Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Deception is not a Means of Financial Engineering!!

Dr. Marianne M. Jennings, a professor of legal and ethical studies in business at the WP Carey School of Business at Arizona State University, has penned a noteworthy commentary in Financial Engineering News entitled An Ethical Breach By Any Other Name . . .. Her main argument is “Ours is an era of technicalities, literalism and labels. That last category of labels is a phenomenon of these times that serves as salve for the conscience. If we attach a lovely enough label to what we are doing, we can convince ourselves that something we propose or have done could not possibly be an ethical breach.” She continues

Labels have become so pervasive and commonplace that we may no longer even realize the ethical breaches that lie beneath the superficial beauty of a better name. There may be serious ethical breaches beneath our glib dismissals via language choices. A cab driver in Cincinnati taught me an important lesson about these labels and my grip on reality. The cab driver, one Big Jack, was a true entrepreneur who shared his story with me. He had driven his cab for decades and had saved and invested his money for his retirement. However, this cab ride with this colorful personal portfolio manager came on the heels of the collapses of Enron, WorldCom and Adelphia. Big Jack was not terribly pleased with Wall Street or the lack of ethics demonstrated in these collapses. His mood did not improve when I told him that I taught business ethics. He then asked me if I was familiar with a practice known as “earnings management.” Armed with my undergraduate degree in finance, I offered Big Jack my best support for the shareholder value that comes from smoothing out those earnings. Following my theoretical discussions, Big Jack thought for a moment and then commented, “I don’t really call it earnings management. I call it lying.”

His thought was a punch to the gut. I had fallen into the trap and comfort of “labelese.” The sophisticated label we in finance had attached to smoothing out earnings had become the extent of our ethical analysis on that process. “Earnings management” sounds suave, sophisticated, grounded in theory, perfectly appropriate and certainly not unethical. When the label sounds intelligent and/or comfortable enough, we need no longer think about the ethical implications of our choices or how far the label may have allowed us to move the line on the components of earnings management. We lump dilemmas and decisions under the protective umbrella of the lovely label. We get so comfortable that nothing undertaken in the name of earnings management is an ethical issue. There is no such thing as “cooking the books;” there is “aggressive accounting.” Lawyers offer the same comfort when they issue an “aggressive opinion.” Does that mean the conduct could be illegal? Engineers and accountants are often given the directive to “sharpen their pencils.” Does that mean make sure the numbers are accurate? Or could it be code for “make the numbers work”? And who has not made a financial reporting decision on the grounds that the numbers were “immaterial”?

The label phenomenon is one of many human avoidance techniques that have evolved as a means of ignoring or bypassing ethical issues or as a way for easing the pain of crossing an ethical line. Confronting those ethical issues head-on can be awkward! Analysis of ethical issues requires effort that includes fact gathering, a look at consequences and consideration of possible risk and eventual outcomes. Labels make no such demands on us and serve to postpone any deep ethical analysis. [TCM emphasis added]

Dr. Jenning’s commentary concludes with several examples from Tyco International scandal, including

The report of lawyer David Boies, who was hired by the Tyco board in its post-Kozlowski era to try to determine what exactly happened, concludes, “Tyco pursued a pattern of aggressive accounting that was intended, within the range of accounting permitted by GAAP, to increase current earnings above what they would have been if a more conservative approach had been followed” (Eichenwald 2002). There it is – aggressive accounting. Not illegal accounting, but accounting that crossed ethical lines in terms of deceiving shareholders, analysts, investors, and others who could not know the nuances of “aggressive accounting.” When Boies and his staff asked Tyco employees to explain either their conduct or silence in light of these ethical missteps, employees explained that they did not see their conduct as “cooking the books.” Rather, they preferred to think of their steps as “financial engineering.” They were using a label of comfort to justify conduct that proved to be deceptive about the true financial condition of the company. Deception is not a means of financial engineering.

Toomre Capital Markets wholeheartedly agrees with the underlined quote that “Deception is not a means of financial engineering.” Sadly in this time of Enron, Worldcom and various hedge fund accounting scandals, far too many individuals are like the cab driver Big Jack above. They freely associate the term “financial engineering” with negative connotations like “cooking the books,” “aggressive accounting” and that complicated D-word, “derivatives.” Such associations are not what financial engineering and risk management are all about.

Your comments and thoughts on ethical lapses, financial engineering, and enterprise risk management are welcome (registration on site required to avoid spam commentary). Please contact Toomre Capital Markets for more information on these terms. Dr. Jennings can be contacted at mjennings@fenews.com.