Published August 2002

Honesty, not ‘signing’ rule, will deter fraud

In any crisis you have to expect a certain amount of organized silliness. The stock market’s current anxiety attack over accounting is sure to bring on more than its share.

In a sense, it already has. In an effort to calm down investors and markets, the Securities and Exchange Commission (SEC) has ordered that company chiefs and financial officers sign and swear under oath that the numbers in their financial statements are correct. This might not sound like silliness, but it is.

The current rule applies only to publicly traded companies that enjoy over $1.2 billion in sales, but the SEC has already proposed extending the requirement for signing and swearing to all public companies.

At first glance, the new rule seems to make sense. First, it brings the corporate giants into line with small businesses, which have traditionally had to personally guarantee their loans and credit lines and certify their financials. Second, big-hat executives presumably would be less likely to engage in accounting shenanigans if their signature, in the form of a sworn statement, appeared on the bottom line.

The problem with the SEC’s action is that it is more appearance than reality — and that is precisely what markets and investors don’t need right now. While it sounds nice that chief executive officers and chief financial officers will now have to swear by their financials, the truth is that they already do that.

Each publicly traded company has to be audited by an independent CPA firm, and, as part of that process, the CEO and CFO have to certify — that is, sign off on — the correctness of the financials. Signing a second time will add nothing in terms of responsibility or accountability.

The other problem with the new “signing” rule is that it overestimates the value of prosecution and punishment. Certainly, there have to be some serious consequences to irresponsible financial behavior, but it is difficult to believe that someone willing to defraud investors on a massive scale would be deterred by signing off a second time on the company’s financials.

And much the same can be said of President Bush’s proposal to double the jail penalty for mail and wire fraud. The idea that there are CFOs out there willing to risk five years in jail, but not 10, doesn’t make a lot of sense.

The SEC rule is bound to trickle down to our smaller, nonpublic businesses, in part because no one will want to say that it is silly. Still, since as managers, workers and investors in companies we all have an interest in protecting ourselves against fraud, we clearly need something better than the “signing” solution or longer jail terms.

While self-dealing, or self-benefiting, fraud is a recurrent problem, it is worthwhile to point out that many of the accounting “scandals” that we are hearing about today, Enron excepted, didn’t benefit insiders any more than the ordinary shareholders — at least for a while. They began with a desire to “put a good face” on the financials for one period — and then spun out of control.

And it is our understanding of how these things spin out of control that gives us some insight into how to protect ourselves.

In a weak sales quarter you might, for example, decide to recognize income sooner — using some imaginative method — thinking that the next three months will be better and you can make it up then. If the next quarter does come in that way, you might be able to change back and smooth everything over at year-end and pretend that you had made a clerical error. But if sales remain weak, you are stuck with two options: (1) show the real numbers and admit that you tried to cover them up, or, (2) continue faking the income and hoping nobody notices. There is a strong, and very human, tendency to select option two, and then you are in real trouble.

Combating that human tendency is something that all of us can do, whether we are running a very small business, a medium-size enterprise or a department in a large corporation. And the most significant thing we can do is to reinforce the distinction between mistakes and lies.

We can do this at every level of our operation by encouraging people to own up to their mistakes, knowing that we will deal with them in a positive, nonthreatening way. At the same time, everyone must know that anything less than forthright behavior will be dealt with sternly.

The new federal regulations, laws and “get tough” policies aren’t likely to be much help to us. But if we can establish a work environment where honesty prevails, we won’t have to worry much about accounting fraud.

James McCusker, a Bothell economist, educator and small-business consultant, writes “Your Business” in The Herald each Sunday. He can be reached by sending e-mail to otisrep@aol.com.

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