Sometimes 'helpful' laws hinder

11/03/02
Brigham Young University
By By Hal Heaton Printed in the Deseret News
Often laws are passed with the intent to accomplish one objective, only to end up causing an entirely different effect. This phenomenon is called the Law of Unintended Consequences.
Unfortunately, entrepreneurs often bear the brunt of the unintended consequences.

One recent example is reflected in the outrageous executive salaries that have been much in the news recently. One of the causes of these huge salaries was a 1994 law that was actually intended to limit executive salaries. The law limited to $1 million the amount that a corporation could pay to an executive and deduct for tax purposes. However, if the salary was due to "incentive compensation," which would only be paid if the executive reached certain goals, then the salary paid could exceed $1 million and still be tax deductible.

Obediently, many boards of directors limited pay to $1 million but then gave the executives stock option grants, which would only be valuable if the share price went sufficiently high. Little did they know that the next six years would see the biggest run-up in stock prices in U.S. history. Consequently, executives received huge payments -- far beyond anything experienced before that time -- as executives exercised their stock options. As a result, the law intended to limit executive compensation actually had the effect of increasing it dramatically.

A more recent example is President Bush's tariffs on steel imports. The intent was to protect U.S. steelworkers from losing jobs. Unfortunately, the higher steel prices have led industries that use steel to be uncompetitive in world markets, and workers in those industries have started to lose jobs. Other countries have threatened to retaliate with tariffs on products important to their economies; these foreign tariffs would make American products more expensive, Americans would sell less and more jobs would be lost in those industries. As a result, the law intended to save jobs could cost more jobs than it saves.

Currently, many in the media blame the drop in stock prices on what they consider to be fraudulent accounting. In some cases, these instances of fraudulent accounting represent judgment calls. For example, one of the issues with WorldCom is its recording of repair and maintenance salaries as a capital expenditure rather than an expense. If you spend $100 on labor to produce a product, that should be deducted from profits (an expense). If you spend $100 to buy an asset (a capital expenditure), the asset should go onto the balance and expensed (depreciated) over the life of the asset as it generates future revenue.

WorldCom has asserted that when they repair and maintain their network, the repaired network has thousands of times the carrying capacity of the old network due to new technology. They argue that the enhanced capability will result in higher revenues, the asset (network) is more valuable and hence the improvements should be reflected in a higher asset value. They conclude that this cost should be expensed over time like an asset rather than immediately.

Is that fraud or a legitimate judgment call? There are many similar examples in which the current law allows companies to use judgment in how the cash outflow is treated.

A law that is intended to make financial statements more reflective of reality may actually make them less reflective of reality. Perhaps the better solution is to allow companies to make a judgment call but fully disclose those judgment calls -- and the logic behind them -- in their financial reports. Otherwise, a law intended to clarify financial statements may have the opposite and unintended consequence.

author1 is associated with the BYU Center for Entrepreneurship. He can be reached via e-mail at Mr. Williams is associated with the BYU Center for Entrepreneurship. He can be reached via e-mail at cfe@byu.edu. .