Seismograph Bobble Causes Massive Earthquake!

Yesterday, a laboratory assistant in the geology department at Stanford University walked past a seismograph on a workbench, and accidentally jostled it with his elbow.  The contact caused the seismograph to give a Richter Scale reading of 7.6, thereby causing a massive earthquake with an epicenter 125 miles southwest of Mexico City.

In a related development, also yesterday, the U.S. stock market rose 2.5% on news that the Financial Accounting Standards Board voted to relax the “mark-to-market” rules in generally accepted accounting principles (GAAP) governing how companies value certain financial assets on their balance sheets.  This would have a particularly significant impact on the financial statements of financial institutions that are the lucky owners of large amounts of the so-called “toxic assets” we hear so much about.

How odd.  How is it possible that the stock market would go bananas over a change in how companies are allowed to count the beans, when there has been no change whatsoever to the true underlying economic value of those same beans?  There has to be more to this — I’m just not sure what it is.

Ever the faithful optimist, I believe strongly that investors are not stupid.  Don’t get me wrong — a few really are stupid, usually on a rotating basis — but on average the market as a whole isn’t.  Consider, for example, the recent GAAP change requiring companies to run the expense of stock options through their income statements. This led to a sudden and massive drop in the reported income of many public companies.  But the impact on stock prices was nonexistent, because there was no new news for investors — for decades, companies had already been required to disclose extensive details about their stock options, so the financial implications of the options were widely understood whether they flowed through the income statement or not.

I suppose it’s possible that there is some sort of real economic impact related to the accounting rules for financial assets.  For example, federal regulations place limitations on the amount of business a bank can do based on how well it’s capitalized, which in turn is based on its GAAP financial statements.  And in some markets the price at which assets are traded may be based on their value in accordance with GAAP.  Why a market would use that — rather than an assessment of the fundamental underlying economic value of the assets — is hard to understand, but stranger things have happened.

Ah, well. Let’s just remember that business reality and accounting reality are not always the same thing.

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

Ah, Springtime!

 
Spring has come, and the thoughts of many of us — well, those of us with teenage children of a certain age — turn to the letters (or e-mails) that will shortly be arriving from colleges.  Soon, at cocktail parties throughout the land, we will hear the animated, high-pitched chirping of parents, relating anecdotes of superteens they know of who received those dreaded thin envelopes in spite of being captain of the state champion quidditch team, receiving the Nobel Prize in robotics, and scoring 1600 (well, 2400, these days) on their SATs.

As a parent, over the years I have been hearing — and worrying — about the conventional wisdom that it is increasingly “impossible” for kids to get into top colleges.  On the face of it, the CW is credible:  at the top-rated (rated, of course, by the CW) colleges, the percentage of applicants accepted has dropped into the single digits.  But have things really changed that much? Consider:

• The number of 18-year-olds in the U.S. increased by 9.6% from April 2000 to November 2008, or about 1% per year.
• The number of spots in the freshman classes at, say, the 100 top-rated colleges has almost certainly at least stayed constant, and perhaps even increased slightly.
• High school graduates are not getting smarter or more talented.  This is, of course, the personal opinion of someone who was in school, uhhh, let’s just say a while ago, but this opinion of the American education system is shared by talk-show pundits on both sides of the political aisle — the big difference in their views centers around why we are getting those results.
• It continues to be true that it is only possible to attend one college at a time.  Even the superteens of today can’t violate the laws of physics.

So, if we “do the math,” compared to a decade ago we have roughly the same number of high school seniors (OK, OK, maybe 10% more) chasing roughly the same number of spots in college freshman classes.  This doesn’t sound so bad.  Is there really a problem, or is all this just mythology and urban legends?

