Microsoft gets same loophole
The inside story on Enron has actually been spelled out in black and white for quite some time. The trouble is, the only people who might have recognized it were investment managers and personal financial planners.
Enron's remarkable pyramid scheme was based upon what I call 'watered stock fraud,' and its goal was to pilfer the public and private retirement systems. The scheme and its peripheral impacts have been fully documented on my Web site, www.billparish.com, for more than two years.
Strangely, Enron Chief Executive Officer Ken Lay publicly stated that the best way to view Enron was as the Microsoft of the energy field. Let's trust Lay, a Ph.D. economist, and examine Enron through a Microsoft-style window.
At one point, Enron was one of the largest companies in the Standard & Poor's index of the 500 largest U.S.-based firms. This is important because most pension plans have been investing using a strategy based upon the S&P 500 index.
What this means is that if the market value of Enron stock represented 1 percent of the overall S&P 500 index, 1 cent of every dollar going to stocks in these pension plans went to the purchase of Enron stock. Microsoft often has been the largest component of the index, with roughly 4 cents of every dollar indexed to the S&P 500 going to the purchase of Microsoft stock.
So how did Enron get to be so large a component of the index?
The answer is simple. Enron artificially inflated its earnings so that it looked like a better investment than comparable companies. This attracted more investor interest and drove up the stock price.
The most important tool Enron used to inflate its earnings was its ability to pay wages and other expenses in stock rather than cash.
More than 90 percent of all the wages paid to Enron executives were paid in stock, not cash. Investors often forget that all it takes to create new stock is a resolution of the board of directors and a photocopier.
Remarkably, the Internal Revenue Service allows a tax deduction for wages paid in stock, yet these same wages are not required to be charged as an expense to the income statement the public sees.
If you were operating a business, wouldn't you love to give your banker an income statement that excluded half of your wage expense? Chances are good you could qualify for a much larger loan Ñ and the same applied to Enron's much higher stock valuation.
Microsoft was the first to aggressively use the strategy. It led a lobbying effort in the U.S. Senate to defeat a bill introduced by John McCain, R-Ariz., and Carl Levin, D-Mich., in the mid-'90s to close this loophole. Microsoft's No. 1 ally in the Senate was Joe Lieberman, D-Conn., who at one time threatened to take funds from the Financial Accounting Standards Board unless it backed down.
This year, on Feb. 13, McCain and Levin reintroduced a bill to close the loophole, titled the 'Ending the Double Standard for Stock Option Act.'
Microsoft, like Enron, now pays zero federal income tax, even though Microsoft's earnings for the two years ending June 2001 exceeded $15 billion. This nonpayment of federal income tax is indeed the largest source of Microsoft's massive $40 billion cash balance.
Accountants and investment professionals have argued that it does not matter, since the employees pay tax on wages paid in stock as ordinary income, and these amounts are on their W-2s. Why double-tax companies such as Enron and Microsoft?
What the business media and analysts missed was the significance of not showing wage expense on the income statement. This wage expense at Microsoft exceeded $22 billion for the two-year period ending June 2001, and not a dime of this amount is charged against its earnings. Showing this expense as a charge to earnings would indeed make Microsoft, like Enron, an unprofitable company.
What we should be able to agree upon is that a valid earnings scorecard is important for a free-market-based economy Ñ a scorecard that charges wages paid in stock as an expense against income.
Doing so will restore credibility to our capital markets, more broadly distribute investment capital based upon merit and prevent future Enrons.
Quality companies with integrity in their financial results Ñ for example, Willamette Industries Inc. Ñ would also have a better chance of staying independent, and that would be good for the community.
Bill Parish is a registered investment adviser who has operated Parish & Co. since 1994. He previously held positions with Arthur Andersen and U.S. Bank.