Monday, September 12, 2005

Enron and Job Growth?

A New York Times column by Daniel Gross (here) discusses  a National Bureau of Economic Research working paper by two finance professors (at NYU and Rutgers) that seeks to draw a link between companies that have had to restate their earnings (from Jan. 1997 through June 2002) and the loss of jobs. The poster-child for accounting fraud, one of the triggers of a restatement, is Enron, and the authors see a connection between aggressive accounting, which permits increased hiring, and subsequent job losses due to the inevitable restatements that a company must issue and, consequently, the loss of jobs as the company cuts back to deal with the downturn in its business.  The authors cite Enron as a "typical -- if somewhat extreme -- example" of the effect of accounting losses, and the abstract states:

We argue that earnings management and fraudulent accounting have important economic consequences. In a model where the costs of earnings management are endogenous, we show that in equilibrium, bad managers hire and invest too much in order to pool with the good managers. This behavior distorts the allocation of economic resources among firms. We test the predictions of the model using new historical and firm-level data. First, we show that periods of high stock market valuations are systematically followed by large increases in reported frauds. We then show that during periods of suspicious accounting, firms hire and invest excessively, while insiders exercise options and sell stocks. When the misreporting is detected, firms shed labor and capital and productivity improves. In the aggregate, our model seems able to account for periods of jobless and investment-less growth.

I don't purport to know enough of the "dismal science" to argue with their conclusions, but it does not look like they have accounted for the lawyer and accountant full employment effects of the Sarbanes-Oxley Act.  Somewhat less facetiously, accounting fraud is often a reaction to a failed (or failing) business model, or a response to a changing marketplace that corporate management had not anticipated.  For example, Enron and WorldCom resorted to accounting tricks, and ultimately fraud, to hide the losses in their core businesses, which were not nearly as successful as they had sold to Wall Street.  Bristol-Myers Squibb's channel-stuffing is an example of how changes in the business environment can catch companies unaware, and they respond by trying to paper over the problem, figuring that sales and revenue will recover in a future period to help make up for the tricks used to meet current expectations.  In other words, accounting fraud is usually a symptom of a much deeper business problem, and is a means to postpone the effects of the marketplace until a new plan can be implemented.  Enron and WorldCom shed workers because they plunged into bankruptcy when their businesses could not survive, and it no longer made sense to continue to follow an obviously failed business model. 

Many accounting frauds start small, and grow out of control over time (see HealthSouth) as the pressure to meet ever-higher earnings expectations makes it impossible to go disengage, at least not without it being noticed.  I doubt that hiring is a product of accounting fraud, although pumped-up earnings and revenues lead everyone to believe that the company needs to expand, and once that bubble is popped it will lead to job losses.  Check out Tom Kirkendall's post on the Houston's Clear Thinkers blog (here) for his analysis of the effect of Enron's collapse on the Houston economy. (ph)

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