Well, obviously there’s a problem, since both students and parents are stressing out about the experience, and this seems to have gotten worse over time.  But given the immutable math described above, here’s some additional perspective:

• The number of colleges the average student is applying to is increasing dramatically.  When applications at colleges are skyrocketing (especially at the top-rated colleges) and the number of applicants isn’t, there is no other explanation.
• Admissions departments are experiencing the same stress.  With this many applicants, it’s hard to look at each applicant as closely.
• College applicants are tactically better-prepared.  More and more kids understand the importance of advanced placement (AP) courses.  And college counseling is getting more focus at both public and private schools — and private consultants who advise on writing and strategizing applications have become a growth industry.
• Tactics don’t make you a fundamentally better person.  More kids taking courses designated as AP, or spending more time writing college essays doesn’t make them  more talented, any more than you can make kids smarter by handing out more ”A”s, or more diplomas.
• “Playing the game” is necessary.  It’s too bad that kids need to take as many AP courses as they can handle, and work harder to prep for the SATs, and polish and polish their application essays, because kids should get to be kids.  But times change – there was, after all, a time when SATs weren’t a requirement for a college application.

What the math says to me is that the college prospects of a student of a given skill/talent level haven’t changed that much over the last few years, in spite of the dire and depressing stories we hear, provided we bear in mind:

1. The odds of getting into the right college have lengthened, even though the odds of getting into a right college haven’t changed much.  With this many applications, chance plays more of a role.
2. You need to apply to enough colleges.  Again, those pesky laws of chance at work.
3. You have to “play the game.”  It’s a pain, but it’s not the end of the world.

As I think through this chain, I feel better and a little less worried, and I hope you do, too.
 

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

Madoff’s Accountant and the Meaning of Words

 

A while ago, I wrote a deliberately uninformed post, suggesting that the whole Bernie Madoff fiasco wouldn’t have happened if Madoff’s fund had had an audit conducted by a reputable firm, and that this should be a requirement for all investment funds (see “Madoff and the ‘Idiot Plot’” 12/17/08).

Well, I was sort of wrong and sort of right:  Madoff’s funds’ annual reports were accompanied by the opinion of outside auditors.  However, it also appears that no audits were actually performed, and today the head of (and only practicing accountant in, it seems) Madoff’s accounting firm turned himself in, on fraud charges.

Yes, it appears that there is a subtle but very important distinction between writing an auditor’s opinion and actually performing the audit. Who knew?

All this makes me think of the meaning of words, and the word for today is regulation.  Many have suggested that l’affaire Madoff is the result of inadequate “regulation.”  Oh, really?  But is “regulation” the establishment of laws and rules and procedures to ensure that a system behaves the way it was intended?  Or is it the way those laws, rules, and procedures are administered and enforced? Or is it both?

It’s clear to me that inadequate rules is NOT the problem.  A properly performed audit would have ended the Madoff fraud instantly.  There was no problem with the existing rules, other than the fact that they weren’t enforced at all.  What concerns me is that concerned legislators will glob all this together and develop a whole new set of laws and rules intended to “fix” the problem.  What will emerge is a massive structure that

1. most people, including the practitioners, won’t understand, that
2. might lead to some modest preventions of abuses, so the legislators can claim victory, but which
3. will have tangible benefits amounting to only a tiny fraction of the direct and indirect costs society bears as a result of the new “regulations.”  In other words, can you say, “Sarbanes-Oxley”? (see “Sarbanes-Oxley, the Atomic Flyswatter” 11/5/08)

The message I want to get across, and why this post is in Painting with Numbers, is that if we interpret words too broadly, bad and unintended things happen. Moreover, actions have costs, and those costs must be less than the benefits produced by the actions.
 
“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

Boneheaded Compensation Plans #2

 

When I posted “Boneheaded Compensation Plans #1” three months ago (12/19/08), I commented that the “#1″ was appropriate in the title because this would definitely be a recurring topic.  And I was right. 

The big story today is about AIG planning to pay out another $165MM in bonuses.  Yow!  Edward M. Liddy, the government-appointed chairman of AIG, said (a) that they had determined that AIG was legally required to pay the bonuses, and (b) “We cannot attract and retain the best and the brightest talent . . . yada yada yada . . .”

The problem is that as excessive as these bonuses appear — and it really does seem that way— Mr. Liddy might actually be right. On both counts: 

1. Companies that make deals with their workers should stick to them.  Who knows if the AIG agreements are really binding or not?  But this is part of an honorable relationship between employer and employee. 
2. These bonuses were being paid out to about 400 managers, most of whom are competent insurance executives who had little to do with the fantastically bad recent decisions that got AIG into their current pickle.  The Treasury has sunk $170 billion into keeping AIG as a going concern, which AIG will no longer be if its senior talent leaves.  Obviously, it’s hard to tell who or how many would leave in disgust over a reneged bonus, but the ones most likely to leave are the ones AIG (and, now, the U.S. taxpayers) can least afford to lose.

