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Speculative Profit Fetishism in the Age of Finance Capital

Dan Krier Iowa State University, USA

Abstract This article tracks the rise of a new speculative form of ‘profit fetishism’ in the American stock market in the late 20th century as the control of American corporations shifted decisively from production-oriented managers to earning-oriented stockholders. During these years, speculative capitalists made the trading price of corporate stock the primary focus of corporate management. The heightened focus upon stock price coincided with a convergence of stock market actors upon the capitalized earnings model as the primary frame used to value corporate stock, displacing two formerly dominant frames, which focused (respectively) on hard assets and dividend payouts. Despite the notoriously unreliable and unstable nature of speculative accounting with respect to projected future earnings, such accounting profits have become the fetish of an age of speculative finance capital.

Keywords accounting, finance capital, labor, speculation, stock market

Stock Prices and Accounting Fetishism

In 2005 the stock price of Maytag Corporation, one of the USA’s premier industrial corporations, plunged to a low of $9 per share triggering competing takeover offers from a Chinese manufacturer (Haier), a private-equity/hedge fund (Ripplewood Holdings) and a major global competitor, Whirlpool Corporation. Maytag began as a manufacturer of farm implements in Newton, Iowa, and after introducing its first washing machine in 1907 became a pioneering consumer appliance manufacturer, noted for high quality, high profit margins (15% in 1999, the highest in its industry) and remarkably strong brand recognition, partly solidified by its long-standing marketing mascot, the lonely Maytag repairman. Maytag was also noted for high-quality, unionized jobs in at least some of its production facilities. Like many other American industrial corporations,

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Maytag Corporation saw its stock price skyrocket in the 1990s, reaching a high of over $74 per share in the summer of 1999. From this high as an iconic Fortune 500 American manufacturer, Maytag’s fortunes declined rapidly to become a target of bottom-dollar takeover bids.

What triggered the rapid transformation of Maytag? The answer: Maytag’s third- quarter 1999 accounting profit fell short of the consensus ‘earnings estimate’ projections of Wall Street stock analysts. The shortfall was small, a mere seven cents per share (they reported profit of 92 cents a share rather than 99 cents a share as analysts had expected). But the failure to deliver the expected profit sparked a re-evaluation of the stock among financial market operatives, prompting a sell-off that dropped its share price from $74 to $31 per share in a very short period.

The plummeting stock price led to a change in chief executives and several restructur- ing initiatives that included cost-cutting measures, downsizing of employees and a coor- dinated public-opinion campaign placing the blame for Maytag’s troubles upon its unionized workers. Employment at the unionized factory located near its corporate head- quarters in Newton, Iowa was slashed from 2600 employees in 2000 to 1200 in 2005. Maytag’s stock price continued to fall, erasing billions of market value and reaching its $9 per share low in the spring of 2005. The firm was eventually acquired in 2006 by Whirlpool Corporation, for $21 per share. While financiers and insiders profited hand- somely from the takeover ($40 million went to losing bidder Ripplewood Holdings and more than $10 million went to the CEO directly), 2000 salaried and hourly workers at facilities in the town of Maytag’s corporate headquarters lost their jobs as Whirlpool closed these facilities leaving behind a shattered community.

The takeover of Maytag Corporation highlights the vast power of speculation based on future-oriented corporate accounting in present-day capitalism. Actors in this system – stock market analysts, investment bankers, day-traders, union negotiators and much of the general public – have made a speculative fetish of future corporate earnings, as evalu- ated by popular but unreliable accounting methods. Speculative investment in projected corporate value is viewed not only as the hallmark of today’s financialized capitalism, but as the supreme and irreplaceable mover of financial markets and the primary determinant of business fortunes and industrial affairs.

The leading actors in contemporary capitalism repose enormous faith in speculative profit accounting, giving speculative financiers and their allies among managers and accountants untold power to decide the fate of industrial corporations, public policies and communities. The speculative profit quest has largely eclipsed the other professed values of the American polity – democracy, social welfare, economic justice, sustainable communities, living wages, full employment. And even the other main forms of capital- ist profit accounting – which stressed hard corporate assets and actual dividends – have been sacrificed on the altar of hypothetical future earnings.

This article traces the rise of the speculative corporate profit-fetish in US financial mar- kets to its current position of dominance and interprets the significance of accounting profits in comparison to two other determinants of corporate value, assets and dividends.

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The article ends with a consideration of the negative impact that the corporate profit fetish has upon labor.

In the late 20th century, financial speculation in US security markets surged in volume and value, and in combination with escalating corporate mergers, acquisitions and spin- offs, placed enormous pressure upon corporate executives to manage the trading price of their company’s stock (Harrison and Bluestone, 1987; Harvey, 1989, 2005; Krier, 2005; Prechel, 2000). While investors buy and hold income-producing property, speculators quickly buy and sell property in order to capture value from fluctuating trading prices. Speculators’ short time-horizon, combined with an ever-increasing scale of operation, focused attention upon stock prices, since large speculative losses could be generated by declining prices and sometimes huge gains generated by increases. Widespread use of stock-options as executive compensation and intensive speculator activism on corporate boards further solidified corporate fixation upon share prices (Krier, 2005; Useem, 1993). By the end of the 1980s, most large US corporations were run by teams of stock- compensated executives who conspicuously proclaimed their commitment to ‘share- holder value’ – high stock prices (Krier, 2005).

