Norm-based behavior and corporate malpractice

Journal of Economic Issues, March, 2007 by Miguel A. Duran

Note also that corporations made increasing use of pro forma accounts such as Ebitda--i.e., earnings before interest, taxes, depreciation and amortization. These accounts are the first sets of results firms release, are not audited and do not follow accounting legislation. Although originally thought to provide additional information concerning the progress of companies to investors, they have become a legal, but vitiated, way to show a better picture than that depicted by the balance sheet. Moreover, the great amount of detailed, prescriptive rules that make up American accounting legislation has two perverse consequences. First, what is not forbidden by any rule is understood to be permitted. Second, the accounting procedure focuses on obeying the letter of the law, whereas its spirit can be ignored; that is, rules-based accounting standards "can result in financial reporting that is not representationally faithful to the underlying economic substance of transactions and events" (SEC 2003d, Exec. Summary).

Using pro forma statements and taking advantage of the detailed nature of accounting legislation in the above sense does not necessarily imply illegal disclosure. Nevertheless, in the context of slacker oversight, deregulation and the rest of the liberalization policies of the 1990s, the use of under-regulated financial instruments for earnings management has been combined with the use of flatly illegal means to create a deceptive image of corporations. All of these means made it possible, therefore, to observe Norm II: "Do whatever you can to show the profit rate is growing." But this norm can now be put more accurately by adding new details about the way the expression "whatever you can" should be understood. The new version of the norm could be put as follows:

NORM III: Do whatever you can, even deceive about or disguise any potentially disadvantageous aspects you know of, in order to show a growing profit rate.

As Hayek suggested, a norm just establishes the substratum of a type of behavior that is given specific form in different ways of acting. In this sense, Norm III embodies the following particular practices (SEC 2003a, 5-30): (1) abusive use of pro forma accounts which could mislead investors; (2) creation of special purpose entities to keep liabilities off the balance sheet; (3) improper timing of revenue recognition--including, for instance, those cases where revenue depends on a contingency which could preclude its realization; and (4) creation of fictitious revenues obtained, for example, by means of false trading.

Regardless of the particular forms adopted by Norm III, the point is that it is a norm entailing deceitful behaviors and that it has spread spontaneously throughout the marketplace. This spontaneous process involves an "element of contagion" between misbehaving and "healthy" firms (Demski 2003, 67). There was a pioneering company we can call "Enron"--but this should not be taken as implying that Enron was really the first company to implement the way of acting embodied in Norm III. As a result of its accounting maneuvers, competition brought this corporation success and its equity price went up (Fusaro and Miller 2002; Healy and Palepu 2003). The business press considered it the most innovative company year after year from 1996 to 2002. It rose to fifth place in the Fortune 500 in 2002. Credit rating agencies rated it a good credit risk--and they continued to do so until four days before Enron declared bankruptcy (SEC 2003b, 16). Analysts rated it a "strong buy" until almost the last moment.