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Last year, John Allison became the new president and CEO of the Cato Institute, succeeding the legendary Ed Crane. I therefore picked up his book— The Financial Crisis and the Free-Market Cure (McGraw-Hill, 2013)—as an interested citizen who shares the author’s and the institute’s pro-capitalist perspective. And it proved to be just what I was looking for: the perfect combination of free-market theory and first-hand knowledge of the financial industry. The latter, of course, is drawn from Allison’s incredibly successful twenty years as CEO of the major southeastern bank BB&T. During his tenure, the bank’s assets grew from $4.5 billion to $152 billion.
I can recommend the book heartily, not only in contrast to anti-capitalist explanations of the financial crisis but even by comparison with the explanations of certain Austrian economists, whose analyses have tended to be formulaic (the Federal Reserve did it).
But beyond my general appreciation of Allison’s book, I was especially delighted and surprised to find that the author shares my perspective on two topics that have been central to my own recent writings: the backdated options frenzy and the irrationality of “Generally Accepted Accounting Principles.” My delight needs no explanation. But my surprise may.
Although I have never suspected that the employees of Cato might be less than purely laissez-faire in their thinking, my experience in the matter of the backdated options frenzy of 2005–2011 was disappointing. Last spring, I spent much of my time working on the monograph Rich-Hunt: The Backdated Options Frenzy and the Ordeal of Greg Reyes . And as I am trained in neither economics nor law, I had to devote much of that working time to searching for pro-capitalist analysts who could help me answer the prosecutors’ and accountants’ arguments supporting the backdating prosecutions. Unfortunately, the only reliable source that I could find was the blog of the (now deceased) Larry Ribstein, a professor of business law at the University of Illinois—Champaign. The libertarian Cato Institute, I was particularly chagrined to discover, had apparently not stood up for those businessmen attacked during the backdating frenzy. Executive vice president David Boaz had posted an amusing item about an “international manhunt” for someone who had not expensed his company’s options. But that seemed to be about it.
More recently, Professor David Henderson (a research fellow at the Hoover Institution) wrote a laudatory review of my monograph Rich-Hunt for Cato’s quarterly magazine Regulation. For that, I am profoundly grateful. Nevertheless, I have continued to wonder whether any of the scholars employed by Cato shared my understanding of the backdating frenzy—and of the deeper causes for it that I laid out in Rich-Hunt. That is why I was so pleasantly surprised to discover that John Allison does.
In his book, Allison devotes several pages to the issue of options and how they should be treated by accountants. His understanding, based on his experience as CEO of BB&T, is this: “The reason that stock options were not expensed is that there is never a cash outflow from the business. In fact, when the stock option is exercised, there is a cash inflow to the corporation. The basis of the accounting model was designed to deal with cash flows into and out of a business, as in the end, the only thing you can spend is cash. Items that represented current or future cash outflows were expensed.”
He gives an illuminating parallel. Options, if exercised, are a transfer of ownership. Some percentage of the current shareholders’ equity is transferred to the exerciser of the option. But that is not a corporate expense. Imagine that I am a business owner who owns 100 percent of my company. Imagine that I then transfer 50 percent of that ownership to my son. Clearly, I have lessened my ownership and my right to future earnings. But the company itself has not incurred any expense, cash or “noncash.”
Allison’s quiet explanation is the same as Greg Reyes’s astounded response to the revelation that his CFO had failed to “expense” Brocade’s options according to APB 25, the absurd rule that the SEC used to judge whether companies had properly accounted for their options. When he was told that the company would therefore have to “restate its earning” for past years, Reyes said, in effect: “Fine. I don’t care if we have to ‘expense’ the options at a trillion dollars. All they involve are hypothetical non-cash expenditures that were never made. Expensing a trillion dollars of outdated options against former earnings would not mean that we made one cent more or less during those years.” Of course, as readers of Rich-Hunt know, Greg Reyes was fired, prosecuted, and sent to prison. I do wish that Allison had mentioned the human cost of the options frenzy as well as its irrational accounting.
But more exciting than the options issue, for me, was my discovery that Allison understands the politicized and irrational nature of the GAAP. I cannot recall that anyone, during the whole backdating frenzy, joined me in denouncing the very existence of “generally accepted accounting principles.”
“I do not know of a single business, large or small, that manages its operations based on GAAP.”
Allison writes: “The most fundamental fact to understand is that in the United States today, we no longer have, as we once did, a private accounting system with dispassionate and objective professionals in charge. We now have a heavily government-influenced (corrupted) accounting system. . . . For a century prior to the establishment of the SEC (a government agency) in 1935, the stock exchange and self-interested shareholders demanded and then built a system of objective financial reporting and rational accounting rules.” That is very true, and how we came to have our current SEC/GAAP arrangement is a fascinating story of New Deal vengeance that I shall be telling in the revised and expanded version of Rich-Hunt. (Two minor points: The SEC began in 1934, and it does not “appoint” members of the Financial Accounting Standards Board. Legally, they are appointed by the Financial Accounting Foundation, a private, self-perpetuating 501(c)(3) corporation. But it is certainly true that at least since April 2007 the SEC has exercised very close oversight of, and sometimes political pressure on, FASB appointments.)
As for the irrationality of GAAP, Allison writes: “I do not know of a single business, large or small, that manages its operations based on GAAP. Every business I am familiar with (and there are many) has internal reports that are converted to GAAP when public disclosure is required.”
Consider what that means: The whole purpose of creating “generally accepted accounting principles” was to make it easy for the SEC to “protect the investing public” by overseeing thousands of companies without having to understand the individual lines of business that they were in. But the result, Allison is saying, is that the actual financial conditions of American corporations are being kept from investors because proper depictions of those conditions would not conform to the overly broad “generally accepted principles.” That, too, is a fascinating story that I shall be telling in my new book. In essence, it is the story of how accounting professionals transformed themselves from valued professional counselors helping executives manage their individual firms into quasi-public servants helping the SEC assure investors that they could rely on a government guarantee of corporate soundness rather than on their own understanding. To see how that worked out, one has only to consider the Enron fiasco .
The Malum Insanum that Created Backdated Options by Roger Donway
Rich-Hunt: The Speech by Roger Donway