CHAPTER AT A GLANCE

1. The credibility of top executives in the American model of capitalism depends on their generating consistent increases in earnings and carefully guiding analysts' expectations.

2. With performance criteria for bonuses and share incentive schemes increasingly linked to the share price, the temptation to massage earnings numbers is acute.

3. Partly thanks to aggressive earnings management US corporate profits were significantly overstated in the late 1990s, sending misleading signals to the markets and resulting in the misallocation of capital.

4. Massaging the numbers can be done legitimately, but the ethical question is often one of degree: is it just a way of reducing short term share price volatility, or is it more seriously misleading in a way that could ultimately damage the company and destroy shareholder value? There is evidence that managers are increasingly prepared to destroy value in the interests of smoothing earnings.

5. A key question concerns motivation. Managers may be tempted to keep shareholders in the dark to preserve their jobs or to give a boost to the share price to help inflate bonuses or equity-related incentive scheme awards.

In the American model of capitalism the stock market imposes a ferocious discipline on the managers of quoted companies. For a start, the movement of the company share price offers a minute-by-minute critical commentary on corporate performance and prospects. Quarterly results are closely examined by stock market analysts, professional fund managers and business journalists, and there is an ever-present threat of hostile takeover. The credibility of top executives in this system depends on their generating consistent increases in earnings. They also have to develop the art of carefully guiding analysts. expectations and subsequently "hitting the numbers". Any shortfall of performance against expectation can result in a sickening slide in the share price and an immediate question being raised over the tenure of the chief executive and chief financial officer.

Putting CEOs into a financial pressure cooker in this way has its disadvantages. The underlying assumption is that companies are capable of delivering consistently rising, above-average earnings. Yet this is absurd because all companies cannot be above average. Equally absurd is the implicit assumption that accountancy is a precise, objective science capable of producing a single exact number that is worth hitting. The reality is that in the modern knowledge economy accountancy is more a matter of judgement than ever before. The system also creates a tension between short-term earnings performance and long-term value creation. As for the discipline, it is peculiar, in that top executives set the benchmarks against which they themselves are measured. It is as if pupils were shown the answers to the mathematics exam the evening before and then thrown out of school if they failed to achieve full marks on the day. The discipline is nonetheless real and top executives do fail for one reason or another to meet their own benchmarks. And the US capital market approach is being adopted increasingly by other countries around the world despite the questionable definition of performance.

Because so many employees now own stock in the company where they work, the categorical imperative of hitting the numbers may be felt throughout the organisation. Inevitably there is a temptation, in this ritualized expectations game, to massage the results to keep the stock price up. Where performance criteria for bonuses and stock incentive schemes are related to the behaviour of the stock, the temptation is particularly acute. In the wave of corporate scandals from Enron to Royal Dutch Shell, this pressure drove top executives to cook the books, which had the effect of boosting their own compensation packages. Yet it is also open to executives to tailor quite lawfully their spending decisions and choice of accounting policies in order to smooth the quarterly earnings trend.

The nature of these dilemmas emerges in a surprising way in the autobiography of Jack Welch, former chairman and CEO of General Electric, most notably when he recounts the disaster that struck the big conglomerate's investment banking subsidiary, Kidder Peabody, in 1994. Kidder's government bond trading desk was run by Joseph Jett, who made a series of fictitious trades to inflate his own bonus. These artificial trades had inflated Kidder's reported income and the team of GE managers that was sent in to assess the damage concluded, with GE's first quarter earnings release due to be published in just two days time, that a $350m write off would be needed to deal with the financial black hole left by the rogue trader.

Welch explains how he apologized to 14 of GE's business leaders for what had happened and felt terrible because this nightmarish surprise would hit the stock and hurt every GE employee. And he continues:

The response of our business leaders to the crisis was typical of the GE culture. Even though the books had closed on the quarter, many immediately offered to pitch in to cover the Kidder gap. Some said they could find an extra $10m, $20m, and even $30m from their businesses to offset the surprise. Though it was too late, their willingness to help was a dramatic contrast to the excuses I had been hearing from the Kidder people.

Instead of pitching in, they complained about how this disaster was going to affect their incomes. "This is going to ruin everything," one said. "Our bonus is down the toilet. How will we keep anyone?" The two cultures and their differences never stood out so clearly in my mind. All I heard was, "I didn't do it. I never saw it. I never met with him. I didn't talk to him." No one seemed to know anyone or work for anyone.

It was disgusting.

For Jack Welch the ethical issue here boils down to the contrast between the selfish, footloose individualism embedded in the culture of Wall Street's investment banks and the healthy team spirit exemplified by managers in GE's mainstream businesses. He seems astonishingly blind to the possibility that others might be shocked that the corporate culture at GE was one in which playing fast and loose with the quarterly numbers was regarded as good teamwork. Some might argue that on the Richter scale of ethical lapses this does not rate very high. Jack Welch could no doubt claim that smoothing the numbers is an antidote to stock market short termism and thus in the interests of all shareholders. The fact that the market responds so fiercely to missed earnings targets suggests that investors anyway believe that most companies can "find the money" to meet targets and that missing a target is an indication of very poor management.

Yet while it is true that smoothing quarterly earnings is a rational response to the somewhat arbitrary discipline of the capital market expectations game, there is also a question about whether shareholders should have been told on what basis this was being done at GE, not least because such an opaque approach to reporting can put management onto a slippery slope. For the risk, in creative accounting, is that managers end up fooling themselves about the real profitability and viability of the businesses they run.

That, indeed, is what appears to have happened across much of the US corporate sector in the 1990s.