The focus upon shareholder value/stock price turned the attention of corporate manag- ers away from the production of value in industrial processes and toward the creation of fictitious or putative value in financial markets (Harvey, 1989; Krier, 2005). Stock options ensured that American corporate managers took speculative positions in their own corpora- tions, giving them privileged access to market-moving information as well as an unprece- dented capacity to conjure it. The ascendancy of speculative finance in US corporate governance leads to a consideration of the kinds of information that move markets, that lead market operators to re-evaluate the stock price of firms and to a consideration of the scope provided to stock-optioned executives for shrewd manipulation. How did corporate accounting profit emerge as the leading determinant of stock market value?

Even under the best of circumstances, gauging the value of a corporation is difficult, perhaps impossible with any degree of precision. In a general sense, the value of corporate stock or equity securities is determined by the same mechanisms as any other commodity in an auction system. Sellers of securities indicate their intention to sell at an ‘ask’ price (or ‘at market’) and buyers of securities indicate their intention to buy at a ‘bid’ price (or ‘at market’). Security exchanges match buyers and sellers of securities and the resulting sales generate market ‘quotations’ which are widely reported as the ‘value’ of the security. But like participants in all markets, stock traders are faced with the problem of determin- ing whether the current stock market price prices represent the ‘true’ underlying value of the corporation and use a variety of ‘equity valuation models’ to guide their trading.

Three basic models of equity valuation are considered here (see Table 1). The first assigns value to equity securities based upon the value of the ‘assets’ that underlie or back the security (hard-asset model). A second model assigns value to equities in accordance with the dividend pay-out rate or yield of the security (dividend pay-out model). A third model assigns value to equities based upon the discounted value of the future earnings of the firm (capitalized earnings model). Each of these valuation models has been in

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ascendancy at different moments in American financial history and among different sec- tors of the security marketplace (there are still firms today that are valued by the market according to all three models). For example, the ‘hard-asset’ model of equity valuation was the predominant form of equity valuation in the 19th century. It also reappeared in the 1970s and 1980s when financiers realized that high interest rates, inflation and low profits had created a situation where the value of the underlying assets of many corpora- tions, called the ‘break-up value’, exceeded the current market capitalization of the firm as measured by capitalized earnings.

Each model of equity valuation implies different equity price dynamics on American securities markets. The value of securities literally fluctuates for three very different rea- sons depending upon the model of valuation that is relevant: variations in the value of property, plant and equipment; variations in the dividend pay-out rate, variations in earnings and the discount rate.1

Regardless of the valuation model, investors rely upon corporate financial statements to gather information about the determinants of value. The ‘balance sheet’ supplies the relevant information in the first two valuation models: asset and liability values for the hard-asset model and cash balances and other liquid assets for the dividend yield model. Both of these equity valuation models follow the investor monitoring formula of credi- tors: the creditworthiness and liquidity of the firm are the essential features to examine. The third model, which values equities as discounted future profit (capitalized earnings model), relies upon different types of investor monitoring of corporate activity and also requires different kinds of financial accounting information. The critical information to estimate future earnings is presented not on the balance sheet but on the income state- ment since earnings lie at the center of equity valuation in this model.

Each equity valuation model (or valuation frame) is discussed in turn: the hard-asset model, the dividend yield model and the capitalized earnings model. Changes in finan- cial accounting are a particular focus of attention, especially changes in the elaboration of (and attention paid to) the income statement to determine the quantity and quality of corporate earnings as the capitalized earnings model spread in American markets.

Hard-Asset Model

In the late 18th and early 19th century, shares of ‘stock’ or equity securities were sold primarily to fund canals, railroads, turnpikes and insurance companies. These early equity securities were sold by subscription (Roy, 1997). Investors ‘paid in capital’ up to the par or face value of the shares. Fixed assets, in the form of a rail line, a canal, a steamline, were purchased or built by the corporate managers with these funds and dividends were paid out of the revenues from these assets. Equity securities in the early 19th century were primarily valued according to this ‘par value’, an amount stamped on the security equal to the ‘paid in capital’ actually invested in the corporation by the security holder. If an inves- tor paid $100 to a corporation in exchange for a share of $100 par value stock, the value

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of the equity security was held to be equal to $100 since the security was backed by $100 of concrete assets. This hard-asset theory held that upon liquidation of the corporation, sufficient assets would be available to fully cover the par value of the equity shares.2 The hard-asset theory was especially suited to the early ‘public works’ corporations in America that built canals, railroads and mines, and careful double entry bookkeeping was utilized to track the ‘assets’ of the corporation:

Large sums of money were raised by investors at the outset, and spent establishing the infrastructure of the concern. The building stage often took a number of years, and as

Table 1 Overview of equity valuation models

Hard-Asset Model

Dividend Pay-out Model

Capitalized Earnings Model

Valuation formula

Aggregate value of fixed assets (property, plant and equipment) and other assets with clearly discernible ‘hard’ value (cash, receivables)

Value of routine dividend payments adjusted for risk and discounted by prevailing rates of interest on corporate bonds

Value of projected future operating earnings adjusted for risk, volatility and potential growth and discounted by prevailing interest rates

Period when dominant in American capitalism

Early Modern Industrialization, 1750 to 1880

Corporate Revolution (1880 to 1914) and Regulated, Fordist, Monopoly Capitalism (1930 to 1970)

Speculative Bull Markets (Jazz Age, Conglomeration Wave), dominant in de-regulated, neo-liberal, Post-Fordist Capitalism (1970s to 2000s)

Contemporary application

Distressed properties without accounting profits and with negative cash flow; break-up acquisitions; real-estate companies; construction firms

Utility companies, especially regulated public utilities; dramatic 2002 reduction of dividend taxes has boosted dividend pay-outs and application of this model

Dominant equity valuation model

Corporate and analyst focus upon

Completion of construction projects (canals, railroads, turnpikes) and maintaining asset values

Cash flow to pay routine dividends and sufficient profit to sustain them

Accounting profit

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the canal was the only tangible evidence of how capital raised had been applied, it was natural that a statement, called the ‘capital account’ should be used … a stewardship document designed to provide a history of all the past dealings with capital raised. (Baskin and Miranti, 1997: 163)

The capital account was closed upon completion of the canal. With railroads, the capital account was never closed, since the lines required ongoing capital expenditures.

