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Ethics and Maximizing Profit A Practical

Approach
by Paul J. Updike
INTRODUCTION
Most people realize there may be conflicts that exist due to a firms
desire to maximize profits yet still fulfill its ethical obligations. I will
demonstrate in this article that it is possible, in fact, it is necessary to
behave ethically while focusing on maximizing a firms profit. But such
behavior necessitates understanding the difference between a firms
short-term profit and a firms long-term viability.
Ethics, the noun, is defined by Websters unabridged dictionary as
the study of standards of conduct and moral judgment. Ethical, the
adverb, is defined by Webster as conforming to the standards of
conduct of a given profession. In my opinion, whether the people in a
firm act ethically is perhaps even more important than whether the
firm is profitable, in the short-term. We will explore several business
situations that different people responded to differently and attempt to
find a working definition of ethics, as opposed to a textbook
definition of ethics.
We also need to explore and explain what the phrase focused on
profits means. We know that as a public firm makes increasing
amounts of profit, the price or value of its stock tends to increase as
well. Because many of the executives of todays firms receive a
significant portion of their compensation from stock options, if the
value of the firms stock increases, then the value of those executives
compensation also increases. If the value of the firm is also
increasing, then shareholders like the fact that the value of the stock is
rising too. However, when the value of the stock increases,
disconnected from a long-term appreciation in the value of the firm,
then that reality can be the source of an ethical dilemma.
Since economic theory assumes that investors are rational, we
assume that every investor wants the price/value of their stock to rise
over time. This also means that capital investors expect that the
professional managers running public corporations, which are owned
by investor/shareholders, are likewise maximizing profits. However, in
order for a firm to actually maximize profits, that firm must ensure its
long-term viability. My contention is that ethical behavior actually
enhances a firms long-term viability.
A Typical Business Scenario
For most of the first 40 years of my life I was consumed by
numismatics. Not only did I spend an inordinate amount of time in the
world of coins, I also spent an inordinate amount of money. From age
10 to age 40, I spent tens of thousands of dollars buying and selling
coins.
A coins value is determined by a coins grade and its rarity. Whether
the coin is rare or not is usually an objective judgment. But a specific
coins exact grade is a subjective judgment, subject to the anecdote
that a dishonest coin dealer buys a coin at a lower grade than he sells
that same coin. Coins in a high grade might be 100 times more
valuable than the same coin (assuming same denomination, same
date and same mint mark) in a low grade. Expertise in grading takes
years to learn. I have spent thousands of hours carefully looking at
tens of thousands of different coins and I am only an informed
amateur.

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When I was younger, I worked for a coin dealer friend, Don McConkie,
who related to me the following story. Don was in another coin
dealers store when a woman walked into that store with a roll of fifty
uncirculated, same date and same mint mark dimes. Upon further
conversation, the lady revealed that the death of a progenitor allowed
her to come into possession of these coins. These dimes were quite
rare and in exceptional condition. The dealer (who was an expert
grader) acted moderately interested in the coins and offered the lady
$250 dollars ($5 for each dime) for the entire roll and the lady was
excited to make the trade.
Ethical Choices
Yet, any one of those dimes, individually, would have easily fetched
$250 apiece at that current point in time. Did the coin dealer who
made this exchange have an ethical obligation to tell the lady how rare
and how valuable the dimes actually were?
The simple answer is yes, the coin dealer bore an ethical obligation to
explain to the lady that she possessed something rare and valuable.
Ethical behavior requires that the expert share information with the
untrained such that any future business transaction between the two
can happen at arms length. In the coin world, if two people agree
about the exact date, mint mark and condition of a coin, (therefore
they both know the approximate value) then they can negotiate an
appropriate price.
The coin dealer carried the ethical obligation to tell the owner of the
rare dimes something similar to the following: These dimes have a
street value between $10,000 and $12,500. I typically buy at around
60% of retail value which might be $6,000 or $7,000 for the entire roll.
But 50 coins of the same date and condition might sit in my inventory
for several years. Therefore, I could offer you $5,000 for the whole lot
today. But he did not say these words, or anything like them.
In my three decades negotiating the world of coins, I only met two
ethical coin dealers that I could trust, (one of whom was Don
McConkie, noted above) though I dealt with literally hundreds and
hundreds of coin dealers. I know that I only met two ethical dealers,
because I tested them. These two dealers are people who graded and
offered me a similar price for the same lots of coins separated by
many months. Both these dealers were focused on profits, but neither
one ignored his ethical obligations. Because we are talking about
maximizing profit, it is important to note that both these coin dealers
retired from the coin world after lengthy careers.
Can a Firm Choose to be Ethical?
When I was asked by the Vice President of a national firm about the
ethical behavior of the General Manager of my plant, I did not flinch. I
told him exactly what happened. The General Manager was fired
shortly after my conversation with the GMs boss.
The VP then promoted the Sales Manager of my division to GM and
the new GM and I (as Controller) had a thoughtful conversation. We
committed to each other to focus on profits. We also decided that
whenever a situation arose where our honesty and integrity were
challenged, obviously or not, we would choose to behave ethically,
whether or not that specific behavior would enhance our profits at the
time.
The answer to the question, How does one behave in an ethical
manner? especially if such behavior costs oneself or ones firm real
profit, is simply to decide beforehand how one will act under any
circumstance. If one waits until the situation arises, with that
situations attendant pressures and deadlines, one may not act the
way that they had hoped they would. Only if one decides now to act in