Where is the real problem?  Well, it seems to me that AIG’s corporate directors, and especially the ones who were serving on the compensation committee, should be spending a little quality time in front of a mirror, asking themselves questions like:

1. Were the bonus metrics properly related to high-level corporate strategic (and stockholder) objectives? 
2. Was the size of the total bonus pool properly tied to overall corporate results? 
3. Did the bonus calculation algorithms properly reward/punish over/underachievement?  A good bonus plan leads to sensible bonus payouts at ALL levels of likely outcomes.

Sorry to be throwing technical terms like “boneheaded” at you, but it’s hard to imagine that a bonus scheme that pays out to the tune of nine digits given performance like AIG’s isn’t exactly that.  AIG is in an ugly, embarrassing situation, almost certainly because of a comp plan that shouldn’t have been in place to begin with. 

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand.  I welcome your interest and your feedback.

All Dollars Are Still Green

 

Recently, I took a bank CEO to task for asserting that you could actually identify which dollars in your bank account were used to pay which bills, thereby insulting the intelligence of many (see “All Dollars Are Green,” posted 2/15/09). But corporations aren’t the worst offenders here. That award goes to state and federal legislatures.

For example, in 1984 California state officials supported a statewide lottery on the grounds that the profits would go specifically to the state’s public schools. “Your schools win, too” was the ballot initiative’s slogan, and it passed.

So. . . did it work? OF COURSE NOT!!!

Why not? Because the state legislature, recognizing that the lottery was a guaranteed source of funding for the state’s schools, could reduce funding for the schools from the general fund. . . . Not too hard to see that coming, eh?

What happened next? Realizing the loophole they had created, in 1998 the voters passed another ballot proposition, essentially stating that each year’s budget for K-14 education, excluding funding from the lottery, must be as great or greater than the previous year.

So. . . did it work? OF COURSE NOT!!!

No, today, California is not exactly known for its lavish spending on public education, nor for the great results its school systems deliver. What went wrong? It’s hard to tell, but here are some things that point to a less-than-perfect result:

1. A state ballot initiative process prone to hastily-drawn resolutions, which are publicized in voluminous, incomprehensible voter booklets and advertised at the bumper-sticker level of profound insight
2. Legislators who understand the ins and outs of the budgeting and funding process far better than the drafters of the initiatives and the voters who decided on them
3. The fact that, as in any complicated system, those who stand to gain or lose the most from the way the system works are the most adept at taking advantage of it.
4. A budgeting and appropriations process that’s no more transparent in California than it is in other states or at the federal level.

It all started with a “simple” proposal to get more money to the California schools systems, and from there things got more and more complicated, and less and less successful. There’s a lesson in this somewhere.
 

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

All Dollars Are Green

 

Just the other day a senior corporate executive reminded us why much of the public thinks of corporate executives as not only greedy, but also contemptuous of the public’s intelligence. 

I’m referring to Tony Wolfe, President and CEO of the ironically named Peoples Bank.  The North Carolina-based bank is a recipient of $25.1 million in funds from the Troubled Asset Relief Program (TARP), and like many other banks has been questioned about the appropriateness of both receiving TARP funds and paying out management bonuses.  Wolfe’s reply was to assure us that none of the TARP funds would be used to pay the bonuses!!!  No, I am not making this up. 

Let’s for the moment leave aside whether legislation limiting executive pay for companies receiving federal “bailout” money is sound public policy.  Or whether those ceilings will achieve the desired public policy objectives, regardless of how pointless those objectives might be.  OK? 

Wolfe’s remark is just astonishing.  Does he understand money?  Is he actually trying to say that if you have $30 gazillion in the bank, and you spend $1 gazillion on something, you can actually identify which of the sources of the $30 gazillion that $1 gazillion did, or didn’t, come from?  Does Wolfe also plan to deny that even if the TARP funds won’t be used to pay the bonuses, the TARP funds made it possible for Peoples Bank to pay the bonuses with the other money? 

The problem with remarks like this is that almost everyone sees through them.  The end result is not only a lame defense, but damage to the speaker’s credibility. 

