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Federal Reserve Bank
of Richmond
2002 Annual Report

Accounting for
Corporate Behavior

Message from the President
and First Vice President

History may well designate

new jobs were created. In the District, conditions in

both 2001 and 2002 as watershed years

some high-tech industries improved, but several of

for the United States—years in which
the country was strenuously challenged

the region’s traditional manufacturing industries
remained weak.
The recovery from the 2001 recession has

in several important areas of national life.

featured two extraordinary developments that have

It has become almost a cliché to say that the

strongly affected both the Fed’s conduct of monetary

terrorist attacks in September 2001 have changed

policy and its own internal operations. For the first

America forever, yet the statement is probably true.

time in over half a century, Fed policymakers have

In 2002, the nation continued its recovery from the

had to take account of the risk of de flation as well

attacks, but revelations of serious deficiencies in

as inflation in their efforts to maintain price stability.

corporate governance and accounting practices

This Bank has long been in the forefront of the

presented a significant new challenge, economic

fight against inflation, and we are pleased, to put it

growth remained lackluster, and the stock market

mildly, that price stability has finally been achieved.

declined further. The threat of war in the Middle

If sustained, price stability will provide a firm foun-

East toward the end of the year created a level of

dation for growth in production and jobs. But when

geopolitical risk that appeared to place a consider-

core inflation is below 2 percent, as it has been

able additional drag on the economy. In this envi-

recently, policymakers obviously need to give more

ronment, the Bank, as an important component of

attention to guarding against deflation than when

the Federal Reserve System, gave its highest priority

inflation is 4 or 5 percent or higher. Through our

to reducing risk and increasing confidence and

research and our participation in the formulation

trust in the economy and financial markets.

of monetary policy, the Bank worked diligently

Despite these challenges, there were some

in 2002 to prevent the economy from drifting

bright spots in both the national and Fifth District

toward either deflation or a reemergence of infla-

economies. Consumer outlays for goods and services,

tion. We were strongly supported in this effort by

in particular, continued to advance, and purchases

information on business and financial conditions

of both new and existing homes remained robust.

supplied by our boards of directors in Richmond,

Business investment in equipment, software, and

Baltimore, and Charlotte.

structures, however, continued to lag, and few net

1
1

The second extraordinary development was

collectively to reduce the number of check process-

continued robust growth in labor productivity.

ing sites nationwide. As part of this effort, this Bank

Productivity grew about 4 percent over the four

decided to discontinue its processing operations

quarters of 2002, well above even its relatively high

in Richmond and in Charleston, West Virginia, and

2 1 2 percent average growth from 1996 to 2001.
/

Columbia, South Carolina. At the same time, we

Productivity growth is a principal way the nation

continued our preparations to standardize and

increases the incomes and living standards of its

modernize our check services operations in Baltimore

citizens over time. But productivity growth can also

and Charlotte as part of the Fed’s nationwide check

temporarily displace workers and products. The

modernization program.

Federal Reserve is not immune to these forces of

The Bank’s banking supervision and regula-

creative destruction. Our financial services busi-

tion resources are also adapting to changes in

nesses—check processing in particular—came under

market conditions. We are focused on retaining

severe pressure in 2002 as a result of technological

and attracting staff with a broad range of experi-

progress in the payments system.

ence and skills to help supervise the complex and

A recent study commissioned by the Fed

sophisticated activities of two of the nation’s four

showed that consumers and businesses increasingly

largest banking organizations. Our District is also

are choosing electronic forms of payment rather

home to numerous community banks, several large

than checks—roughly 40 billion checks were written

regional banks, and several banks with particular

in the United States in 2002, down from about 50

complexities or areas of specialization. In 2002, the

billion in 1995. While this is a welcome—and long

Bank established a new bank supervision unit that

sought— development from the standpoint of the

will focus specifically on these large regional and

efficiency in the payments system, the Federal

specialized institutions.

Reserve Banks face the challenge of adapting their

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2

These accomplishments reflect the combined

check processing infrastructures to this fundamental

efforts of many Bank employees and our board of

change in the market environment. Late last year

directors. We are fortunate indeed to have strong,

the Banks embarked on a major national initiative

knowledgeable, and independent directors whose

to reduce operating costs in their check services

perspective on District economic conditions as well

businesses while still maintaining and strengthening

as corporate governance issues served us exceed-

the Fed’s presence as a nationwide provider of

ingly well this past year. We especially thank our

check services. As the year ended, the Banks decided

retiring directors, Fred Green and Jeremiah Sheehan.

Fred shared his extensive banking experience with

American economy. The essay recognizes that

us, and we are pleased that he is now serving as the

some new government regulation may be inevitable

District’s representative to the Federal Advisory

in these circumstances. It argues, however, that the

Council. Jerry served as chairman of our board

most effective way to confront this problem is to

and provided an enormous reserve of practical

reinforce and strengthen the market forces already

business experience that helped us strengthen

working to align the incentives of managers and

both our operations and policies.

investors. Ultimately, the need to sustain investor

The strength of corporate governance
arrangements in American corporations became a
subject of intense scrutiny and debate in 2002.

confidence and trust is the most effective discipline
on the behavior of corporate managers.
We thank all of the Bank’s stakeholders for

The year opened with the unfolding accounting

their support in 2002, and we look forward to

scandals at several large firms. These revelations

serving them in 2003.