In this model, the firm’s assets covered the ‘par value’ of all securities, equities and bonds of the firm. Both bonds and equity shares were considered to be ‘asset backed’ securities. In the 19th century, investors and business analysts often described a firm as ‘fully capitalized’ or ‘over-capitalized’ depending upon whether the par value of outstand- ing securities exceeded the value of the underlying assets. A fully capitalized firm pos- sessed assets just sufficient to cover the outstanding balance of bond debt and stock at par value. An over-capitalized firm lacked sufficient assets to cover its securities at face value. Financial markets apparently valued securities so that the trading price was sup- ported by fixed assets of the corporation. This notion was still current at the beginning of the 20th century (Veblen, 1904) and it is still in use today, though employed only under special conditions, when this model generates a higher valuation than others.

A resurgent application of the hard-asset model occurred in the late 20th century dur- ing the period of high inflation and interest / low profits of the 1970s and early 1980s. The discounted present value of future earnings of many firms were quite low, because the ‘discount rate’ was so high and the earnings so low. Under this situation, firms often had a higher ‘break-up’ value if their underlying assets were sold. Currently, the hard- asset model of value is used by investors who specialize in ‘distress’ situations when companies are seriously unprofitable yet have high asset values.3

Dividend Yield Model: Stock Price Determined by Cash Payments

Many early (and a significant number of current) investors valued stocks in the same manner as bonds, which have value only because they produce a ‘yield’ in the form of steady, relatively risk-free returns in the form of reliable, fixed interest payments. The recognition that many investors preferred bond-like routine payments led to the develop- ment in the early 20th century of ‘preferred stock’ that were designed and marketed to provide investors with routine, fixed dividend payments that mimicked the interest pay- outs from bonds. Managers favored preferred stocks over bonds in some cases because the dividend payments on preferred stock could be suspended at management’s discretion while debt payments could not, providing managers with greater cash-flow flexibility.

Through the early 20th century, stock markets were dominated by the dividend yield model, which meant that investors viewed stocks as quasi-bonds and expected relatively fixed, stable returns from their investments (Baskin and Miranti, 1997: 181). Distinctions between bonds and stock remained unclear in the mind of the investing public, and

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investors thought of the value of their stock as a function of the ‘dividend yield’ that it produced.

In the early 20th century, both preferred stocks and common stocks were frequently valued as a function of the dividend yield from the stock. Writings in this period indicate that bonds and stocks were valued with parallel models: ‘A common-stock investor was likely to consider himself as in no very different position from that of a purchaser of second-grade bonds,’ Graham and Dodd explained. ‘Essentially his venture amounted to sacrificing a certain degree of safety in return of larger income’ (1934: 305).

Investors clung to dividends as a basis of equity valuation in part because accounting rules and regulator reporting requirements for earnings were unreliable and undeveloped. Though investors wished to see indication of actual earnings in financial statements to support asset values or dividends, earnings reporting remained secondary to dividend streams through the early 20th century (Graham and Dodd, 1934). Since investors paid such close attention to the dividend yield, corporate managers were under pressure to ensure that routine dividends were paid sufficient to satisfy shareholders.4

The immature state of earnings accounting practices allowed managers of corpora- tions to manipulate financial reports. Investors remained satisfied so long as routine dividends were paid and were not focused upon accurate periodic statements of earnings. It was common practice among railroad companies in the 19th century to ‘smooth’ or manage earnings by increasing reported expenses when revenues were high and to reduce them when revenues were low (Baskin and Miranti, 1997: 189).5

Managers under the dividend pay-out model have an unwritten obligation, then, to provide steady dividends from quarter to quarter. Investors purchase equity shares to receive returns equal to bonds: the dividends serve as a proxy for interest payments. To investors and managers who value equities according to this model, the dividend rate of the firm is more important than the earnings of the firm for determining the value of equity securities. The careful attention paid to the dividend policies by corporate management honors this valuation model. The payment of dividends depends upon the availability of cash, observable on the balance sheet of the firm, and not upon immediate profits. Indeed, some firms (utility corporations in particular) did and still do maintain steady dividends even while their earnings fluctuate widely to maintain consistent pricing of their dividend-valued equity securities from period to period.

Speculative Profit Fetishism: Capitalized Earnings Valuation

A decisive development of 20th century American capitalism was the increasing domi- nance of the capitalized earnings model of equity valuation (Baskin and Miranti, 1997; Brown, 1971; Graham and Dodd, 1934; Krier, 2005; Veblen, 1904, 1922). This valua- tion model has determined major swings in equity prices and has contributed to the fetishization of accounting profit in recent times. Estimation of corporate stock value is fundamentally linked to estimation of corporate profits.

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Corporate managers in the late 20th century influenced markets not primarily by reporting altered asset values or by raising the dividend pay-out rate (though both were still frequently done) but rather by altering the profits reported by the firm and by raising expectations for future profits. The manipulation of accounting profits to boost stock price is a primary motivation for business reorganization. Corporate restructuring pro- vided an important mechanism for the manipulation of reported profits and was an important tool for speculative management in the late 20th century.