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand.  I welcome your interest and your feedback. 

A New Year’s Wish – Calculating Really High Returns

 

Happy New Year!  Today’s post is about an easy way to quickly estimate annual return for very high returns over several years, without needing a calculator.  My New Year’s wish to you is that this will actually be useful to all of you, and soon. 

Low returns are easy to calculate.  Just divide the percentage increase by the number of years.  For example, if your 5-year return was 15%, an estimate of 3% (15% ÷ 5) is pretty close. 

Actually, the exact return is 2.83%, because of the “miracle of compound interest.”  What’s happening is that the original amount you invested gets a little bigger each year.  Your starting investment balance for Year 2 isn’t the, say, $100.00 you started with, but $102.83, and it goes up to $105.75 for Year 3, etc.  But the 3% return you calculated  in your head is pretty close. 

But the miracle of compound interest means the above method doesn’t work for high returns.  For example, suppose your money tripled in 5 years.  The above method – divide the 200% return by 5 years – gives you a 40% annual return.  But that’s not very close to the 24.6% that’s the correct number. 

But there’s still a calculator-free way to estimate the return:  Divide 75% by the number of years it took your money to double.  In the above example, tripling your money means it doubled a little more than 1.5 times.  Since the time period was 5 years, that means your money roughly doubles every 3 years (5 years, divided by slightly more than 1.5).  Now we divide 75% by 3, and get 25%! 

Here’s another example:  your money increases 8-fold in 15 years.  That means your money doubled exactly 3 times (2 x 2 x 2 = 8), so it doubles every 5 years (15 years ÷ 3 doublings).  So your estimated return is 15% (75% ÷ 5 years).  The exact calculated return is 14.87%.  Not bad for an estimate! 

May this subject be relevant to us all! 

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand.  I welcome your interest and your feedback. 

Boneheaded Compensation Plans #1

In a New York Times op-ed piece this morning, Paul Krugman rails about the excessive compensation that “Wall Street” has extracted from the economy over the last few years. He makes the interesting observation that over the last few years, the share of GDP going to the finance sector has risen from 5% to 8%.

In a $10 trillion economy, that is a LOT of money. Krugman goes on to speculate that much of that increment has gone to dramatically increased executive compensation in that sector, a speculation that is probably accurate. And what have we gotten for all that extra pay? Uhhh, not much. To say the least.

And what is the cause of this excessive compensation? Well, greed, of course. But so what? Market systems run on greed, a natural human behavior, and the job of senior management (and stockholders) is to ensure that greed is properly channeled into useful behavior. What’s really wrong is something just as fundamental: BONEHEADED COMPENSATION PLANS! (Sorry if I’m using overly technical terms here.)

Consider, for example, a bank executive overseeing mortgage lending. A bonus plan based simply on total loan production – an approach that I’m sure is widespread – would reward him for sheer volume of loans produced, no matter how schlocky (again with the technical terms) the loans were. Suppose instead, though, that the bonus is structured so that some of the bonus is earned when the loan transaction closed, but the remainder is paid as the loan gets paid back. Such a plan would (a) encourage the executive to focus on loans to better credits and, as an added plus to the bank, (b) encourage employee retention, since the executive would stop receiving the bonus if he went to another company. And the executive’s behavior would be much more in line with what the bank’s interests really are.

For a depressingly high percentage of executive bonus plans that in retrospect were outrageously generous, the cause is nothing more evil than just unclear thinking and poor communications. The solution isn’t rocket science; it just takes a little focus, and the recognition that people behave the way you pay them to behave.

The good news is that there are creative solutions. For example, today’s Wall Street Journal reported that a significant portion of this year’s bonuses at Credit Suisse Group would be paid in the form of various illiquid, junky assets like corporate loans. This “lump of coal in the stocking” approach has a certain rough justice, especially since those assets could turn out to be more valuable than their current book value.

And folks, the title includes “#1” because I’m certain there will be many more posts in the area of boneheaded comp plans. Thank God for boneheadedness!

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

Madoff and the “Idiot Plot”

 

First of all, a confession: I’ve read very little about l’affaire Madoff. I just don’t want the facts as I’m almost certain they are to be muddied by the facts as they actually are.