ultimately led to the enactment of the SarbanesOxley Act to reform corporate accounting and

As this Annual Report was going to press, we were

oversight practices. Our Annual Report essay this

saddened to learn of the death of Irwin Zazulia, deputy

year addresses corporate accounting. The essay

chairman of our board of directors and chairman of the

written by John Weinberg, vice president and

board’s committee on financial and strategic planning for

economist, discusses this topic in terms of the fun-

2003. As the retired president and CEO of the Hecht’s

damental challenge in corporate governance: how

department store chain, Irwin generously shared his broad

can a large public corporation align the incentives

knowledge of retailing and management with the Bank.

of professional managers with those of widely dis-

Most importantly, though, his personal warmth and strong

persed shareowners? The economic literature on

commitment to public service lifted our spirits and made

corporate governance builds on an inescapable

us a better Bank. We will miss him.

3

asymmetric condition—managers are much better
informed than shareholders and other outside
stakeholders about both a firm’s actions and its
performance. As last year’s events demonstrated,
this asymmetry can lead to abuses and even criminal
activity by corporate managers that erodes the
investor trust so essential to the health of the

3

J. Alfred Broaddus, Jr.
President
Walter A. Varvel
First Vice President

Accounting for Corporate Behavior
John A. Weinberg
Vice President and Economist

The year 2002 was one
of great tumult for the
American corporation.

As the year began, news of accounting
irregularities at energy giant Enron was
unfolding at a rapid pace. These revelations
would ultimately lead to the demise of that

firm and its auditor Arthur Andersen. But Enron was not an isolated case, as other accounting
scandals soon followed at WorldCom and Global Crossing in the telecommunications
industry and at other prominent companies in different sectors. In July of 2002, Forbes.com
published a “corporate scandal sheet” listing some twenty companies that were under
investigation by the Securities and Exchange Commission (SEC) or other government
authority.1 Of these cases, the vast majority involved misreporting of corporate earnings.
These allegations certainly created the appearance of a general phenomenon in corporate finance,
and the resulting loss of confidence in financial
reporting practices arguably contributed to the weakness of markets for corporate securities. The fact that
many of the problems were surfacing in industries
that had been at the center of the new economy
euphoria of the late 1990s contributed to the sense
of malaise by shaking investor confidence in the
economy’s fundamental prospects. In most of the
recent cases, the discovery of accounting improprieties was accompanied by a spectacular decline of
high-flying stocks and, in a number of cases, criminal
charges against corporate executives. Consequently,
the state of corporate governance and accounting
became the dominant business news story of the year.
To some observers, the recent events confirm a
sense that the stock market boom of the 1990s was
artificial — a “bubble” backed solely by unrealistic
expectations with no grounding in economic fundamentals. According to this view, investors’ bloated
expectations were nourished by the fictitious performance results reported by some firms. In the aftermath of these events, Congress enacted a new law

known as the Sarbanes-Oxley Act to reform corporate
accounting practices and the corporate governance
tools that are intended to ensure sound financial
reporting.
The attention received by the various scandals
and the legislative response might easily create the
impression that a fundamental flaw developed in the
American system of corporate governance and
finance during the late 1990s. It does appear that the
sheer number of cases in which companies have
been forced to make significant restatements of their
accounts, largely as the result of SEC action, has risen
in recent years. Beginning in 1998 with large earnings restatements by such companies as Sunbeam
and Waste Management and with a heightened commitment by the SEC, under then chairman Arthur
Levitt, to police misleading statements of earnings,
the number of cases rose significantly above the
dozen or so per year that was common in the 1980s.2
While the frequency and magnitude of recent cases
seem to be greater than in the past, accounting scandals are not new. Episodes of fraudulent accounting
have occurred repeatedly in the history of U.S. financial markets.
The views expressed are the author’s
and not necessarily those of the
Federal Reserve System.

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6

In the aftermath of the stock market crash of
1929, public attention and congressional investigation
led to allegations of unsavory practices by some
financial market participants during the preceding
boom. This activity led directly to the creation of the
Securities and Exchange Commission in 1934. One of
the founding principles of this agency was that “companies publicly offering securities . . . must tell the public the truth about their businesses.”3 The creation of
the SEC, however, did not eliminate the problem, and
scandals associated with dubious accounting remained a
feature of the financial landscape. In 1987 a number of
associations for accounting and finance professionals
organized a National Commission on Fraudulent
Financial Reporting. The commission studied cases from
the 1980s and characterized the typical case as involving a relatively small company with weak internal controls. Although incidents of fraud were often triggered
by a financial strain or sudden downturn in a company’s
real performance, the companies involved were usually
from industries that had been experiencing relatively
rapid growth. So while the size of companies involved in
recent cases may be atypical, the occurrence of scandals
in high-growth firms fits the established pattern.
Does fraudulent financial reporting represent
the Achilles’ heel of U.S. corporate finance? This
essay addresses such questions by examining the
problem of financial reporting in the context of the
fundamental problem of corporate governance.
Broadly stated, that fundamental problem is the
need for a large group of corporate outsiders (shareholders) to be able to control the incentives of a
small group of corporate insiders (management).
At the heart of this problem lies a basic and
inescapable asymmetry: insiders are much better
informed about the opportunities and performance of a business than are any outsiders. This
asymmetry presents a challenge that the modern
corporation seeks to address in the mechanisms it
uses to measure performance and reward managers.
While the tools of corporate governance can
limit the effects of the incentive problem inherent in
the corporate form, they cannot eliminate it.
Ultimately, there are times when shareholders just
have to trust that management is acting in their best
interest and realize that their trust will sometimes be
violated. Still, management has a powerful interest

