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Hold Up Your Hand
by Bob Ferchat and Tony Carlson

 
   
 
   

We are all taught in school that if we want to be listened to - or at least recognized - we should hold up a hand. Whether it's to ask a question, answer a question or even be allowed to exit for personal and very important reasons, the signal is the same: hold up your hand. It takes a little personal courage to do this the first few times, until we learn that nothing uncomfortable - or at least permanently damaging - happens. Though we do expose ourselves to potential embarrassment, the vast majority of us soon find the risk to be trivial in the great scheme of things.

By the time we learn this basic action at school, most of us have been exposed, in one way or another, to the classic fairy tale of The Emperor's New Clothes. You'll recall the plot. Some ne'er-do-well con artists convince a vain Emperor that his new suit - in reality made of thin air - is fashioned of such fine cloth that it can be seen only by the wisest people. Despite the evidence of their own eyes, the Emperor and his sycophantic advisors, wanting to demonstrate their wisdom, all claim they can see, feel and admire the allegedly magnificent garments. And so do most of the Emperor's loyal subjects, except for one young girl who calls it like she sees it when his royal highness parades the new "finery". It takes a few minutes, but eventually the crowd admits to itself that the girl is right and that their unclothed Emperor looks ridiculous. Out of the mouths of babes, indeed.

Ask and you will learn

At about the same time, we are taught the basics of mathematics, in particular that the sum of two parts is a correct total, with all talk of synergies left to soft subjects like literature ... and motivational speakers. In the world of straight sums, exchanging parts is pretty simple - the total increases or decreases directly according to the quantities added or taken away.

Simple concepts really. Hold up your hand to get attention. Don't let your senses be blinded by position, politics, pressure. 2 + 2 = 4, -2 + -2 = -4. Question is, how well do we apply these lessons, and others?

Well, consider the business world where the rule makers define systems ostensibly designed to reflect the true worth of corporations. In accounting, the mother of all these rules systems is GAAP, although other regulations are proclaimed from time to time. But despite the best efforts of the accounting community, even these systematized sets of rules can distort the sums from time to time.

The villain in all this is that substance, as reported, can follow form instead of the correct sequence of form following substance. That's a subtle but critically important difference. If substance follows form, then the directives will decide how a given transaction is portrayed . . . according to the rules. Thus, the rules allowed the creation of the Special Purpose Entity of Enron fame. The rules accommodated the act of accounting for trades of assets as sales and purchases in the Global Crossing case. In both cases, the substance of the companies and their transactions were very different than the rules-based value. In these and other cases, the technical professionals - accountants and lawyers - sought or approved ways to make substance follow form to benefit external appearances heedless of the economic realities.

And now we ask who let this happen. Is it a case of the Emperor's cloth being appreciated by the Emperor and his wise advisors?

Surely the role of the professional advisors and appointed guardians, the corporate directors, is to ensure that the appearance - also known as financial statements -- discloses the reality. If errors appear, or if more than one interpretation of the data is possible, then management must carefully and clearly describe the underlying assumptions in ways that investors - and their proxies, the directors -- can understand so that the risks can be effectively weighed.

If that isn't happening, if the cloth is more virtual than real, directors must have the courage and confidence to hold up their hands and call for attention, to make themselves heard, to ask for explanations or express dissent. They cannot let politics, pride or insecurity interfere with their obligation to inquire and analyze. They cannot delegate the clarity of disclosure.

Pretty basic and uncomplicated. Yet too often we appear to forget.

Did any of Enron's directors or senior executives hold up their hands to demand an explanation for things they did not understand? Did they think that adding liabilities does not increase the liability? Were they too proud to admit they did not understand, that they could not see or feel the cloth? Did they believe that the technicalities of rules accounting change reality? Where was the courage of conviction to question the rules-based "truths" and get beneath the rules to the fundamentals?

Enron, of course, was not the only enterprise left unclothed, as the slag heap of wrecked companies from 2000 and 2001 will attest.

Don't be dazzled by the gloss

The rules say that if one company with a negative accounting "net worth" buys another company with a similar deficit, then it is possible and even likely that the result will be a positive value based on the intangible asset of the market price of the shares used to consummate the deal.

-2 + -2 = +4? The Emperor's weavers would be proud to share the intellectual property credit for this sleight-of-hand.

Today, other rules are being questioned, especially where companies trade assets or the utility of the assets they each own. The rules say that trades of this nature create accounting revenue on each side of the deal, albeit non cash-based revenue since no money changes hands. The claim is that the goal of positive EBITDA is brought closer, though the rules say that EBITDA is an indicator of cash flow. Nonsense. The rules applied strictly create results that defy logic and obscure underlying values.

The fundamental question is this: Is accounting a matter of rules or is it matter of estimating the true value of the assets and obligations the business must balance. The experts try hard to make rules that accomplish the latter so that investors will understand the value of their actual or potential investment. But recent examples tell us that there have been some serious failures, failures that have sucked many, many billions of dollars out of the savings of investors. We know personal financial loss when our prices decline on the shares in our own portfolios. But when a bank or mutual fund loses money, whose dollars are going down the tube? Ours. Pension funds, our savings, the costs added to our next borrowing. Whatever, always ours.

While risk is always at play in markets, it hardly seems unreasonable to expect the custodians of our trust to hold up their hand, to risk their popularity, to not be misled by their pride or sense of infallibility, to question persistently in search of an objective viewpoint. Nor is it unfair to ask them to ignore the rules if the rules create the appearance of false economic reality.

One caveat. The temptation of reacting to the recent crisis in market confidence is to implement still more rules and more fulsome disclosure in plain English. But recall that the best place to hide something is in plain sight. The disclosure of business risk in the rules-based documents can be so worded that the threats are largely disregarded because the real risks are obfuscated by the near-endless catalog of sky-may-fall possibilities.

We pay people such as directors, management and auditors to make judgments. What are their assessments of each risk?

Further, if the legal advisors, auditors, directors and management are wrong, what do they stand to lose? Have they got money at risk? Savings? We investors certainly do. Too often they walk away having taken their spoils before the collapse, subject only to lengthy civil debates on who knew what, when. But the horse is gone and we lose interest in the irrevocable past.

Our losses are real and immediate. Should there not be an equally swift downside for those to whom we entrust our money if they lose it, determined not by accounting rules but by the natural laws of the market? Or should we be considering even more pointed remedies, like clawbacks for instance?


     
   
     
   

The Authors

 

Bob Ferchat - former chief executive of companies such as Bell Mobility and Northern Telecom Canada - and Tony Carlson are principals of I-Magin-ation Inc., a Mississauga-based company that creates innovative content for the Internet. Their first book, Tangled Up In The Past is an analysis of why big companies miss technology opportunities that are staring them in the face.

     
   
     
   
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Copyright 2002 by Bob Ferchat and Tony Carlson. All rights reserved.

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