Second, a note on the title: I first heard the term “idiot plot” on Siskel & Ebert at the Movies, to describe a movie whose plot progression depends on the characters behaving in ways that normal people never would – like having the attractive, inadequately dressed, and very endangered young woman protect herself by barricading her doors with sofa cushions, instead of picking up the phone and dialing 911.

Where was I? Oh, yes, Madoff. Most of the reporting I’ve seen has focused on two causes for what might be the most spectacular financial fraud in history:

1. Inadequate regulation. Yes, yes, yes, the SEC missed this one – they themselves have acknowledged that they failed to react to complaints about Madoff’s practices. [Yet another example showing that self-criticism is the new saintliness.]
2. Investor due diligence. The reportage I’ve seen cites many people who didn’t invest with Madoff because of red flags they noticed. While these reports don’t actually blame the suckers who did invest, there’s at least an implicit criticism here, and some schadenfreude directed at the Palm Beach cocktail party set. [I’m somehow reminded of one of my favorite scenes from Ferris Buehler’s Day Off, when a character phones in her absence from high school because she says her grandmother has died, and the suspicious principal demands to see the death certificate.]

But these criticisms are terribly unfair. Do we really want to have a control system that depends principally on an agency competent enough to distinguishing the real problems from the many crank calls, or well-funded enough to check them all? And the U.S. investment climate is the envy of the world – or at least it was – precisely because investors don’t have to rely on heroic due diligence measures.

Here’s an even simpler solution: Require all funds that invest other people’s money to have an annual audit by a reputable firm. It’s inconceivable to me that Madoff’s operation ever had such a thing. The audit could focus simply on whether investor funds were being used for their stated purpose – you know, like being used to buy listed securities, and not just transferred to the accounts of other investors. Such a requirement falls far, far short of “excessive regulation,” even to a free-marketeer like me.

So Madoff is a movie with an “idiot plot” that would never have been filmed without archaic views about information. The solution isn’t more “regulation.” Nor is it more “due diligence.” It’s disclosure. Disclosure. DISCLOSURE. Got it?

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

Accounting Rules and Accounting Fraud: Blood Brothers?

 

Financial Executive magazine arrived today with “Fraud’s House of Cards: Has Complexity Created an Unmanageable Situation?” by Lynn Brewer, an Enron whistleblower and founder of The Integrity Institute, as the cover story. Ironically (so say I), there’s also an interview with Charles Niemeier, a member of the Public Company Accounting Oversight Board, entitled “Can More. . . or Less Regulation Fix What’s Wrong?”

In “Fraud’s House of Cards,” Ms. Brewer suggests that the very complexity of business today sows the seeds for fraudulent behavior. (She even starts with a very cool quote from Albert Einstein!) Among other problems, it becomes harder for the internal and external people who would normally play watchdog roles to sniff out the behavior.

In the other article, Niemeier’s main focus is on the current hot debate (OK, OK, it’s “hot” by CPA standards) about whether U.S. public companies should move from Generally Accepted Accounting Principles (GAAP) to the emerging International Financial Reporting Standards (IFRS). The main difference is that GAAP is “rules-based” and IFRS is “principles-based.” Niemeier is against the move to IFRS, arguing that GAAP gives American companies’ financial statements more integrity, and that the right approach is to fix what’s broken with GAAP rather than throw the whole thing out. [FYI, I don’t agree – see my post of 10/23/08 on this subject, plus more to come.]

Why do I say that it’s “ironic” that articles about accounting fraud and accounting rules would appear together? Because each creates a market for the other!

Huh? Well, accounting fraud – Enron, MCI Worldcom, flaky revenue recognition practices, etc. – creates the need to tighten up on the accounting rules, at least in the minds of many. These folks figure that tweaking the existing rules, or adding a “clarification” here and there, will close up the loopholes. The result is a set of GAAP documents that currently runs to about 25,000 pages. I am not making this up.

Does it go the other way? YES! First of all, labyrinthine accounting rules are one of the complexities that Ms. Brewer suggests are making fraud hard to spot. Even worse, rules-based approaches create a culture that breeds fraud. When rules get so complicated that it takes enormous effort just to ensure compliance, the issue of whether the financials are presenting an honest picture of the enterprise gets lost in the shuffle.

Until we acknowledge and understand this dynamic, the arms race will continue.

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.