in earning and preserving the trust of investors. With
trust comes an enhanced willingness of investors to
provide funds, resulting in reduced funding costs for
the business. That is, the behavior of corporate insiders
is disciplined by their desire or need to raise funds
in financial markets. This discipline favors efficient
corporate governance arrangements.
As discussed in the next section, there are a
variety of tools that a corporation might use to control managerial discretion, ranging from the makeup
and role of the board of directors to the firm’s relationship with its external auditor. To say that such
tools are applied efficiently is to say that managers
will adopt a tool as long as its benefit outweighs its
cost. In the absence of government intervention, the
forces of competition among self-interested market
participants (both insiders and outsiders) will tend to
lead to an efficient set of governance tools. It bears
repeating, though, that these tools do not eliminate
the fundamental problem of corporate governance.
The observation of apparent failures, such as the
accounting scandals of 2002, is not inconsistent,
however, with a generally well-functioning market for
corporate finance. Still, such episodes often provoke
a political response, as occurred during the Great
Depression and again in 2002 with the Sarbanes-Oxley
Act. Through these interventions, the government
has assumed a role in managing the relationship
between shareholders and management.
The final sections of the essay consider the
role of a government authority in setting and enforcing rules. After reviewing the functions of the SEC,

“

Does fraudulent financial
reporting represent the Achilles’
heel of U.S. corporate finance?
This essay addresses such questions by examining the problem
of financial reporting in the
context of the fundamental

”

problem of corporate governance.

“

In the modern American corporation,

discussion turns to the SarbanesOxley Act, the provisions of which
can be classified into two broad
categories. Parts of the act attempt
to improve corporate behavior by
mandating certain aspects of the
design of the audit committee or
the relationship between the firm
and its external auditor. The discussion in this essay suggests that
there is reason to doubt that such provisions, by
themselves, can do much to reduce fraud. Other
parts of the act deal more with enforcement and the
penalties for infractions. These provisions are more
likely to have a direct effect on incentives. An open
question is whether this effect is desirable. Since
reducing fraud is costly, it is unlikely that reducing it
to zero would be cost effective from society’s point of
view. Further, it is unrealistic to expect the new law to
bring about a substantial reduction in instances of
fraud without an increase in the resources allocated
to enforcement. Given that it is in the interest of corporate stakeholders to devise mechanisms that
respond efficiently to the fundamental problem of
corporate governance, one might doubt that the
gains from government intervention will be worth
the costs necessary to bring about significant changes
in behavior.

ownership is typically spread widely
over many individuals and institutions.
. . . Owners delegate management

”

responsibilities to a hired professional.

The Nature of the Modern Corporation

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8

In the modern American corporation, ownership is
typically spread widely over many individuals and
institutions. As a result, owners as a group cannot
effectively manage a business, a task that would require
significant coordination and consensus-building.
Instead, owners delegate management responsibilities
to a hired professional. To be sure, professional managers usually hold some equity in the firms they run.
Still, it is common for a manager’s ownership stake to be
small relative both to the company’s total outstanding equity and to the manager’s own total wealth.4
This description of the modern corporation
featuring a separation between widely dispersed
ownership and professional management is typically
associated with the work of Adolf Berle and Gardiner
Means. In their landmark study, The Modern
Corporation and Private Property, Berle and Means

identified the emerging corporate form as a cause
for concern. For them, the separation of ownership
and control heralded the rise of a managerial class,
wielding great economic power but answerable only
to itself. Large numbers of widely dispersed shareholders could not possibly exert effective control
over management. Berle and Means’ main concern
was the growing concentration of economic power in
a few hands and the coincident decline in the competitiveness of markets. At the heart of this problem
was what they saw as the impossibility of absentee
owners disciplining management.
Without adequate control by shareholders in
the Berle and Means view, managers would be free to
pursue endeavors that serve their own interests at
shareholders’ expense. Such actions might include
making investments and acquisitions whose main
effect would be to expand management’s “empire.”
Managers might also use company resources to provide themselves with desirable perks, such as large
and luxurious corporate facilities. These actions
could result in the destruction of shareholder wealth
and an overall decline in efficiency in the allocation
of productive resources.
The experience of the last seventy years and
the work of a number of writers on the law and economics of corporate governance have suggested that
the modern corporation is perhaps not as ominous
a development as imagined by Berle and Means.
A field of financial economics has developed that
studies the mechanisms available to shareholders
for exerting some influence over management’s
decisions.5 These tools represent the response of
governance arrangements to the forces of supply
and demand. That is, managers implement a governance mechanism when they perceive that its
benefits exceed its costs. The use of these tools,

