Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Auditing Main Page | Creative
Accounting Main | Capital Markets Main Page
The purpose of this article is to discuss how regulatory and market changes destroyed the efficacy of investment analysis, and to provide some proposals for reforming the capital markets system. Healy and Palepu begin by commenting on some of the companies involved in well publicized financial scandals such as Enron, WorldCom, Tyco and Global Crossing. These scandals provoked what they refer to as "hastily prepared regulatory reforms intended to guarantee that greedy, overpaid business executives and their tame accountants would never again dupe the innocent investor." Reforms such as the Sarbanes-Oxley Act and various rules changes at the New York Stock exchange are helpful, but do not attack the real causes of the problem. The stock market and corporate leadership failures are rooted in regulatory and market changes made in the 1970s and 1980s. The authors discuss problems in three areas including auditing, investment analysis, and fund management. These discussions are followed by three proposals to correct the problems.
Auditing: A Race for the Bottom
The decline of the accounting profession's reputation can be traced to two changes. First, in the 1970s, the Federal Trade Commission pressured the "Big Eight" accounting firms to compete more aggressively with each other for audit clients. The idea was to lower audit costs and improve audit quality. Second, a series of legal judgments made it easier for investors to sue companies and their auditors. Judges believed that this would increase the auditor's accountability. Healy and Palepu refer to this as the "fraud on the market theory". Although audit costs decreased, the effect of these changes on the quality of audits was disastrous. Accounting standards became more mechanical, detailed and lengthy to reduce variations in audits. From 1985 to 2002 the FASB standards increased from approximately 2,300 pages to 4,000 pages. These mechanical rules have encouraged companies to satisfy the letter, but not the spirit of the standards. According to Healy and Palepu, this standardized, or mechanized approach to auditing also enables auditors to abdicate their responsibility for making a broad judgment about the financial health of the company. Severe price competition and a decline in the quality and quantity of accounting graduates (e.g., from 50,000 university accounting degrees per year in the 1980s to 40,000 in 2002) added to the accounting profession's problems. These changes led the auditing industry into what Healy and Palepu refer to as "a race for the bottom". The overall effect is that investors and regulators now perceive audit reports as unreliable.
Investment Analysis: Where Conflicts Abound
In 1975, the traditional system of fixed brokerage commissions was abolished. The idea was to reduce investors' trading costs making markets more liquid and more efficient. This lowered trading costs significantly. But the high fixed commissions paid the salaries of the research analysts of the brokerage firms. Brokerage firms became unprofitable and were absorbed by Wall Street underwriters and investment banks. Payments for research now comes from the profitable underwriting segment of the business. This creates a conflict of interests for research departments and their analysts. In addition, the analysts' relationships with the management of the companies that they analyze creates other conflicts. One recent study showed that favorable earnings forecast are more likely the longer an analyst follows a particular company.
Fund Management: Joining the Herd
Professional fund managers have benefited greatly from market deregulation, tax law changes that promote retirement accounts, and the low costs of buying and selling mutual funds. So why were they blindsided by the stock market crash? The competition for fund performance caused risk-averse fund managers to follow the crowd. Investors' perception of an efficient market promoted investment in index funds. But index funds invest in a balanced portfolio of securities that track the index so the fund managers do not need to research the stock selections. Fund managers also subscribe to the efficient market concept and use a strategy the authors refer to as "passive indexing" rather than doing independent analysis. This means that retail investors drive the market. But evidence shows that retail investors display herd behavior and buy the latest hot stocks. So the belief in an efficient market and the increase in investment management services have only served to undermine the market's efficiency.
How Can We Save the System?
Healy and Palepu offer three main proposals.
1. To enhance audit quality, the lines of communication and responsibility in auditing must be completely redefined. The stock exchanges should be put in charge of audits since they have a strong incentive to ensure that companies provide high quality information to investors. The stock exchanges should hire and fire auditors, negotiate their fees and oversee the outcome of the audits. The stock exchanges could cover the audit fees from an increase in stock-trading fees. Stock exchanges would work with audit committees, not replace them. The Federal Drug Administration and Federal Aviation Administration perform similar oversight functions.
2. To improve company analysis, an independent, nonprofit organization for the financial markets should be created similar to Consumer Reports. The authors suggest that it could be named the "Investors Union." This organization would rate the performance of analysts, tracking the quality of their earnings forecasts, stock recommendations and degree of independence.
3. To reduce investors' short term orientation and incentive to trade so actively, fund companies could set their fee structures to reward long-term investments. They also recommend a graduated tax on capital gains that declines as the length of time an investment is held increases. For example, a 35% tax for a gain on an investment held for one year or less, 25% after two years, and zero after five years.
An efficient market depends on liquidity and the availability of high quality information. Rules and regulations that promote liquidity at the expense of high quality information damage the market. The reforms presented in this article are intended to correct this imbalance.
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