The development of the ‘capitalized earnings’ model of equity valuation was a momentous event that radically affected American capitalism.6 Unlike the other two valuation models, the value of an equity security in terms of ‘future earning power’ is nearly limitless. Currently, the highest valued large firms can be valued at more than 400 times their annual earnings. As long as the market believes that earnings will grow in the future, the value can rise without any easily defined limit. The value of equities under the other two valuation models is more limited and exhibits a definite ceiling. The development, implementation and diffusion of this model had a profound impact on financial accounting: the rise of the income statement as the focus of corporate reporting. The income statement of American corporations (other- wise known as the profit and loss statement, the P & L, or the earnings report) became the most widely used and useful accounting document in the late 20th century.

But this was not always the case. For most of the long history of capitalist develop- ment, the primary accounting document used to control capitalist production and monitor firms was the balance sheet. The balance sheet is an adequate accounting docu- ment in financial systems dominated by debt financing. As we have already discussed, the value of debentures is not a direct function of earnings but is instead determined by the financial condition or solvency of the firm. Firms with many liquid assets and high cash balances can sustain years of losses without damaging the value of bonds as long as there is sufficient liquidity to make debt payments. In general, the differential value of the bonds of various corporations is a function of their probability of loan default. Companies with high debt ratings are viewed to be in stronger financial condition than are firms with low ratings. On secondary security markets, bonds of corporations with low debt ratings trade at a lower price (a discount) to the bonds of higher-rated, more solvent firms.

The balance sheet is a financial accounting document that owes its form to double entry bookkeeping.7 The balance sheet is simply a snapshot picture of the accounts or double entry ledger of the firm. Its basic outline follows the formula: Assets - Liabilities = Capital (or equity or ownership interest). In its presentation, the assets of the firm are identified, classified, enumerated and valued. Liabilities are also identified, classified, given a value and offset against assets. The ‘balance’ between the two sides of the ledger represents the ‘capital’ or ‘owner’s equity’ of the firm.

The development of double entry bookkeeping accelerated with the growth of corpo- rations, and was first broadly linked to the joint-stock form in the canal companies in the late 18th and early 19th centuries. For most early American industrial firms, accounting rules and procedures designed to provide an accurate balance sheet did not often generate useable profit figures, as indicated in the following description:

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During the seventeenth and eighteenth centuries businessmen adopted double entry bookkeeping mainly as a means of providing a more effective memory aid and mechanism for financial control. Because the calculation of profit was rarely the reason for installing a system of bookkeeping, the numbers generated were often of poor quality. (Edwards, 1989: 89)

In Britain and America in the 19th century, the balance sheet alone constituted a complete set of accounts. The 1862 Companies Act in Britain required that auditors review and provide an opinion on corporate balance sheets but not on any other financial document. The balance sheet was used in the 19th century as the sole document for external financial reporting and it served the interests of many external users of financial information.

External parties with an interest in the firm (bondholders, investment bankers, gov- ernment agents, creditors, and stockholders receiving dividend income from the firm) cared most about the financial condition of the corporation. The primary contingency was that the firm would go bankrupt and the investment would be lost. The balance sheet answered the questions most pressing to external investors: Are there sufficient assets backing the liabilities of the firm? Is there sufficient cash to pay dividends/interest? Is the firm solvent? The balance sheet is the most important tool for external users of financial statements. Bondholders were primarily interested in the financial condition of the firm, not its profitability. Even early equity holders wanted to be assured that there were sufficient assets to cover the value of securities if the firm should go into receivership and have to be dissolved. The balance sheet depicting the assets, liabilities and equity of the firm was the most important financial statement.8

The shift toward earnings as the focus of investor valuations required changes in finan- cial accounting as the balance sheet ceased to be the major document of interest to share- holders, supplanted by the earnings statement, or profit and loss statement (Brown, 1971).9 Initially, detailed income statements were developed as a device of managerial cost accounting. As the following remarks by Kroose illustrate, most early industrialists disliked accounting and instead stressed ‘efficiency as measured by the volume of output … They generally did not believe in evaluating a business on the basis of its earning power’ but, rather, concretely:

Usually starting on a small scale, he raised most of his capital by plowing earnings back into his business. He despised financial mechanisms, such as balance sheets, income statements, and value based on earnings, and drew no distinction between the stockholder and the speculator. (cited in Brown, 1971: 12)

As the scope of American business increased during the 19th century, industrial firms became too large to manage by such direct, substantive methods. The separation of man- agement from financial interests (either ownership of equity shares or ownership of bonds) also required financial accounting reports to monitor investments. Both of these forces led to the development of a distinct approach to financial accounting.10 The needs

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of management were focused on profitability and control of the production process and these needs were met through the development of the modern ‘income statement’. The needs of external parties with financial interests in the firm were focused on financial soundness and liquidity and these needs were met through the development of the mod- ern ‘balance sheet’. It is interesting that the external needs of financiers were recognized in Britain’s 1862 company law, which required firms to file an annual audited balance sheet, complete with an auditors’ opinion (which was not required in the USA until 1933). The income statement was not viewed as necessary to the evaluation of creditwor- thiness and was not required (Brown, 1971: 14).