however, cannot eliminate the fundamental asymmetry between managers and owners. Even under
the best possible arrangement, corporate insiders
will be better informed than outsiders.
The most obvious mechanism for affecting an
executive’s behavior is the compensation arrangement between the firm and the executive. This tool,
however, is also the most subject to problems arising
from the separation of ownership and control. Just as
it would be difficult for owners to coordinate in
directly running the firm, so it is difficult for them to
coordinate employment contract negotiations with
managers. In practice, this task falls to the board of
directors who, while intended to represent owners, are
often essentially controlled by management. In terms of
this relationship, management can benefit by creating
a strong and independent board. This move signals
to owners that management is seeking to constrain its
own discretion. Ultimately, however, shareholders
face the same challenge in assessing the board’s independence as they do in evaluating management’s
behavior. The close contact the board has with management makes its independence hard to guarantee.
Another source of control available to owners
comes from the legal protections provided by corporate law. Shareholders can bring lawsuits against
management for certain types of misbehavior, including fraud and self-dealing, by which a manager
unjustly enriches himself through transactions with
the firm. Loans from the corporation to an executive
at preferential interest rates can be an example of
self-dealing. Of course use of the courts to discipline
management also requires coordination among the
widespread group of shareholders. In such cases,
coordination can be facilitated by class-action lawsuits,
where a number of shareholders come together as
the plaintiff. Beyond suing management for specific
actions of fraud or theft, however, shareholders’ legal
rights are limited by a general presumption in the law
that management is best positioned to take actions in
the firm’s best business interests.6 For instance, if
management chooses between two possible investment projects, dissatisfied shareholders would find
it very difficult to make a case that management’s
choice was driven by self-interest as opposed to shareholder value. So, while legal recourse can be an
important tool for policing certain types of managerial

malfeasance, such recourse cannot serve to constrain
the broad discretion that management enjoys in running the business.
Notice that this discussion of tools for controlling managers’ behavior has referred repeatedly to
the coordination problem facing widely dispersed
shareholders. Clearly, the severity of this problem
depends on the degree of dispersion. The more concentrated the ownership, the more likely it is that
large shareholders will take an active role in negotiating contracts and monitoring the behavior of management. Concentrated ownership comes at a cost
though. For an investor to hold a large share of a
large firm requires a substantial commitment of
wealth without the benefits of risk diversification.
Alternatively, many investors can pool their funds
into institutions that own large blocks of stock in
corporations. This arrangement does not solve the
corporate governance problem of controlling incentives; however, it simply shifts the problem to that of
governing the shareholding institutions.
In spite of the burden it places on shareholders,
concentrated ownership has won favor as an approach
to corporate governance in some settings. In some
developed economies, banks hold large shares of
equity in firms and also participate more actively in
their governance than do financial institutions in the
United States. In this country, leveraged buyouts
emerged in the 1980s as a technique for taking over
companies. In a leveraged buyout, ownership
becomes concentrated as an individual or group
acquires the firm’s equity, financed through the
issuance of debt. Some see the leveraged buyout
wave as a means of forcing businesses to dispose of
excess capacity or reverse unsuccessful acquisitions.7
In most cases, these transactions resulted in a temporary concentration of ownership, since subsequent
sales of equity eventually led back to more dispersed
ownership. It seems that, at least in the legal and

9
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“

Any tools shareholders have
to control management’s
incentives are limited by a
basic informational advantage

”

that management enjoys.

10
10

financial environment of the United States, the benefits of diversification associated with less concentrated
ownership are great enough to make firms and their
shareholders willing to face the related governance
challenges.8 Still, there is considerable variation in
the concentration of ownership among large U.S.
corporations, leading some observers to conclude
that this feature of modern corporations responds
to the relative costs and benefits.9
A leveraged buyout is a special type of takeover,
an additional tool for controlling managers’ incentives.
If a firm is badly managed, another firm can acquire
it, installing new management and improving its use
of resources so as to increase profits. The market for
corporate control, the market in which mergers and
acquisitions take place, serves two purposes in corporate governance.10 First, as just noted, it is sometimes
the easiest means by which ineffective managers can
be replaced. Second, the threat of replacement can
help give managers an incentive to behave well.
Takeovers, however, can be costly transactions and
may not be worth the effort unless the potential
improvement in a firm’s performance is substantial.
The threat of a takeover introduces the idea
that a manager’s current behavior could bring about
personal costs in the future. Similarly, a manager
may have an interest in building and maintaining a
reputation for effectively serving shareholders’
interests. Such a reputation could enhance the
manager’s set of future professional opportunities.
While reputation can be a powerful incentive
device, like other tools it is not perfect. There will
always be some circumstances in which a manager
will find it in his best interest to take advantage of
his good reputation for a short-run gain even
though he realizes that his reputation will suffer in
the long run. For example, a manager might “milk”

his reputation by issuing misleading reports on the
company’s performance in order to meet targets
needed for additional compensation.
The imperfections of reputation as a disciplining tool are due to the nature of the corporate
governance problem and the relationship between
ownership and management. Any tools shareholders have to control management’s incentives are
limited by a basic informational advantage that
management enjoys. Because management has
superior information about the firm’s opportunities,
prospects, and performance, shareholders can
never be perfectly certain in their evaluation of
management’s actions and behavior.

