April 2003

Whose Ball Is It? Understanding How the Game Is Played

By Jagdish Pathak

In recent months, we have seen how the selfish decisions of CEOs and top management can make people question whether these individuals ever consider how their actions affect others. If business is a game, who is playing by the rules? Based on my own experiences, I’ve developed an idea of what it takes for a business to function ethically and what happens when some don’t.

Recent corporate scandals have illuminated a number of trouble spots—directors, accountants, analysts, managers, and regulators—but the problem has no single source or single solution. The majority of proposals assert tougher rules as the solution. I thought that, as a business academic with an accounting and auditing background, I needed to form my own opinion. I decided to study the diverse opinions of my colleagues. Some found fault with the independence of auditors, some with the greed of executives, and some with the irrelevance of governance systems. Many agreed that the game was being misplayed, maybe by everyone, but that finger pointing would not solve the problem.

My personal experience with investing in a failed corporation suggests the wisdom of skepticism when things seem too good to be true. A wealthy investor friend suggested a “hot” stock to me. Unsure of the future, but hoping to become rich, I bought what he suggested and watched the stock’s price daily. I was also informed that the CEO and other top executives of the entity had bargained for huge, undisclosed amounts of stock options for themselves. My friend was right and the stock price rose. With very little knowledge of the company’s bottom line, it was difficult for me to understand how it grew so quickly. Everyone sung the praises of the competent and capable CEO, who grew in stature in my mind. Regulators, auditors, and employees were happy, and they decided to put their savings into the growing stock.

Becoming a bit nervous, I sold my shares without informing my friend, and I earned more than I could have ever dreamed. A month later, the entity was in trouble, and eventually it went bankrupt. My friend blamed the auditors and questioned the independence in their reporting. Others said the company was brought down by the CEO’s greed.

When my investor friend asked how I knew to sell when I did, I tried to explain to him how I think the business game is played: Any venture consists of risk-taking, an entrepreneurial spirit, and financing. A person needs to begin with a risk-taking and enterprising spirit and some amount of financing, either personal or from investors. Venture funding demands future expectations. Market conditions are dynamic, but investors demand constant growth through value creation by the entity. There are three types of financiers: promoters that provide a small seed sum, venture financiers that expect a lot of risk and a lot of return, and agency financiers that invest on behalf of clients hoping for a big gain.

The beginning of the rewards comes in the form of profits. If profits are substantial, then competitors enter the marketplace or takeovers are attempted. A high-profit venture attracts all kinds of financiers, and the stock value soars. As investors’ expectations increase, professionals take over the enterprise, and the inner growth declines while external growth continues. The attention shifts from increasing the intrinsic worth of the entity to satisfying investors’ demands. The professionals want to get as much from the stock as possible, as quickly as they can, and agency financiers assist in this mission. Equity and investment analysts do not always form their opinions objectively, with bias, whether natural or induced, entering when the analysts issue advisories to market players and common investors. Modern auditors have the duty to be independent, but they face competitive pressures and may also be providing additional lucrative services to the company. Ordinary investors are happy because they perceive that investment to be in safe hands. Regulators may not be aware of any problems or not be able to investigate.

Many participants become blind to the reality of the enterprise. Truth gives way to fiction and facts to speculation. Everyone is happy with what they see today and no one is concerned about tomorrow. Every document gets certified for its truth and fairness. The game goes on, but the ball gets lost. In the end people blame each other for the fall of the empire, but who is really to blame?

Whose court and whose ball is it? Who will step in and clean up the game?

Jagdish Pathak, PhD, is an accounting and auditing professor at the University of Windsor, Edmond and Louis Odette School of Business, Windsor, Ontario.

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