The income statement, developed for managerial cost accounting, was completely separated from the balance sheet, developed for financial reporting to external interests.11 The basic outline of the income statement, also known as the profit and loss report, is: Revenues - Expenses = Profit (or earnings). Whereas balance sheets represent a snapshot of the firm at a single point in time, income statements are periodic in nature, represent- ing the earnings of the firm over a yearly period. The development of American cost accounting maintained a singular interest in ‘costs’ and profitability, and hence the ‘income statement’, and was fueled by the development of ‘scientific management’. F.W. Taylor extensively used cost accounting principles and techniques in his efforts to meas- ure and control work processes for profit maximizing efficiency.12 Investors scrutinized the income statements of industrial corporations not so much because they understood them or particularly valued the ‘bottom line’. Rather investors believed that if manage- ment prepared highly detailed cost accounting figures in an income statement it was a signal that management was employing scientific management principles in the opera- tion of the firm. Investors scrutinized the income statement during the era of scientific management (roughly from 1914 to 1929) to ensure that the firm was being scientifically managed, not to determine the ‘net income’ of the firm. Income statements provided investors with the capacity to judge how closely costs were being tracked and minimized. In this way, investors could ensure that a firm’s management was conforming to the prevailing definition of aggressively good management.13

The rise of retail equity investing and the popularization of the capitalized earnings model during the Jazz Age bull market created a demand for more detailed and accurate earnings accounting (Gilman, 1939: 27–8, cited in Brown, 1971: 49). Stockholders and speculators were concerned with the expected trend of earnings which would determine the value of their stocks. Though stockholders still received dividends, investors increas- ingly purchased equity securities to benefit from rapid, speculative capital appreciation. The best speculative stocks – those with the most rapidly escalating values – were ‘growth stocks’ that were expected to produce high future earnings. Growth stocks commanded high market valuations because of the anticipation of increased future earnings. While leading blue chip industrial stocks might be valued at about 10 times annual earnings, rapidly growing companies might sell for 20 to 30 times earnings: ‘Thirty times 1928 earnings would be ten times 1931 earnings – and equivalent to one or two times 1937 earnings! Surely such a stock deserved a higher price’ (Sobel, 1968: 355).

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The apostle of the capitalized earnings model was Benjamin Graham, who, with Dodd (1934), systematized the New Era Theory of stock value that apparently prevailed on 1920s secondary equity markets. During the 1920s, the public became acclimatized to the investment merits of common stocks and the capitalized earnings model became the most important indicator of security values.

The new theory or principle may be summed up in the sentence: ‘The value of a common stock depends entirely upon what it will earn in the future.’ From this dictum the following corollaries were drawn: 1. That the dividend rate should have slight bearing upon the value. 2. That since no relationship apparently existed between assets and earning power, the asset value was entirely devoid of importance. 3. That past earnings were significant only to the extent that they indicated what changes in the earnings were likely to take place in the future. (Graham and Dodd, 1934: 307)

Graham and Dodd emphasize that this shift occurred gradually and without awareness of any sharp moment when these new valuation standards were adopted by the investing public. They further distinguish between the investing public and speculators, arguing that it was during the period of the great bull market that common stocks became ‘valued’ by investors using these rules. Graham and Dodd ultimately point to the great disruptions and consolidations that occurred after the turn of the century that ultimately made valuing securities according to the old rules fruitless:

Past earnings and dividends could no longer be considered, in themselves, an index of future earnings and dividends. Furthermore, these future earnings showed no tendency whatever to be controlled by the amount of the actual investment in the business – the asset values – but instead depended entirely upon a favorable industrial position and upon capable or fortunate managerial policies. In numerous cases of receivership, the current assets dwindled and the fixed assets proved almost worthless … less and less attention came to be paid either by financial writers or by the general public to the formerly important question of ‘net worth’, or ‘book value’, and it may be said that by 1929 book value had practically disappeared as an element in determining the attractiveness of a security issue. It is a significant confirmation of this point that ‘watered stock’, once so burning an issue, is now a forgotten phrase. (1934: 308)

In the early decades of the 20th century, the popularization of stock ownership and stock market speculation shifted managerial attention almost exclusively to the ‘trend of earnings’. Hailing a ‘New Era’ of capitalism, retail investors plunged into the market focused upon earnings as the indicator of stock value. In the wake of the 1929 stock mar- ket crash, investors were assured that corporations that could produce earnings would be safe from liquidation in market panics and crashes. Investors were encouraged to buy and hold corporate stocks with rising earnings in order to eventually capture speculative gains. Graham and Dodd note that these principles ‘abolished the fundamental distinctions

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between investment and speculation’ and that they ‘ignored the price of a stock in deter- mining whether it was a desirable purchase’ (1934: 309).

On this basis there arose a devout belief in unchecked speculation and an incredible incentive for accounting maneuvering to show a trend of rising earnings. Stocks were ‘regarded as attractive irrespective of their prices’, since their earnings, and the price of the stock, would continue to increase, an idea propounded in popular books, like Edgar Lawrence Smith’s Common Stocks as Long-Term Investments (1924).

New investors bought and sold securities according to the capitalized earnings model, yet found that obtaining high quality corporate earnings information was very difficult. The accounting profession in America (and elsewhere) had traditionally focused upon providing high quality balance sheets. The capitalized earnings model of equity value required high quality income statements. The accounting profession’s income and expense reporting rules were rudimentary when compared to rules that guided the reporting of assets and liabilities, a focus of frequent criticism in the wake of the 1929 market crash. During the 1930s, more adequate rules for the determination and report- ing of income were developed by the accounting profession.

Though the capitalized earnings model was already employed in American equity markets at the turn of the century – Veblen’s analysis of watered stock dates from 1904 – good quality profit and loss statements were not widely available until the 1930s. Despite the growing significance of capitalized earnings as a frame of speculative activity in the late 19th and early 20th centuries, investors were basing their decisions upon unreliable, discretionary and some- times fictitious accounting data. Though stock prices would rise in anticipation of future earnings, these earnings were often a mere un-audited, unverifiable representation of corpo- rate management. Indeed, many firms traded on major exchanges did not provide investors with any income statements in their financial report (Ripley, 1927).