Corporate Governance as an Agency Problem
At the heart of issues related to corporate governance
lies what economists call an agency (or principalagent) problem. Such a problem often arises when
two parties enter into a contractual relationship, like
that of employer-employee or borrower-lender. The
defining characteristic of an agency problem is that
one party, the principal, cannot directly control or
prescribe the actions of the other party, the agent.
Usually, this lack of control results from the agent
having superior information about the endeavor
that is of mutual interest to both parties. In the
employer-employee relationship, this information
gap is often related to the completion of daily tasks.
Unable to monitor all of their employees’ habits,
bosses base workers’ salaries on performance to
induce those workers to put appropriate effort into
their work.11 Another common example of an agency
problem includes insurance relationships. In auto
insurance, for instance, the insurer cannot directly
monitor the car owner’s driving habits, which directly
affect the probability of a claim being filed. Typical
features of insurance contracts such as deductibles
serve to enhance the owner’s incentive to exercise care.
In interpreting corporate governance as an
agency problem, it is common to identify top corporate management as the agent and owners as the
principal. While both management and ownership
are typically composed of a number of individuals,
the basic tensions that arise in an agency relationship
can be seen quite clearly if one thinks of each of
the opposing parties as a single individual. In this

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12

hypothetical relationship, an owner (the principal)
hires a manager (the agent) to run a business. The
owner is not actively involved in the affairs of the firm
and, therefore, is not as well-informed as the manager
about the opportunities available to the firm. Also, it
may not be practical for the owner to monitor the
manager’s every action. Accordingly, the control that
the owner exerts over the manager is primarily indirect. Since the owner can expect the manager to take
actions that maximize his own return, the owner can
try to structure the compensation policy so that the
manager does well when the business does well. This
policy could be supplemented by a mutual understanding of conditions under which the manager’s
employment might be terminated.
The agency perspective is certainly consistent
with a significant part of compensation for corporate
executives being contingent on firm performance.
Equity grants to executives and equity options are
common examples of performance-based compensation. Besides direct compensation, principals have a
number of other tools available to affect agents’
incentives. As discussed earlier, the tools available to
shareholders include termination of top executives’
employment, the possibility of a hostile takeover, and
the right to sue executive management for certain
types of misbehavior. Like direct compensation policy,
all of these tools involve consequences for management that depend on corporate performance. Hence,
the effective use of such tools requires that principals
be able to assess agents’ performance.
In the usual formulation of an agency problem,
the agent takes an action that affects the business’s
profits, and the principal pays the agent an amount
that depends on the level of those profits. This procedure presumes that the principal is able to assess the
firm’s profits. But the very same features of a modern
corporation that make it difficult for principals
(shareholders) to monitor actions taken by agents
(corporate management) also create an asymmetry
in the ability of shareholders and managers to track
the firm’s performance. Since owners cannot directly
observe all of the firm’s expenses and sales revenues,
they must rely to some extent on the manager’s reports
about such measures of performance. As discussed in
the next section, the problem of corporate governance
is a compound agency problem: shareholders suffer

both from an inability to directly control management’s
actions and an inability to easily obtain information
necessary to assess management’s performance.
The characterization of corporate governance
as an agency problem might lead one to doubt the
ability of market forces to achieve efficient outcomes
in this setting. But an agency problem is not a source
of market failure. Rather, agents’ and principals’
unequal access to relevant information is simply a
condition of the economic environment. In this
environment, participants will evaluate contractual
arrangements taking into account the effects on the
incentives for all parties involved. An individual or a
firm that can devise a contract with improved incentive effects will have an advantage in attracting other
participants. In this way, market forces will tend to
lead to efficient contracts. Accordingly, the economic
view of corporate governance is that firms will seek
executive compensation policies and other governance mechanisms that provide the best possible
incentive for management to work in shareholders’
best interest. The ultimate governance structure
chosen does not eliminate the agency problem but is
a rational, best response to that problem, balancing
the costs and benefits of managerial discretion.

Account ing for Corporate Performance
All of the tools intended to influence the incentives
and behavior of managers require that outsiders be
able to assess when the firm is performing well and
when it is performing poorly. If the manager’s
compensation is tied to the corporation’s stock
price, then investors, whose behavior determines
the stock price, must be able to make inferences
about the firm’s true performance and prospects
from the information available. If management’s
discipline comes from the threat of a takeover,

then potential acquirers must also be able to
make such assessments.
The challenge for effective market discipline
(whether in the capital market or in the market for
corporate control) is in getting information held by
corporate insiders out into the open. As a general
matter, insiders have an interest in providing the
market with reliable information. If by doing so they
can reduce the uncertainty associated with investing
in their firm, then, they can reduce the firm’s cost of
capital. But it’s not enough for a manager to simply
say, “I’m going to release reliable financial information about my business on an annual (or quarterly or
other interval) basis.” The believability of such a
statement is limited because there will always be
some circumstances in which a manager can benefit
in the short term by not being fully transparent.
The difficulty in securing reliable information
may be most apparent when a manager’s compensation is directly tied to accounting-based performance
measures. Since these measures are generated inside
the firm, essentially by the same group of people
whose decisions are driving the business’s performance, the opportunity for manipulation is present.
Certainly, accounting standards set by professional
organizations can limit the discretion available to
corporate insiders. A great deal of discretion remains,
however. The academic accounting literature refers
to such manipulation of current performance measures as “earnings management.”
An alternative to executive compensation that
depends on current performance as reported by
the firm is compensation that depends on the market’s perception of current performance. That is,
compensation can be tied to the behavior of the

