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Market Failure
Tim Francis-Wright

The Enron scandal has overshadowed a growing crisis in the American stock market. Many companies have found ways to boost artificially their reported revenues and earnings. Some have avoided taxation merely by reincorporating overseas. Others have engaged in outright fraud. What ties these actions together is that the professionals that Americans thought they could trust are not trustworthy. When investors cannot trust anyone to tell the truth or to act ethically, then the stock market is just a sucker's bet.

As almost everyone knows by now, the accounting firm of Arthur Andersen was intimately involved in the financial shenanigans at Enron. Andersen accountants certified Enron financial statements with inflated assets and sales figures. Enron, however, was not the only recent high-profile debacle for Andersen. Recently, Andersen agreed to pay over $200 million because it negligently failed to detect a pyramid scheme run by the Baptist Foundation of Arizona. It also was the auditor that approved of bogus financial statements put forth by Sunbeam. And Andersen is not the only large accounting firm to have real trouble doing the auditing part of being auditors. KPMG, for example, is the auditor for Xerox, which the Securities and Exchange Commission accuses of inflating profits by some $1.5 billion over several years. PriceWaterhouseCoopers is the longtime auditor of Kmart, another subject of an SEC investigation about false financial statements.

But, more importantly, the large accounting firms, and their consulting divisions, are deeply involved in helping corporations dodge taxes. Certainly, corporations can and should make use of the tax code to reduce their tax liability. The Internal Revenue Code contains a great deal of social and economic policy, and individuals and corporations are supposed to take the tax code into consideration when they make decisions. But some of the machinations by American corporations make a mockery of the spirit of the tax code.

Stock options

Many corporations grant stock options to their executive employees. On their tax returns, they report the cost of the stock options as expenses in the same year that the employees recognize income. But on their financial statement, the cost of the options appears only in the footnotes to the financial statements; in the main part, the options have no effect on corporate earnings whatsoever. One common conclusion from the collapse of Enron is that Enron granted so much in stock options that its executives made decisions for the good of their portfolios, not for the company. Accordingly, Senators Levin and McCain have introduced legislation (S. 1940 to counter this strategy: corporations could only claim the tax deduction of they made the corresponding deduction on their financial statements. The Levin-McCain plan faces opposition from not only the White House but the Republican and Democratic leadership in the House and Senate. The truth is that too many corporations like to pay millions of dollars in stock options to their top employees without having those payments hurt their reported earnings. And those corporations have many friends in Congress.

Some critics of the Levin-McCain bill correctly note that it treats stock options more harshly than ordinary compensation. However, Levin and McCain are dealing with the disconnection between reported earnings and taxable income the only way possible, through the tax code. The rules that govern how options appear on corporate financial statements are part of SFAS 123, a dictum of the Financial Accounting Standards Board. Faced with the problem of how to treat stock options, the Board forgot that the purpose of financial statements is to present an accurate picture of the financial situation of a company. If a company grants stock options to an employee, it dilutes its worth to enrich that employee.

The purpose of auditing firms, however, has become more nebulous. While auditors are paid by their clients, they are supposed to serve the public good. But the growth of consulting services has meant that the same accounting firm often serves as both business consultant and auditor. With respect to the treatment of stock options, consultants would want to present their clients in the best possible lights, so SFAS 123, which hides the effect of stock options from all but the most diligent investors, was the result.

Reincorporation: the Bermuda Triangle

An increasingly popular form of tax avoidance for American corporations is to reincorporate in a low-tax country. A location like Bermuda without a corporate income tax would be ideal. But Bermuda has no income tax treaty with the United States, so firms like Accenture (formerly Andersen Consulting) and PWCC (formerly PriceWaterhouseCoopers Consulting) have devised the following scheme.

