Book Report - The Number

I’m glad that I had the opportunity to read the “Number” by Alex Berenson because it has provided me with a great deal of past information that I did not know about at all before and to understand how accounting works outside of the classroom as I have been taught all about the concepts in the accounting classes I have taken so far. I would have never thought of the past repeating itself in the financial market world, but as the book talks about, the Arthur Andersen scandal that gave the creation of new acts and regulations such as the Sarbanes-Oxley act shows that unscrupulous behavior has existed way before companies such as Enron and WorldCom made world headlines when it was revealed that they had overstated their earnings. These scandals cots investors billions of dollars and shattered the dreams of thousands of people and their confidence in the nation’s security markets. (Never was I aware of the past repeating itself in a revolving financial market. I was more or less aware of how Sarbanes-Oxley came about after the fall of Enron, and the Arthur Andersen major part in helping the top executives at Enron forge numbers to increase its earnings. There is a phrase they have on Wall Street. It’s called raising the bar. If you can raised the bar, or brighten the outlook for your company, if you can see your growth accelerating, your stock will go higher and you will be given the currency to expand, acquire, and do whatever you want” (pg. 178.) This is the main reason why our noble citizens easily turned in to con men without hesitating and take advantage of good honest people.

In the book, Berenson talks about how Earnings per Share (EPS) is the most important piece of information that controls the markets. Companies and investors alike are most interested about these numbers because they can use that information to determine the outlook of the share in the future whether if it will rise or fall. Earnings per share is considered to be one of the most important variable to determine a share’s price, and in some cases everything else in sacrificed to get the best earnings per share possible, so investors should be aware of earnings manipulations that can affect the real value of the earnings numbers. Unfortunately, these are calculations that can be easily manipulated to make a company look more attractive to possible investors. “There is a phrase in Wall Street that is called “raising the bar”; if you can raise the bar, or brighten the outlook for your company, if you can see your growth accelerating, your stock will go higher and you will be given the currency to expand, acquire, and do whatever you want” (pg. 178).

Accounting steps into play because that’s what earning reports are all about in business. There are 4 earning reports that are issued each year from public companies; three quarterly reports (10-Qs) and one audited annual report (10-K). In these reports we measure companies financial health based on the accounting used. The problem with accounting here is that it has been abused many times to inflate the company value. From top company executives to independent accountants and auditors, accounting has been taken advantaged of and eventually led to a much greater devastation.

Even in the 1920’s, companies used a slew of accounting tricks to inflate reported profits just by; hiding ongoing expenses in large one-time charges; failed to account for losses that their subsidiaries had suffered; passed money to subsidiaries that later returned the money to the companies and recognized it as profits; understated depreciation; sold assets and claimed it as profit from operations. During this time, stocks were only viewed as increasing in value, but no one believed it would ever decline in value and when it did, the market crashed very severely. With the market crashing, and these accounting tricks coming to light, the government ended up creating 3 laws to regain the trust of investors. The 3 laws are: the Securities Act of 1933 (requiring companies to file registration statements with the government before selling shares); The Glass-Steagall Act (forced financial institutions to choose between investment banking or commercial banking); The Securities and Exchange Act of 1934 (this act created the Securities and Exchange Commission.)

“Accountants are the plumbers of capitalism, unappreciated but vital to the system” (pg 24.) It was in the 19th century that accounting was seen as an integral part in business. The accountants during this period of time didn’t know how to correctly balance books, but the work they did was most honest then than now because they didn’t work for the companies, but their loyalty was to investors. They had no pressure from companies whatsoever to inflate numbers and they didn’t have the fear of losing their jobs as the accountants had in the 1920s.

The main problem accountants faced back then was that companies were employing them. No one is going to bite the hand that feeds them, goes the saying. In order to make the most money, accountants and companies worked together to increase profits on earning reports. Increased profits meant that people would want to invest more money into companies, which promised to increase the amount of money that went in the pockets of the company executives and accountants as well.

From 1920-1960, the general public had little faith in the stock market. They didn’t know how much they could actually trust these companies anymore since the market crashed a few times due to inflated earnings. During this time as we all know, the world was going through wars, depressions, anything that could happen during a time period, did happen.

Between the 1980s-2000s, the market started to actually do well all over again. The general public started to have faith again in the stock market and began to buy stocks. Leveraged buyouts came into play and forced executives to pay more attention to shareholders and their prices. In order to look less attractive for potential LBOs, companies started to cut back on dividends to reinvest or repurchase stock back. Research started to play a part in analysts work. Research started to pay the bills on Wall Street because investment firms would charge bank fees to fund research. This research generated consensus information that the public started to rely heavily on. If companies did worse then what the consensus had predicted, the public would sell or not buy that companies stock to prevent losses.