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an ethical manner in any and all future business transactions that they
are party to in the future, can one hope to act in an ethical manner
when a new situation, with its attendant pressures, arises. Also, as an
MBA professor once suggested to me, always have three job offers in
your pocket, just in case the current one does not pan out.
Different Incentives Often Mean Different Results
A firm is simply an amalgamation of people. If the corporate culture
expects ethical behavior, then it is reasonable to expect ethical
behavior from each person in the firm. But more than a few corporate
cultures have allowed and even rewarded unethical behavior in the
last few years. Why?
GE
In December 2001, Jeffrey Immelt, the new chairman of the ultrasuccessful (as measured by market capitalization) public corporation
GE, told assembled analysts We give investors a chance to sleep at
night knowing that [we are] going to outperform the S & P
500. (Fortune, 11/11/02)
On the one hand, perhaps Immelt said these words to set the
performance bar higher for his employees than the level at which
employees from an ordinary company might perform. On the other
hand, and the next year of revelations from GE bears this likelihood
out, Immelt also perhaps allowed for continued questionable behavior
by his employees. (Fortune, 11/11/02, p108-117) In fact, during his
first five years at the helm as GE CEO, the value of GE stock has only
moved mostly sideways.
One economist makes the following observation about corporations.
Why is the question of who controls a firm important? Because
economic theory assumes the goal of business owners is to maximize
profits, which would be true of corporations if stockholders made the
decisions. [However] managers dont have the same incentive to
maximize profits that owners do. (Colander, Macroeconomics, 4th
Edition, p60)
The manager of a corporation has the incentive to maximize his or her
own gain, not the corporations. If the corporations goals and the
corporate managers goals coincide, then corporate profit-maximizing
may happen. However, currently, the corporate managers concern,
since government regulations require profit disclosure of public
corporations on a quarterly basis, is that the managers appear to have
the corporate shareholders interest foremost in their mind. Thus we
have an inordinate concern among corporate executives to report
ever-increasing profit each quarter. This pressure creates an ethical
crisis waiting to happen.
Jack Welch
After Jack Welch, the prior Chairman and CEO of GE, retired, he was
quickly involved in a messy divorce occasioned by his infidelity. His
soon to be ex-wife threatened Welch that if he did not deal with her in
an upfront manner, she would reveal his retirement income and
benefits. Because she decided that he was not being fair, she
revealed to the world that Jack Welch had personally accumulated
retirement perquisites worth tens of millions of dollars a year on top of
the hundreds and hundreds of millions of dollars of wealth Welch had
been paid while running GE.
Remember, a Board of Directors typically has a compensation
committee composed of people who usually pay the CEO whatever he
insists on being paid. At first blush Jack Welchs remuneration
seemed appropriate, because during his 20-year tenure, GE had
grown in market capitalization many, many times. Shortly after
retirement, the market cap of GE tumbled by one half and GE was

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revealed to be another house of cards, a house that Jack (Welch)

built. (Fortune, 11/11/03, P108-117) Did Jack Welch offer to return
any of his ill-gotten gains? What do you think? Did he behave
completely ethically? What do you think?
Ways to Cheat Investors by Spinning
Geoffrey Colvin, of Fortune magazine, has written several columns
over the years about unethical behavior. Colvin points out three ways
public corporations manipulate accounting rules and other regulations,
to appear more profitable (in the short-term) than they really are, by
reporting profits not produced by current operations.
The first way is for public companies to treat their pension fund as a
profit center. Current GAAP rules (in 2002) allow firms with a definedbenefit pension fund invested in the stock market to make an annual
assumption about the percentage return that the fund may earn. If you
change the assumption, then you change the reported profits up or
down, whichever way is needed.
The second way is to set up reserves based on something other than
reality. For instance, most companies have a significant account
receivable balance that they hope to collect. We know that some
percentage of the account receivable (AR) balance will not be
collected. Customers go bankrupt, customers dispute the AR
amounts, some portion is credited back to the customers, etc. In order
to not legitimately overstate the amount of AR that a firm might collect
in the future, GAAP has instituted a contra asset account called
Allowance for Bad Debt. Unethical companies can over-reserve the
Allowance for Bad Debt account in good years, creating a cookie jar
and take from the cookie jar in bad years to smooth reported profits,
an SEC quarterly requirement for public companies.
The third way is to play the guidance game. Stock market analysts
often ask the CEO and CFO of public companies how things are going
along the way, before quarterly results are reported. Depending on the
public statements made about current operations, the CEO and CFO
can shape expectations of their quarterly results, which often have a
dramatic impact on whether the firms stock price moves up or down.
(Colvin, Fortune, 10/28/02, p66)
Who Cares About Stock Price/Value?
Why do corporate executives care about the price/value of the stock?
Because the price/value of the stock is one important signal to
everyone, including investors, of how the market perceives the quality
of current profit and how likely continued profit might be tomorrow. But
the bigger reason that managers care is because corporate
executives often have millions or tens of millions or even hundreds of
millions of dollars in stock options that they can cash in, if they can
manage (in the short-term) to keep the price/value of the stock high
until they sell.
In fact, in the year 2000, just before the stock market bubble burst,
collectively, billions and billions of dollars of value due to stock
appreciation was cashed in by corporate executives. However,
ordinary shareholders were not as fortunate as corporate executives
to know the complete information regarding the quality of the reported
profit. Most people, (after all, around 50% of Americans adults are
stock market investors), were not surprised to learn later that a
significant portion of the reported profits for public firms were bogus,
especially after their own 401k plans imploded.
In many situations, millions of shareholders in America were left
paying the consequences of the executives focusing on short-term
reported profit. This unethical behavior by corporate