“

firm’s stock price. In this way, rather than depending on self-reported numbers, executives’ rewards
depend on investors’ collective evaluation of the
firm’s performance. Compensation schemes based
on this type of investor evaluation include plans
that award bonuses based on stock price performance as well as those that offer direct grants of
equity or equity options to managers.
Unfortunately, tying compensation to stock price
performance hardly eliminates a manager’s incentive
to manipulate accounting numbers. If accounting
numbers are generally believed by investors to provide reliable information about a company’s performance, then those investors’ trading behavior will
cause stock prices to respond to accounting reports.
This responsiveness could create an incentive for
managers to manipulate accounting numbers in order
to boost stock prices. Note, however, that if investors
viewed earnings management and other forms of
accounting manipulation as pervasive, they would
tend to ignore reported numbers. In this case, stock
prices would be unresponsive to accounting numbers,
and managers would have little reason to manipulate
reports (although they would also have little incentive to exert any effort or resources to creating accurate reports). The fact that we do observe cases of
manipulation suggests that investors do not ignore
accounting numbers, as they would if they expected all
reports to be misleading. That is, the prevailing environment appears to be one in which serious instances
of fraud are occasional rather than pervasive.
In summary, the design of a system of rewards
for a corporation’s top executives has two conflicting
goals. To give executives an incentive to take actions
that maximize shareholder value, compensation needs
to be sensitive to the firm’s performance. But the
measurement of performance
is subject to manipulation
by the firm’s management,
and the incentive for such
manipulation grows with
the sensitivity of rewards to
measured performance.
This tension limits the
ability of compensation
plans to effectively manage
executives’ incentives.12

The problem of corporate governance is a
compound agency problem: shareholders

suffer both from an inability to directly

control management’s actions and an
inability to easily obtain information neces-

”

sary to assess management’s performance.

13
13

14
14

Are there tools that a corporation can use to
lessen the possibility of manipulated reporting and
thereby improve the incentive structure for corporate
executives? One possible tool is an external check on
a firm’s reported performance. A primary source for
this check in public corporations is an external auditor.
By becoming familiar with a client and its performance, an auditor can get a sense for the appropriateness of the choices made by the firm in preparing
its reports. Of course, every case of fraudulent financial reporting by corporations, including those in the
last year, involves the failure of an external auditor to
detect or disclose problems. Clearly, an external audit
is not a fail-safe protection against misreporting. A
significant part of the Sarbanes-Oxley legislation was
therefore devoted to improving the incentives of
accounting firms in their role as external auditors.
An external audit is limited in its ability to prevent fraudulent reporting. First, many observers
argue that an auditor’s role is limited to certifying
that a client’s financial statements were prepared in
accordance with professional accounting standards.
Making this determination does not automatically
enable an auditor to identify fraud. Others counter
that an auditor’s knowledge of a client’s operations
makes the auditor better positioned than other outsiders to assess the veracity of the client’s reports. In
this view, audit effectiveness in deterring fraud is as
much a matter of willingness as ability.
One aspect of auditors’ incentives that has
received a great deal of attention is the degree to
which the auditor’s interests are independent of the
interests of the client’s management.13 Some observers
argue that the objectivity of large accounting firms
when serving as external auditors is compromised
by a desire to gain and retain lucrative consulting
relationships with those clients. Even before the
events of 2002, momentum was growing for the idea
of separating the audit and consulting businesses
into separate firms. Although the Sarbanes-Oxley Act
did not require such a separation, some audit firms
have taken the step of spinning off their consulting
businesses. This step, however, does not guarantee
auditor independence. Ultimately, an auditor works
for its client, and there are always strong market
forces driving a service provider to give the client
what the client wants. If the client is willing to pay

more for an audit that overlooks some questionable
numbers than the (expected) costs to the auditor for
providing such an audit, then that demand will likely
be met. In general, a client’s desire to maintain credibility with investors gives it a strong interest in the
reliability of the auditor’s work. Even so, there will
always be some cases in which a client and an auditor
find themselves willing to breach the public’s trust
for a short-term gain.
Some observers suggest that making the hiring of
the auditor the responsibility of a company’s board
of directors, in particular the board’s audit committee,
can prevent complicity between management and
external auditors. This arrangement is indeed a standard procedure in large corporations. Still, the ability
of such an arrangement to enhance auditor independence hinges on the independence of the board and
its audit committee. Unfortunately, there appears to be
no simple mechanism for ensuring the independence
of directors charged with overseeing a firm’s audit
relationships. In 1987 the National Commission on
Fraudulent Financial Reporting found that among
the most common characteristics of cases that resulted
in enforcement actions by the Securities and Exchange
Commission was weak or inactive audit committees
or committees that had members with business ties to
the firm or its executives. While such characteristics
can often be seen clearly after the fact, it can be more
difficult and costly for investors or other outsiders to
discriminate among firms based on the general quality
of their governance arrangements before problems
have surfaced. While an outside investor can learn
about the members of the audit committee and how
often it meets, investors are less able to assess how
much care the committee puts into its work.

“

Are there tools that a corporation can use to lessen the
possibility of manipulated
reporting . . . ? One possible
tool is an external check on a

”

firm’s reported performance.

