The Number: How the Drive for Quarterly Earnings Corrupted Wall Street and Corporate America [Paperback]

However, earnings depend a great deal on the methods of accounting used by the firm. In the 90s we saw a rise in very aggressive accounting. Any system of rules that is intended to be applied generally over a wide range differing conditions is going to have gaps and unintended effects that distort the intention of the rules. General rules rely upon the good will and integrity of the participants to keep the intention or spirit of the rules in tact in order for the rules to have any real meaning in application. In sports we also have referees to keep the game fair, but both teams still have to intend to follow the rules completely. No game could be played if the participants tried to push every rule to an extreme interpretation. Aggressive accounting uses extreme interpretations of the Generally Accepted Accounting Principles (GAAP) to present as favorable earnings number as possible. This results in a higher (and therefore more pleasing) EPS number.

Analysts started giving forecasts of coming EPS reports for firms and those that met or slightly exceeded that forecast were rewarded with higher share prices because investors competed for their shares. Those that missed the forecast by even a penny per share were punished as investors abandoned their stock. Mr. Berenson demonstrates that many companies had reserves and other accounting tricks to make sure their EPS forecasts were always met. However, as companies grow this becomes harder to do. And for companies such as Tyco, Enron, Adelphia, and even the mighty General Electric, it finally became impossible. The most aggressive companies had presented such a distorted picture of reality that they collapsed. Those that were still within shouting distance of reality remained solvent, but still suffered a significant depression in their stock price.

Since the EPS is inherently inexact it seems strange that the markets would react so strongly to that single measure. Mr. Berenson calls the number a lie. I think he does that for rhetorical effect and one time he does admit it is a white lie. I think he has a very strong point for those companies using aggressive interpretations of GAAP. The author also provides a history of the SEC and calls for stronger enforcement powers and the staff to provide that enforcement. While there is certainly a good case to have an effective SEC with sufficient resources (there will be a debate on what this level is), Mr. Berenson has more faith in regulation than I do.

Even if I fully concede his point and support an SEC of enormous size, it still could not provide the necessary enforcement to keep companies in line if the market keeps rewarding companies for fudging the numbers. The market will provide what people want to buy even if they want to buy lies. I agree with Mr. Berenson that INVESTORS need to become better educated and make more demands of the management of the companies in which they invest. Investors, by NOT investing in companies who use very aggressive accounting, could affect the way finances are reported than any regulatory body.

Not every company can be a growth company. Heck, even Microsoft isn't a Microsoft anymore. Investors have to demand that financial statements actually present a real picture of the financial state of the firm rather then providing a manufactured dream of ever expanding growth. One of the strengths of this book is the compelling evidence Mr. Berenson provides of management spinning these euphoric visions just long enough to cash out and then let the bad news (read reality) come to light on someone else's watch.

This is a fine book. I think that anyone who has investments in public companies ought to read it and better educated themselves on the realities of the equities marketplace. I think Mr. Berenson's recommendations for public policy are measured and good for debate even if I don't personally agree with all of them. There are a few minor quibbles I have with some of his explanations, but they don't affect my recommendation.

The book has a couple of short appendices to help the reader understand the accounting issues involved. There are helpful notes for sources and an index.

Where Roger Lowenstein's "Origins of the Crash" had the air of being something of an aggregation of newspaper clippings, and Frank Partnoy's "Infectious Greed" was less focussed, less penetrating, and in no real sense dispassionate, Mr. Berenson clearly sets out his stall with an interesting (and relevant) history of the regulation of corporate governance and reporting since the 1920s, and an analysis of the issues associated with accounting of any sort. In two short but clear appendices, Berenson explains in lay terms the difference between (and pros and cons of) accrual and sale accounting, and then balance sheets as opposed to income statements. These are fundamentals that one needs to understand what was going on, and not all of the authors who have written on the subject necessarily have a grasp of them.

Where as other authors have targeted (with varying degrees of persuasiveness) bodies such as ISDA, the SEC and the credit rating agencies as the main culprit, Berenson's focus stays very much with the auditing accountants and the corporate executives. A number of sectors in the financial system (in fact pretty much all of them) took their eye off the ball at the critical stages of the bubble, but were it not for the vagaries and flexibilities of accounting policy and sheer out-and-out greed of executives, this might not have happened, at least perhaps not quite so dreadfully. Berenson is convincing on both these scores.

That said, I don't subscribe to all Berenson's views. While the actions of some auditors (notably Andersen) are indefensible, Berenson supplies a pretty solid excuse for the profession generally: the preparation of company accounts, he notes, necessarily involves hundreds of assumptions, approximations and best guesses, and as even with the best will in the world these can be wrong, and "those who want to cheat have an almost infinite number of ways to do so". Given that the auditing function can only cost so much before it drives a company out of business by itself, there must be limits to what any auditor can be expected to detect. But Berenson still holds the profession to book. This isn't always consistent with Berenson's other view, which he expresses convincingly, that the "number" is intrinsically unreliable and should be much less of a determinant for market sentiment than it currently is. On the other hand, as he notes in his conclusion, even this view has its limits: the stagnation of the Japanese markets in the last five or so years is testament to the perils of ignoring the "number" altogether.

Like most financial authors (with the exception of Michael Lewis, for whom he has considerably less respect than I have) Berenson favours more government regulation as part of the solution to the problem: Congress could limit the number of options companies could grant their CEOs or put restrictions on executive pay, he suggests. Perhaps accountants could be required to bid for audit work to a federal board.

With respect, this is silly: Irrespective of how ridiculous executive compensation may be (and Berenson is certainly convincing that it is), such a Soviet technique is absolutely the last thing that is required. The market has to learn these lessons and discount the stock of profligate companies itself: the government has no means (let alone resources: Berenson is similarly persuasive as to the lack of funding for the SEC) for ascertaining what is reasonable, whereas the market - albeit eventually - will find the charlatans out. I dare say Michael Eisner is finding this out to his discomfort at the moment. At some point short sellers will be able to exploit the arbitrage opportunity. Investors may lose in the short term, but if you aren't able to take a short term loss, you shouldn't be in the market. Like Partnoy does, Berenson concludes his book with recognition of this. Caveat Emptor, indeed. In some ways having the SEC as a comfort blanket for investors in itself fuelled the boom.

Elsewhere Berenson is occasionally guilty of sophistry. He points out the irony of price regulation of the commissions charged for trading on the NYSE, perhaps the most potent symbol of the free market on the planet. But then mixes his examples: "Wall Street has always loved free markets, except when they might cut into its fees. Today, when even real estate agents are being forced to compete on price, the 7 percent commissions charged by big investment banks for initial public offerings are sacrosanct." This is naughty, and I suspect Berenson knows it. Commissions for underwriting IPOs are quite a different thing to commissions for brokering stock sales across the exchange. They have never been subject to any regulation, and if the fees tend to stick at a certain level, that not so much to do with price fixing, as the inherent risks and huge amount of work and expense required to get an IPO away. That is the market level. Given the dearth of IPOs in the last three years, the pitching for them will have been feverish.

I am prattling on. These quibbles are largely that: just quibbles, and in the round this would be the book I would recommend out of the four on the subject I have recently read.