Early financial statements were not aimed at the determination of profitability. Profit and loss accounting was performed almost strictly on a cash basis until well into the 20th century, with only a few leading 19th century corporations deploying such basic income- statement accounting techniques as depreciation of assets.14 Early accounting methods hindered the determination of income for all of the following reasons: cash-basis account- ing, manipulation of the timing of reported revenues and expenses, inconsistent application of accounting principles across firms and across time periods, the reporting of unrealized gains on appreciated assets that had not yet been sold, and discretionary reporting of income to manipulate investors to the benefit of management (Edwards, 1989: 89).

Until the 1930s, profit measurement was not a central task of American financial accounting. Profit accounting became more important during the Fordist period and in the late 20th century became the dominant focus of financial accountants and the agen- cies which regulate them. Though they will not be reviewed here, it is important to note that the majority of new accounting principles and rules enacted since 1973 have focused upon accounting for corporate profit. Rules have been enacted to control the content of profit, the timing of transactions and accruals that impact profit and the appropriate levels of management power to manipulate profit (Krier, 2005).

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Pensions, Speculative Management, and Speculative Accounting

The profit fetish was not abandoned in the wake of the accounting scandals of the early 2000s. Instead, regulatory and cultural reaction to the scandals focused upon the restora- tion of confidence in the profit fetish by instituting various make-do reforms in the accounting system, most prominently those contained in the Sarbanes-Oxley Act. While some accounting techniques that were utilized for strategic advantage before Enron have been extinguished, others have remained intact and some new opportunities for manipu- lating the bottom line have emerged. The complexity of modern corporations – especially their multi-layered subsidiary form (Prechel, 2000) – makes it impossible for all flexibility and discretion to be removed from the system.

In general, complicated firms – those with multiple subsidiaries, complex multi- layered legal structures, and highly diverse businesses – have more opaque accounting than simple firms. The largest conglomerate firms (such as GE or Berkshire Hathaway) are so diverse, complicated and opaque that outsiders are unable to arrive at a detailed or comprehensive understanding of the firm by perusing its financial statements. Such large firms overwhelm analysts who are forced to rely upon summary or aggregate accounting figures and management discourse to project the future earnings and appropriate trading value of the firm’s securities. In such a scenario, corporations deploy ‘celebrity’ CEOs who carefully court and manage relationships with stock mar- ket operatives, such as GE’s Jack Welch. Though the details of its operations were hidden from view, GE carefully massaged its earnings so that they were always steadily improving, always slightly higher than the previous quarter’s earnings. This track record – extended for perhaps 20 years – of quarter after quarter improvement of earn- ings (smoothing) made GE a highly desirable stock because its low earnings volatility combined with steady growth gave it a maximum earnings multiple by the formula used by analysts. The actual operations of General Electric remained diverse and opaque and analysts have few ways of verifying the source of these steadily growing reported earnings.

In speculative capitalism, the ‘bottom line’ – a corporation’s accounting ‘operat- ing’ profits – and the trend of profits over time determine the trading value of cor- porate stock. Even after the Sarbanes-Oxley reforms, accounting profit remains subject to management discretion and strategic control. Accounting procedures and principles constrain, but do not entirely control, the professional judgments and deeply-layered decisions that determine final accounting profit. The final value of accounts is often a political decision arrived at by auditors and corporate manage- ment based upon a balance of risks that would follow from understating an account versus risks that follow from overstating accounts.15 As the Maytag case illustrates, accounting scandals have become more prominent and consequential because of the potential damage that follows upon the release of accounting results that fail to meet analysts’ expectations.

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Speculative Profit Fetishism: The Impact on Labor

Corporate financial reports are not only used to guide speculative activity on financial markets, they are also used to guide labor contract negotiations. As the capitalized earn- ings model of equity valuation has become dominant in recent decades, accounting rule- making developed to reign in aggressive, results-oriented earnings manipulation. Accounting reforms have sought to protect shareholders, not workers, from the machina- tions of management. But financial accounting data remain ‘at play’ in many labor dis- putes. Corporate management points to low profits and declining asset values to claim that they lack an ‘ability to pay’ the wages and benefits of workers, and use these data to justify severe labor policies, including layoffs, outsourcing, wage cuts, health care reduc- tions and pension plan terminations. How do accounting profits, shaped within the framework of the capitalized earnings model and profit fetishization, impact labor? How does management benefit when accounting profits, derived under profit fetishist rules, are used as objective measures of corporate value in labor disputes?

First, the entire apparatus of accounting regulation, standard setting and enforcement is designed to protect shareholders and creditors, not workers. GAAP (Generally Accepted Accounting Principles) as a law-like series of rules primarily constrains actions that overstate earnings and firm value and encourages ‘conservative accounting principles’ that limit opportunities for overstatement. GAAP does not require economic accuracy, but conformity to rules that almost always understate book value and almost always work to the advantage of management seeking wage and benefit concessions.

Second, the Sarbanes-Oxley Act of 2002 protected shareholders (not unions or workers) by increasing the oversight of accounting maneuvers that falsely overstate firm profitability or share-prices. Creation of fabricated revenues and improper removal of liabilities off the balance sheet are all constrained, but primarily to prevent overstating of firm value. Sarbanes-Oxley requires ‘conservative accounting principles’ that systematically overstate expenses and under- state book value. This means that since 2002 financial reporting has become more conservative, meaning that accountants remain within GAAP and auditors within GAAS (Generally Accepted Auditing Standards) while significantly understating corporate ‘ability to pay’.

Third, many analysts substitute a figure labeled EBITDA (short for operating ‘earnings before interest, taxes, depreciation and amortization’) as an improved measure of corpo- rate ability to pay. This figure is considered preferable to net income because it is less subject to managerial manipulation than the bottom line. EBITDA is a rough indicator of the cash generated by the operations of a firm since it excludes non-recurring expenses, some non-cash expenses (depreciation and amortization) and disbursements to finance capital and government. But EBITDA is still subject to numerous subjective and discre- tionary management decisions and can be significantly manipulated, both positively (by leaving off executive stock-option expense) and negatively (by adopting aggressive write- offs or conservative inventory and revenue practices).

