to me and complained about the [other firms] service, Id immediately warn the other firms chief executive. Today, I try to take away his client. At the same time, the Big Eight became increasingly interested in selling services that had nothing to do with traditional auditing and moved into management and information technology consulting. A serious concern was whether or not a Big Eight firm with a profitable consulting contract could also perform auditing service for the same client and remain objective. Would an accounting firm that discovered a problem in the clients books hide it long enough to get paid for its consulting work? 1978 to 1979 a Senate subcommittee recommended that accountants be banned from all nonaudit work for companies they audited. Also, the SEC asked accountants to avoid certain consulting jobs, such as creating internal financial control systems that they might later be asked to audit and said that a firm that became too dependent on auditing revenues risked impairment of its independence. The entire accounting industry strongly objected to these recommendations, nothing came of the recommendations, and the Big Eight moved aggressively into consulting. By the mid-1980s consulting revenue amounted to more than half of the revenue of several of the biggest accounting firms. One article in 1987 wondered about the impact of the consulting revenue and wrote: When a company lavishes huge consulting and advisory fees on its accountants for services unrelated to the actual auditing of financial statements, the accounting firm may be less likely to ask tough questions about a clients financial health. Eventually, between the mid-1980s and the mid-1990s, consultants within the biggest accounting firms seized power from the accounting partners and the worst fears came true. The author believes that there was a link between the growth in consulting and the decline of accounting standards and that it accelerated in the 1990s. Restatements of earnings were rare during the 1970s and 1980s. But by 1997 restatements increased to almost ninety. Then, in 1998, Cendant, a big franchising company, admitted it had overstated its profits by $640M from 1995 through 1997. Worse, the fraud was not even noticed by its auditors, Ernst & Young. However, Ernst & Young refused to accept responsibility and stated Nothing has been brought

to our attention to suggest that our work was not in accordance with professional standards. Eighteen months later, Ernst & Young paid $335M to resolve shareholder lawsuits for its poor work but stated that the settlement should not be considered to be an admission of wrongdoing. In 1997 a major health maintenance organization, Oxford Health Plan, admitted that its billing and payment systems were so overwhelmed that it had no idea if it was making or losing money. This was no surprise to doctors who had been complaining for months that Oxford was not paying them but was not noticed by Oxfords auditor, KPMG. In 1998, the appliance maker Sunbeam admitted it had inflated sales by encouraging retailers to buy out of season appliances such as outdoor barbeque grills and promising not to bill them for several months and other illegal practices. Sunbeams auditor for the two year period, Arthur Anderson, did not uncover the practices and was fired. Later, Arthur Anderson was even found to have allowed profits from Sunbeams illegal sales because they were immaterial when in fact the illegal sales amounted to 12% of Sunbeams fourth-quarter profits in 1997. By 1998, thousands of Ernst & Young consultants were working as employees of software companies that they audited. Other accounting firms had similar relationships but, in every case, the firms denied that their dual roles presented a conflict of interest. In 1997 the SEC created an Independence Standards Board to study whether accountants should face stricter rules. In 2000 the SEC proposed that accountants be barred from technology consulting or from setting up internal audit systems at companies where they were also the auditor on the principle that accountants should not audit their own work. In a meeting with the SEC, the three biggest accounting firms most opposed to the proposal told the SEC If you go ahead with this it will be war. The firms meant what they said. With the Presidential election of 2001 coming up, the biggest accounting firms were among the largest corporate political donors and directed their contributions heavily toward the Republican Party (the GOP). The biggest accounting firms even successfully lobbied their Republican allies in Congress to reduce the SECs budget. One Congressman who had personally received $280,000 in campaign contributions from accounting firms challenged the SEC to prove that consulting damaged auditors independence before moving ahead with its proposal. Facing strong opposition from Congress and unable to generate public interest in the proposal, the SEC backed off of its proposal and announced that accounting firms could continue consulting as much as they wanted as long as the fees they received were disclosed to investors in corporate proxy statements (documents which the SEC requires companies to send to its shareholders that provide material facts about matter on which the shareholders will vote). But in 2002, when dozens of cases of audits gone bad became apparent, the big accounting firms would finally be forced to own up to their misdeeds. Chapter 9 Archaeologists and Detectives