16
16

The difficulty in guaranteeing the release of
reliable information arises directly from the fundamental problem of corporate governance. In a
business enterprise characterized by a separation of
ownership and control, those in control have exclusive
access to information that would be useful to the
outside owners of the firm. Any outsider that the
firm hires to verify that the information it releases
is correct becomes, in effect, an insider. Once an
auditor, for instance, acquires sufficient knowledge
about a client to assess its management’s reports,
that auditor faces incentive problems analogous to
those faced by management. So, while an external audit
might be part of the appropriate response to the agency
problem between management and investors, an audit
also creates a new and analogous agency problem
between investors and an auditor.
An alternative approach to monitoring the
information released by a firm is for this monitoring
to be done by parties that have no contractual relationship with the firm’s management. Investors, as a
group, would benefit from the increased credibility
of accounting numbers this situation would provide.
Suppose that a small number of individual investors
spent the resources necessary to assess the truthfulness of a firm’s report. Those investors could then
make trades based on the results of their investigation. In an efficient capital market, the results would
then be revealed in the firm’s stock price. In this way,
the firm’s management would suffer the consequences
(in the form of a lower stock price) of making misleading reports. The problem with this scenario is
that while only a few investors incur the cost of the
investigation and producing the information, all
investors receive the benefit. Individual investors will
have a limited incentive to incur such costs when
other investors can free ride on their efforts. Because
it is difficult for dispersed shareholders to coordinate
information-gathering efforts, such free riding might
occur and is just a further reflection of the fundamental problem of corporate governance.
The free-riding problem that comes when
investors produce information about a firm can be
reduced if an individual investor owns a large fraction
of a firm’s shares. As discussed in the second section,
however, concentrated ownership has costs and
does not necessarily resolve the information and

incentive problems inherent in corporate governance.
An alternative approach to the free-riding problem,
and one that extends beyond the governance
arrangements of an individual firm, is the creation of
a membership organization that evaluates firms and
their reporting behavior. Firms would be willing to
pay a fee to join such an organization if membership
served as a seal of approval for reporting practices.
Members would then enjoy the benefits of reduced
funding costs that come with credibility.
One type of membership organization that could
contribute to improved financial reporting is a stock
exchange. As the next section discusses, the New York
Stock Exchange (NYSE) was a leader in establishing disclosure rules prior to the stock market crash of 1929.
The political response to the crash was the creation
of the Securities and Exchange Commission, which
took over some of the responsibilities that might
otherwise fall to a private membership organization.
Hence, a government body like the SEC might substitute for private arrangements in monitoring
corporate accounting behavior. The main source of
incentives for a government body is its sensitivity to
political sentiments. While political pressure can be
an effective source of incentives, its effectiveness can
also vary depending on political and economic conditions. If government monitoring replaces some
information production by private market participants, it is still possible for such a hybrid system of
corporate monitoring to be efficient as long as market participants base their actions on accurate beliefs
about the effectiveness of government monitoring.
Given the existence of a governmental entity
charged with policing the accounting behavior of
public corporations, how much policing should that
entity do? Should it carefully investigate every firm’s
reported numbers? This would be an expensive
undertaking. The purpose of this policing activity is to
enhance the incentives for corporate managements
and their auditors to file accurate reports. At the
same time, this goal should be pursued in a costeffective manner. To do this, there is a second tool,
beyond investigation, that the agency can use to affect
incentives. The agency can also vary the punishment
imposed on firms that are found to have violated the
standards of honest reporting. At a minimum, this
punishment simply involves the reduction in stock

“

A government body like the SEC

price that occurs when a firm is forced to make a
restatement of earnings or other important accounting numbers. This minimum punishment, imposed
entirely by market forces, can be substantial.14 To
toughen punishment, the government authority
can impose fines or even criminal penalties.
To increase corporate managers’ incentive for
truthful accounting, a government authority can either
increase resources spent on monitoring firms’ reports
or increase penalties imposed for discovered infractions. Relying on large penalties allows the authority to
economize on monitoring costs but, as long as monitoring is imperfect, raises the likelihood of wrongly
penalizing firms. The Sarbanes-Oxley Act has provisions that affect both of these margins of enforcement.
The following sections describe enforcement in the
United States before and after Sarbanes-Oxley.

Government Enforcement of Corporate Honesty
Before the creation of the Securities and Exchange
Commission in 1934, regulation of disclosures by
firms issuing public securities was a state matter.
Various states had “blue sky laws,” so named because
they were intended to “check stock swindlers so
barefaced they would sell building lots in the blue
sky.”15 These laws, which specified disclosures required
of firms seeking to register and issue securities, had
limited impact because they did not apply to the
issuance of securities across state lines. An issuer
could register securities in one state but offer them
for sale in other states through the mail. The issuer
would then be subject only to the laws of the state in
which the securities were registered. The New York
Stock Exchange offered an alternative, private form
of regulation with listing requirements that were generally more stringent than those in the state laws.
The NYSE also encouraged listing firms to make regular, audited reports on their income and financial
position. This practice was nearly universal on the
New York Stock Exchange by the late 1920s. The many
competing exchanges at the time had weaker rules.
One of the key provisions of the Securities
Exchange Act of 1934 was a requirement that all
firms issuing stock file annual and quarterly reports
with the SEC. In general, however, the act did not
give finely detailed instructions to the commission.
Rather, the SEC was granted the authority to issue

might substitute for private
arrangements in monitoring

”

corporate accounting behavior.

