Markkula Center of Applied Ethics

The Link Between Moral and Market Values

By William K. Black

The current wave of financial crises has renewed interest in one of the "silver bullet" solutions proposed during the savings & loan debacle of the 1980s. Larry White, former Federal Home Loan Bank Board member, proposed then that market value accounting was the key to avoiding future financial scandals. White has recently proposed this reform again as the key to preventing a repetition of the ongoing scandals. However, at the same time he advanced this argument another column was noting that Enron had requested permission to use market value accounting in order to facilitate fraud.

I am not suggesting that market value accounting is a bad idea and would generally aid fraud by controlling persons (control fraud). But market value accounting cannot prevent control fraud.

A little background. Generally accepted accounting principles (GAAP) normally uses a "book" or "original cost" accounting "basis." That means that if a business buys a piece of real estate for $10 million, its value for accounting purposes is that original cost of $10 million, and the value is not adjusted upwards even if the market value of the land soars to $60 million. Gains on assets, therefore, are only "recognized" for GAAP purposes when the assets are sold. (The treatment of market value losses under GAAP is more complex and has changed over the last decade.)

Most of the arguments against market value accounting are unconvincing. Critics have emphasized that adjusting the accounting value of assets to reflect their current market price would be expensive and would make earnings more volatile. Investors dislike volatility (because it represents increased risk); therefore, market valuations would lower share values. If true, that is quite a strong argument against the "efficient markets hypothesis." The argument requires that false accounting values fool consumers and create a systematic upward bias in stock prices. The standard financial hypothesis denies that such a systematic bias exists or could persist (because it would create profit opportunities that would be arbitraged away only when the systematic bias was removed).

On the other hand, fundamentalist believers in the efficient markets hypothesis consider all accounting irrelevant. They argue that market participants have Superman-like vision that allows them, inerrantly, to "look through" accounting statements and discern a firm's true financial condition no matter how opaque and abused the accounting is. The S&L debacle should have put an end to that extreme view; the current crisis in which control frauds have deceived investors for years to the tune of many billions of dollars of fictional capital has shattered the remaining hubris.

What remains is this. Original cost and market value accounting system are both capable of monumental abuse by control frauds. Publicly traded firms that are in fact deeply insolvent have been able to get clean opinions from Big 5 (now 4) audit firms for financial statements that purport to show that the firms are not simply viable but extraordinarily profitable.

It takes ethical principles on the part of the top audit firms to make accounting principles meaningful. It is no coincidence that the large control frauds always use the top audit firms. They want that imprimatur; a clean audit opinion by a top audit firm provides respectability. There are three reasons the top audit firms have proved so vulnerable to manipulation by control frauds. First, it only takes one bad audit partner to create a disaster. In the S&L debacle, one office, Arthur Young and Company's Dallas office, produced clean opinions for many of the worst control frauds in Texas. Second, there is an "agency" problem. While the audit firm's interest in its reputation outweighs any gain the firm might make from overlooking securities fraud by its client, the same may not be true of individual audit partners. They are under enormous pressure from their firms to bring in clients. Firms want to see their top audit partners as heroes, not villains. Third, there is a variant of "Gresham's law" at work. Gresham's law deals with hyperinflation. It observes that "bad money drives good money out of circulation." Bad accounting can drive good accounting out of circulation. These perverse financial incentives can be compensated for to some extent through deterrence, but they cannot be eliminated. Audit partners have to rediscover the professional and ethical restraints that once made them symbols of rectitude.

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