When options came into play it hurt investors severely. Options allowed companies to overstate profits by hiding compensation and bonus costs. Executives had bigger incentives to cheat all shareholders because options allowed executives to take bigger business and financial risks in order to increase share value just because they could make millions with increased earnings or they could lose nothing if their options expired worthless as it did sometimes, while shareholders could lose potentially everything because of their greed.

From the securities act, accounting business had boomed. From 1920-1980 there were 3 times as many accountants then there were doctors back then. The top big eight accounting firms were able to audit the largest multinational companies, almost allowing for no competition in the field amongst the top 8. The big 8 did whatever to gain and keep clients. Besides audits, they started to offer other services to their clients. The big 8 influenced the SEC in allowing them to provide consulting services to their clients, since consulting services were limited before. In 1986, 30% of Arthur Anderson’s revenue was from consulting services, where as in 1994, more than 50% was from consulting. In 1998, employees of the big 8 who were on audits, worked as if they were employees on the companies they audited.

SEC chairman Arthur Levitt was the only one who actually went up against the companies and the accounting firms. The accounting firms themselves told Levitt that he was creating a war if he attempted to go after them. The accounting firms had too much power and all the needed money to let Levitt even try to take it away from them. The SEC couldn’t uphold its duty to investors because as an agency, it couldn’t keep their employees. The SEC was understaffed and was inexperienced. The SEC didn’t have the manpower to review financial statements because they were busy trying to check out all of the new IPOs that were entering the market because that is what keep the market going.

The Internet had also played a major part into the financial market. The rise of Internet companies increased the demand for stocks, public offerings kept booming. The Internet also changed Wall Street and created online brokerages. “The growth of online trading, and especially of day trading, fed the market’s madness.” (Pg. 160.) Day trading began a frenzy for everyone from investors to the average Joe as we say.

In the 1990s, Investors reaction to earnings when they were released began to be more violent. Everyone became obsessed with the number. The pressure to meet earnings began to increase even more. This created companies to once again us accounting tricks to meet or even better, beat expected earnings.

In the 1990s Enron grew into the largest trader of gas and electricity in the world. The company had revenue of $1.2 billion in 2000. Enron’s stock priced valued at $126 per share in the market, until a few months later its inflated stock started to fall very fast and shareholders lost everything. By the end of the year, Enron’s stock had plummeted thanks to a very well grafted system created to commit fraud by the company executives. Enron’s financials were extremely complex and no one bothered to raise concerns, not even fund managers or analysts. It took less than 2 months for Enron to collapse due to its financial fraud where many people lost everything including some company employees.

The biggest problem with Enron was that its accounting was very complicated and the tricks they used were “mind-numbing.” Enron hid losses and had booked fake profits by using their accounting of “mark-to-market.” The demise of Enron showed the world how bad corporate accounting had become. With Anderson admitting to shredding documents, after they had been subpoenaed for investigation, discredited the integrity of the big accounting firms that will take investors money at any level.

“But now Wall Street face the reality that at hundreds of companies, in every industry, earnings management had slid into earnings manipulation,” (pg. 209.) As we see more companies pouring in with financial fraud, the shareholders within the financial market took in another big hit, this time though, the government needed to step in and create better rules because investors were never going to believe these companies again. President Bush signed the Sarbanes-Oxley bill, which increased penalties for fraud, increased the SEC budget and created a new accounting oversight board. Everybody in Wall Street was desperate for a change because they needed to restore investor confidence and it was hard because they have lost lots of money again.

I have learned from this book that there was a lot of corruption in accounting dated back from as early as the 1920’s. Basically, history is repeating itself. That small little number “earnings per share” has affected our financial market for generations. The same pattern kept continuing to happen over and over again even with new rules and laws instituted and will continue unless the government hold some people accountable and penalties had to be harsh in order to avoid more fraud more often. In efforts to raise earnings, companies did whatever was necessary to increase them. Increased earnings benefitted everyone who could easily help manipulate them. Top executives and accountants who were in charge of these numbers couldn’t help themselves as they saw how easily it was for them to get richer, and they couldn’t help their greed so they did what they have to do to commit fraud and make money. The only way to prevent history from repeating itself again and again is not just new rules and regulations, but close enforcement of these rules. The only problem with that small number is that, it will always just be a small number but something has to be done to prevent shareholders losses. I know that we will never have a perfect system in place to protect shareholders and investor, but the government should step in and put stronger laws that will make it harder for companies like ENRON take advantage of shareholders.