Finally, since stock market analysts project corporate stock values based upon operat- ing, or recurring, earnings, they tend to ignore ‘one-time’ or ‘non-recurring’ charges. During the 1980s and 1990s, expenses for corporate restructuring charges lowered

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reported earnings (and ‘ability to pay’) while often boosting share prices (because future earnings projections were improved). One important study (DeAngelo and DeAngelo, 1991) found that restructuring charges were timed to coincide with wage and benefit concession requests. Such concessions are often highlighted in corporate reports to share- holders, in annual reports to shareholders and in press releases.

The capitalized earnings model makes a fetish of projected future accounting profits and is sophisticated enough to discount one-time, unusual or non-recurring charges against earnings or ‘retained earnings’. These charges boost projections of future operating earnings (which pleases shareholders and raises the stock price) while reducing management claims of ability to pay labor wages and benefits (which further pleases shareholders and raises stock prices).

Speculative Profit Fetishism: Managing to Maximize Capitalized Earnings

This article traces the emergence of speculative profit fetishism. Corporations, controlled by teams of stock-optioned executives, manage the financial statements of corporations to maximize stock prices on financial markets that utilize a capitalized earnings model to guide trading. In earlier periods, stock prices responded to fluctuations in the value of the under- lying assets of the firm or the dividend pay-out rate of the firm. In these earlier times, stocks were valued similar to bonds and were maximized by solid creditworthiness: high cash bal- ances, good liquidity positions, substantial reserves, steady cash flow, etc. Under the capital- ized earnings model, a stock’s value is maximized by high earnings: the higher the expected future earnings, the higher the value. Corporations managed to support a high credit rating (maintaining a large supply of ready cash) yet suffered reduced earnings and ‘undervalued’ stock prices. They also managed to support high stock prices, maximizing short-term accounting earnings (using financial leverage, for example) through techniques that often undermine the long-term viability of the firm. Few of the management practices that maximize short-term earnings are favorable to workers or their unions.

Speculative Profits, Actual Losses

The unique dynamic of recent American capitalism results from the speculative profit fetish- ism and the capitalized earnings valuation that supports it. Equity securities are the domi- nant financial vehicle in America and they are predominantly valued in terms of discounted future earnings. Managers of corporations in the late 20th century had powerful incentives to control firms so as to maximize the value of equity securities that were valued in terms of capitalized earnings. American corporations are singularly focused on controlling external investors’ assessments of future profitability which has led to a tremendous amount of sacrifice at the altar of corporate profit: jobs, plant-closings, community decay, and the conversion of pension-funds. In neo-liberal speculative capitalism, tremendous social power is attributed to the fetish of corporate profit.

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As we saw at the start, Maytag’s troubles – which were felt most acutely by Maytag workers – were triggered by an infinitesimal shortfall in reported accounting profit. This is similar in principal to other troubles which befell the United Auto Workers in recent years, when General Motors, Ford, Chrysler and Delphi seized upon accounting woes as a rationale for scaling back wages and eliminating ‘post-retirement employment benefits’ (or, at the very least, containing benefits enough to eliminate fluctuating values on their balance sheets with requisite ‘mark to market’ hits on their income statements). The busi- ness press has reported this as a finance-driven measure – and indeed, the mark-to-market accounting initiative was partly driven by the rising use of derivatives which have large swings in value that often go unreported.

Post-retirement benefits – especially pensions – have been raided by corporations in the past decade too through the use of cash-balance accounting techniques that enabled corporations to harvest excess funds in pension accounts as profit. Now, under-funded or unfunded pension liabilities and liabilities for post-retirement health care benefits are the focus of increasing scrutiny, since the upside of the health care benefits is so great. Eliminating the uncertainty of health care benefits is a prime concern, which means forc- ing retirees to cover a larger share of the benefits in the future.

In other words, to secure the hypothetical future of capital earning projections, specu- lators and their boardroom allies have shown themselves willing to sacrifice the immedi- ate and long-term future of the workers whose labor has carried them this far. That, I would argue, is accounting fetishism with a vengeance.

Acknowledgements

The author would like to thank David N. Smith, Mark P. Worrell, Jack Weller and the anonymous reviewers for constructive comments on this article.

Notes

1 Financial analysts and academic courses in corporate finance deploy various methods useful for the valuation of corporate securities, which are far more advanced than the three broad models I depict here. However, I do believe that these three models reflect the center of the most important forms of valuation actually employed on American equity markets.

2 Early joint-stock corporations did not ‘float’ securities on mass financial security markets but rather found ‘subscribers’ to the company who would ‘pay-in’ money in installments over the period of asset construction up to the amount of the ‘par value’ of the security. Since the company used the funds to build a canal, a railroad, a turnpike or a mine, the ‘par value’ of the security would be fixed in concrete assets of the corporation. A holder of a $100 par value share owns $100 of the fixed assets of the corporation: the security is ‘backed’ by assets equal to the par value. The hard-asset model of equity valuation was still predominant in Veblen’s time. His writings about the problem of ‘watered stock’ and ‘fictitious capitalization’ are based upon a hard-asset understanding of equity

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valuation. It should be noted that Marx’s view of the appropriate value of financial securities was essentially a hard asset model and that trading values for corporate securities in excess of underlying values was considered ‘fictitious’. For clarification, see Harvey (1982). Weber was aware of the dis- counting function of modern financial markets and recognized that securities were increasingly valued according to a discounted present value formula.