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executives actually bankrupted some firms. Maximizing profit is not

going to happen in a bankrupt firm.
Remember, we investors want our investment of capital to be
profitable. Public companies are required to offer to the public
significant amounts of operating information every quarter. Central to
this regular revelation is information about the quantity and quality of
quarterly profit.
Unfortunately, what investors are often given is an excuse by
managers who treat the shareholders somewhat like the government
treats taxpayers. Whatever costly scheme or idea they (whether
managers or government politicians) want to implement is acceptable
to attempt because the managers or politicians are spending other
peoples (the shareholders/or the taxpayers) money. Question -- How
do we align the interests of management with the interests of
shareholder, that is, to focus on maximizing real profit?
The simple and direct answer, believe it or not, is to raise our
(investor) expectations regarding the ethical behavior of corporate
managers. If this is not possible, then no scheme or law will work for
the long-term, period. The question to consider again is, How does a
firm maximize profits?
CONCLUSION
Maximizing profit can be defined as when a firm operates profitably
enough to allow for self-sustained, long-term viability, ensuring an
increasing value to accrue to the assets and the net worth of the firm
over the long-term. The real challenge for a firm to maximize its profits
is to realize that the managers of the firm have a short-term planning
horizon, while the investors who provide the capital, typically have a
much longer-term planning horizon.
Remember when your sports coach told you that you had to endure
short-term pain for long-term gain? That situation also applies to
public corporations. The managers of a corporation must be able to
make short and medium-term decisions that are better for the firms
long-term health, which decisions may not be immediately profitable,
in order for the firm to be viable for the long-term, for the firm to be
able to maximize profit. We investors must stop being
fascinated by quarterly reported profit.
The only way to be sure that the interests of the corporate executives
(assuming they already have sufficient competence and experience)
can be aligned with the corporate shareholders is for the shareholders
to correctly believe that the executives are ethical people. Perhaps the
best way to assure that the corporate executives are ethical is to
watch their behavior. When situations arise that call for sacrificing
short-term profits for ethical behavior, how do these managers
perform?
Jerry Useem, in the 10/28/02 Fortune magazine, cites Bernard Lev,
an accounting professor at New York University, regarding profit. Lev
asks the question if there really is such a thing as true earnings. He
wonders if that kind of profit is easily measured.
Proposal to Fix GAAP
Instead, Bernard Lev proposes what might be termed, Backwards
Accounting. Lev suggests chilling out for a number of years, then
looking to see whether or not the pension fund returns hit the
projected return. After a passage of time, an investor could also look
and see whether or not the bad debt reserves were too high or too
low. However, since asking for shareholders to wait around for a
number of years seems too long to wait, then just like the quarterly
GDP measure is revised once in one month, then revised again a
month later, we could implement the same rolling revision for

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corporate profit, which, though it seems strange, may get us closer to

reality. (Useem, p192)
Just like the best measure of profit may be Backwards Accounting,
the best measure of ethical behavior is historical, after the fact. If
certain corporate executives responded in the past to an ethical
problem in an ethical manner, it is much more likely that when ethical
situations arise in the future, and those situations will, those same
executives will respond in a similar manner.
Therefore, when the interests of the managers of the firm are aligned
with the interests of the shareholders, then the managers can
maximize profits by offering some combination of quality, price and
delivery of their firm's product or service in such a way to ensure that
the firm is profitable. When a firm is truly profitable, then it can survive
today, tomorrow, and next year. Long-term viability for a firm comes
from offering to exchange a product (or a service) with consumers
profitably in the short-term, over and over again. Then, only when a
firm stays viable (both ethically and profitably) for the long-term, can a
firm harbor hope to maximize profits. I suspect there is no other way.
References:
Colander, D.C. (2001). Microeconomics (4th ed.). [University of
Phoenix Special Cover Edition]. Burr Ridge, IL: Irwin/McGraw-Hill.
Colander, D.C. (2001). Macroeconomics (4th ed.). [University of
Phoenix Special Cover Edition]. Burr Ridge, IL: Irwin/McGraw-Hill.
Fortune Magazine, November 11, 2002, p13.
Fortune Magazine, September 16, 2002, p56.
Fortune Magazine, October 28, 2002, p66, p108.

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