At The University of Chicago Booth School of Business Capital Ideas Blog: Stock Options Backdating And Stress Tests

I’ve been writing for the University of Chicago’s Booth School of Business Capital Ideas magazine and blog for more than a year now. The purpose of this Booth School initiative is to highlight faculty research.

The assignment fits right in with what I’ve been doing for the last two years or so when I visit universities. I speak to students but leave as much time to talk to accounting and business ethics faculty about their work. Some of it I can use to bolster my arguments. I often help academics get mentioned in other publications.

For the University of Chicago Booth School of Business, I write for the Capital Ideas magazine and blog. The June issue of the magazine will have two new longer pieces by me. Look for it online or at the Gleacher Center in downtown Chicago.

I’m also writing for the Chicago Booth Capital Ideas blog. Two pieces published recently are:

The sordid history of stock option backdating

The fifth and latest edition of the classic textbook, Taxes and Business Strategy, A Planning Approach, includes a compact primer on the tax issues surrounding the 2005-2007 stock option backdating controversy.

Erickson and the authors explain that, per SFAS 123, an accounting standard, “in-the-money” stock options should have been disclosed, in the financial statement footnotes, as compensation expense. According to research firm Audit Analytics, the stock option backdating investigations resulted in 153 restatements of previously issued financial statements by companies during 2006 and 2007 because companies failed to properly disclose this compensation expense. The stock market reacted negatively to these restatements. This reaction provides, according to a study in 2009 by Gennaro Bernile and Gregg Jarrell, an estimate of the size of agency costs—unanticipated management opportunism arising from poorly governed companies.

Audit Analytics also says only 13 cases were filed against auditors for giving bad advice and only four auditor settlements exceeded one million dollars. Booth Professor Emeritus Roman Weil, and his co-author Jennifer Milliron, argue in a chapter of the Handbook of Litigation Services that the financial illiteracy of executives, lawyers, and auditors with regard to stock option accounting and disclosure rules during the period leading up to Lie’s discovery, while regrettable, is understandable. “The courts should not expect anyone to have followed ‘rules’ that the accounting profession failed to clarify.”

Do you agree?  There’s more on the blog.

Bank stress tests: How much should be revealed?

In a forthcoming research paper, Haresh Sapra, professor of accounting at Chicago Booth, and his colleague Itay Goldstein of the University of Pennsylvania discuss the pros and cons of full disclosure. Market discipline should improve if stress-test results provide insight about a bank’s ability to withstand market shocks.

“Public disclosure of a bank’s financial condition enables market participants to make informed decisions about the bank and such informed decisions, in turn, discipline the bank’s actions,” Sapra and Goldstein note. However, bank-specific disclosures may encourage bankers to game the process by dressing up their balance sheets. That might get them a passing grade, but reduce long-term shareholder value.

That’s certainly true in the case of Citigroup which failed the stress test and also Bank of America, which recently found a longstanding error that had significantly overstated its capital. Both banks saw their stock prices fall as investors questioned the banks’ ability to withstand another severely adverse economic environment if neither could get the basics of putting numbers together for their regulator right.

Here’s a great column on the Bank of America stress test fiasco by the New York Times’ Floyd Norris that includes my favorite question: Where was Bank of America’s auditor PwC when the bank was putting the wrong number, by billions, in its MD&A disclosures year after year?

Bank of America’s auditor, PricewaterhouseCoopers, also declined to comment. It is responsible for auditing the company’s financial statements, which the bank says were correct, at least so far as the income and balance sheets go. But the company’s 10-K annual report, which carried the auditor’s letter of approval, also included a footnote regarding capital levels, which the bank now says were incorrect. One measure of capital was reported at $161.5 billion, when it should have been $157.7 billion. Auditors are supposed to review such footnotes, but either number showed the bank to be more than adequately capitalized, and it could be argued that the difference was immaterial to investors.