A company sets up a shell company in Bermuda and another in a low-tax country like Barbados, which has both a 1% corporate tax rate and a tax treaty with the United States. The Company moves its business office to Bermuda, but its office can be little more than a post office box and some bank accounts. It then becomes a resident company in Barbados by scheduling one meeting per year there. Finally, it arranges for its Barbados operation to bill its American subsidiary for royalties on the company's trademarks and the like. All of the American profits, normally subject to a 35% tax rate, become an expense and are sent to Barbados. The Barbados operation pays a 1% tax, then sends the remainder to the Bermuda headquarters.

David Cay Johnston of the New York Times has written about this Bermuda Triangle in connection with the saga of Stanley Works, whose management is trying to save $40 million in taxes by becoming a Bermuda company. The impetus for the move to Bermuda does not come from the devious minds of Stanley Works executives. It comes from the international tax consultants of the Big Five accounting firms. The Big Five are experts on the Bermuda Triangle because Accenture and PWCC are already headquartered in Bermuda.

There are some drawbacks to Bermuda Triangle scheme. First, under current tax laws, reincorporating in another country is considered to be a sale for tax purposes, so shareholders would have to pay capital gains taxes if their stock had appreciated in value before the reincorporation. (Actually, PWCC claims that its incorporation as a Bermuda concern somehow made it exempt from these tax provisions.) Second, for deductions between related parties to be recognized for tax purposes, they must be made on an "arms-length" basis. If unrelated parties would not do the transaction because it made no sense for one of the two parties, then related parties cannot do so, either. The royalty payment made by an American subsidiary to the Barbados subsidiary cannot be so out of bounds that the disallows it. Third, once money is funneled overseas, it cannot be funneled back into the United States without recognizing it as income once again. Fourth, reincorporating overseas is inherently an unpatriotic act, unpatriotic enough to enrage even some Republicans in Congress.

These are the firms behind other dodgy tax schemes, such as liberal use of the research and development credit, abuse of the foreign tax credit, and construction of cross-border leasing transactions complex enough to addle the stoutest of brains. Generally, these schemes allow the firms to earn money through contingency fees, allowable only because they were doing consulting work. The firm gets paid a fraction of the generated tax savings. Such an arrangement encourages companies to take risks, because any tax savings makes the company more valuable.

The past few years have seen the Big Five accounting firms—Arthur Andersen, Deloitte and Touche, Ernst and Young, KPMG Peat Marwick, and PriceWaterhouseCoopers— become heavy political players. Each of these firms, as well as the accounting trade association, donated several million dollars to federal candidates in the past 12 years, with the majority of that money going to Republican candidates or the Republican Party. All that money pays off. The new chairman of the SEC, Harvey Pitt, used to work for both Andersen and KPMG, and has resisted calls for limits on consulting services offered by accountants. The Bush administration, even in the wake of the collapse and bankruptcy of Enron, has reacted as faintly and deliberately as possible. In the eyes of Bush and his advisors, Enron was not a sign of anything endemic.

Recent revelations, however, point to evidence that Enron was just one of many rogue companies. Enron was far from alone in granting huge amounts of stock options to its top executives. Plus, many of its competitors in the energy and broadband trading business are facing pointed questions about the validity of their revenue figures.

There is no single clear-cut way to make corporations and their accountants more accountable to the public. Some proposals seem worthy, at least, of discussion. Perhaps corporations must rotate auditing firms every few years. Perhaps auditors need to become clients of the SEC, not of the companies that they audit. Perhaps Congress and the FASB need to more closely align tax and book accounting. Perhaps the SEC needs to spend more money on oversight of public companies and their auditors.

Neither the Democrats nor the Republicans can afford to have Wall Street seen as corrupt and irredeemable. But the Democrats should seize stories of corporate greed and malfeasance, because those stories resonate with the American public. Corporate America, if left to its own devices, will never act in the highest and best manner for the public or the country. The United States needs a securities market in which the crooks get caught. It needs a market in which actual profits, not accounting gimmicks, create value. It needs not a free market, but a fair market.

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