3 Speculative management is still possible even when equities are valued in terms of the underlying assets. Ripley (1927) notes that investors in asset-backed securities viewed the balance sheet as a sort of ‘representation of values’ of assets and liabilities. Knowing this, managers would write-up the value of assets. A speculative manager in this period would not manipulate income numbers but rather would record appreciation in the value of underlying assets. Increases in values of land, of fixed assets, of long-term equipment, were recorded in the balance sheet and increased the imputed value of the firm.

4 Since dividends ultimately had to be paid out of earnings (required by law early in the 20th cen- tury), a firm had to report sufficient earnings in order to pay dividends. One can imagine that the incentive for management to manipulate earnings was not wholly absent even in this early period. Financial statement management in the 19th century was an important predecessor to contempo- rary income statement management. The dividend-hungry shareholder of railroad securities in the 19th century created incentives for managers to manipulate the books, since even at this time divi- dends could only be paid out of profits. ‘The crux of the problem was that, although profitability was sensitive to changing economic conditions, managers believed that their shareholders required a steady dividend. This led some of them to employ valuation procedures designed principally to produce a pattern of reported profit sufficient to cover the planned level of dividend. The aim was profit smoothing on a large scale’ (Edwards, 1989: 117).

5 The requirement that dividends be paid out of earnings was an important factor in the development of income statements as accounting documents. A mechanism had to be put into place to ascertain that sufficient earnings are generated to warrant dividends. This may also have been one of the reasons why managers did not develop detailed external profit and loss statements in the 19th century, for accurately measured low earnings may have constrained their routine dividend payments. The require- ment that dividends must be paid out of earnings provided a motive to accurately define earnings.

6 The only major economic sociologist who clearly understood the importance of capitalized earnings for American capitalism was Thorstein Veblen (1904, 1922), though Weber understood much of the dynamic and Marx and Hilferding also saw the existence (but missed the significance) of capital- ized earnings (see Harvey, 1982).

7 Both Weber and Sombart recognized the crucial role played by double entry in the development of modern Western capitalism. Sombart wrote: ‘it is hard to imagine capitalism without double entry bookkeeping: they belong together like form and content’ (Sombart, cited in Edwards, 1989: 60). Sombart believed that double entry bookkeeping was essential to capitalism because it ‘endows the economic world with accuracy, knowledge and system … By facilitating the identification of profit and capital, and demonstrating the link between them, double entry focused attention on the potential of business for maximizing income instead of just providing a living’ (Edwards, 1989: 60). My discussion points out that it is not double entry bookkeeping per se but rather the development of high quality income statements that was necessary to capitalist income maximizing.

8 Even from the standpoint of government taxation, the primary form of taxation was a tax on prop- erty and tariffs and duties. The balance sheet of the firm was more useful in assessing both of these forms of government revenue than the income statement would have been. So long as taxes are attached to property rather than earnings, the balance sheet is more useful.

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9 Some of the standard treatments of accounting history, such as the textbook by John Richard Edwards (1989) A History of Financial Accounting, stretch the time period out so far (back to Greek and Roman times) that they are not useful for understanding accounting issues in corporate restruc- turing. I have relied heavily on the excellent research monograph by Brown (1971) that covers the rise of income statement reporting as a necessary adjunct to equity investing in America.

10 The distinction I am pointing to here is that between financial accounting and cost accounting, where financial accounting deals with the problem of financial representation – representing the business enterprise to persons outside the firm – whereas internal accounting is utilized to aid in the financial and managerial control of the firm. One is a tool of creditors, government and investors; the other is a tool of management.

11 It was not until the late 19th century that accountants worked out a system to integrate the two balance sheets and income statements into a single unified report. ‘Cost accounting, as a science, is a branch of general accounting … With the cost books once established, the best modern usage is to incorporate their record in total in the general financial books. In this way the modern cost system builds up an interworking series of accounts which furnish the basis for a detailed study of the opera- tions of a manufacturing business’ (Nicholson and Rohrback, 1919: 5, cited in Brown, 1971: 16).

12 Taylor is often depicted as maximizing technical, operational efficiency, but it is important to rec- ognize the ‘financial’ side of his efforts. Taylor focused less upon financial efficiency than did some of his acolytes, especially the Gilbreths, who were driven not just to be technically efficient in pro- duction but to be financially efficient – to maximize profits. Hence the full range of cost accounting data was important in this perspective.

13 Sociologists have paid considerable attention to the scientific management movement and have noted how cost accounting and statistical controls were used to reorganize work and maximize efficiency. Little attention has been paid to the emergence during this period of ‘scientific investing’ or ‘the science of finance’ to use the phrase chosen by Veblen for Cohn’s textbook. The whole com- plicated apparatus of technical investment decision making and investment monitoring, ratio analysis, etc. emerged during the same period as scientific management and relied upon the same accounting data.

14 Early financial statements were nearly useless for the accurate determination of income or to use as a management gauge to maximize profits. Indeed, before the development of late 19th century cost accounting techniques it was ‘unlikely that annual income statements were of use for the purpose of testing the profitability of operations as a whole as a guide to future action’ (Brown, 1971: 10).

15 In speculative capitalism, the failure to take full advantage of accounting flexibility in order to present the best ‘front’ to markets as possible is considered a failure of management. The risk of understating is a risk of low market evaluation, which is not only foregone profit but also places the continued occupancy of the control team at risk. If a management team fails to maximize reported earnings in an environment where all else do, they may be forced out by ‘owners’ on control teams and replaced with new team members who will.

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For correspondence: Dan Krier, Iowa State University, Department of Sociology, 103 East Hall, Ames, IA, USA 50010. Email: [email protected]