rules “where appropriate in the public interest or
for the protection of investors.”16 As with many of
its powers, the SEC’s authority with regard to the
treatment of information disclosed by firms was
left to an evolutionary process.
In the form into which it has evolved, the SEC
reviews financial reports, taking one of a number of
possible actions when problems are found. There are
two broad classes of filings that the Corporate Finance
Division of the SEC reviews—transactional and periodic filings. Transactional filings contain information
relevant to particular transactions, such as the issuance
of new securities or mergers and acquisitions.
Periodic filings are the annual and quarterly filings,
as well as the annual report to shareholders. Among
the options available to the Corporate Finance
Division if problems are found in a firm’s disclosures
is to refer the case to the Division of Enforcement.
Given its limited resources, it is impossible for
the SEC to review all of the filings that come under
its authority. In general, more attention is paid to
transactional filings. In particular, all transactional
filings go through an initial review, or screening process, to identify those warranting a closer examination.
Many periodic filings do not even receive the initial
screening. While the agency’s goal has been to review
every firm’s annual 10-K report at least once every
three years, it has not had the resources to realize
that goal. In 2002 around half of all public companies
had not had such a review in the last three years.17
It is possible that the extraordinary nature of recent
scandals has been due in part to the failure of the
SEC’s enforcement capabilities to keep up with the
growth of securities market activity.

The Sarbanes-Oxley Act of 2002
In the aftermath of the accounting scandals of 2002,
Congress enacted the Sarbanes-Oxley Act aimed at
enhancing corporate responsibility and reforming the
practice of corporate accounting. The law contains

17
17

18
18

provisions pertaining to both companies issuing
securities and those in the auditing profession. Some
parts of the act articulate rules for companies and
their auditors, while other parts focus more on
enforcement of these rules.18
The most prominent provisions dealing with
companies that issue securities include obligations
for the top executives and rules regarding the audit
committee. The act requires the chief executive and
financial officers to sign a firm’s annual and quarterly
filings with the SEC. The signatures will be taken to
certify that, to the best of the executives’ knowledge,
the filings give a fair and honest representation of
the firm’s financial condition and operating performance. By not fulfilling this signature requirement,
executives could face the possibility of significant
criminal penalties.
The sections of the act that deal with the audit
committee seek to promote the independence of
directors serving on that committee. To this end, the
act requires that members of the audit committee
have no other business relationship with the company.
That is, those directors should receive no compensation from the firm other than their director’s fee.
The act also instructs audit committees to establish
formal procedures for handling complaints about
accounting matters, whether the complaints come
from inside or outside of the firm. Finally, the committee must include a member who is a “financial
expert,” as defined by the SEC, or explain publicly
why it has no such expert.
Like its attempt to promote audit committee
independence, the act contains provisions regarding
a similar relationship between a firm and its auditor.
A number of these provisions are intended to keep
the auditor from getting “too close” to the firm.
Hence, the act specifies a number of nonaudit services that an accounting firm may not provide to
its audit clients. The act also requires audit firms to
rotate the lead partner responsible for a client at
least once every five years. Further, the act calls on
the SEC to study the feasibility of requiring companies to periodically change their audit firm.
With regard to enforcement, the act includes
both some new requirements for the SEC in its
review of company filings and the creation of a new
body, the Public Company Accounting Oversight

Board. The PCAOB is intended to be an independent
supervisory body for the auditing industry with which
all firms performing audits of public companies must
register. This board is charged with the task of establishing standards and rules governing the operation
of public accounting firms. As put forth in SarbanesOxley, these standards must include a minimum
period of time over which audit workpapers must be
maintained for possible examination by the PCAOB.
Other rules would involve internal controls that audit
firms must put in place to protect the quality and
integrity of their work.
Sarbanes-Oxley gives the PCAOB the task of
inspecting audit firms on a regular basis, with annual
inspection required for the largest firms.19 In addition
to examining a firm’s compliance with rules regarding
organization and internal controls, inspections may
include reviews of specific audit engagements. The
PCAOB may impose penalties that include fines as
well as the termination of an audit firm’s registration.
Such termination would imply a firm’s exit from the
audit business.
In addition to creating the new board to supervise
the audit industry, the act gives the SEC greater responsibilities in reviewing disclosures by public companies.
The act spells out factors that the SEC should use in
prioritizing its reviews. For instance, firms that have
issued material restatements of financial results or
those whose stock prices have experienced significant
volatility should receive priority treatment. Further,
Sarbanes-Oxley requires that no company be reviewed
less than once every three years. Other sections of the
act that deal with enforcement prescribe penalties for
specific abuses and extend the statute of limitations
for private securities fraud litigation.

“

In the aftermath of the accounting scandals of 2002, Congress
enacted the Sarbanes-Oxley Act
aimed at enhancing corporate
responsibility and reforming the

”

practice of corporate accounting.

“

Is there any reason to believe that a private

The goal of the SarbanesOxley Act is to alter the incentives of corporate managements
and their auditors so as to
reduce the frequency of fraudulent financial reporting. In
evaluating the act, one can take
this goal as given and try to
assess the act’s likely impact on
actual behavior of market participants. Alternatively, one could focus on the goal
itself. The act is presumably based on the belief that
we currently have too much fraud in corporate disclosures. But what is the right amount of fraud? Total
elimination of fraud, if even feasible, is unlikely to be
economically desirable. As argued earlier, reducing
fraud is costly. It requires the expenditure of resources
by some party to evaluate the public statements of
companies and a further resource cost to impose
consequences on those firms determined to have made
false reports. Reduction in fraud is only economically
efficient or desirable as long as the incremental costs
of enforcement are less than the social gain from
improved financial reporting.
What are the social benefits from improved
credibility of corporate information? A reduction in
the perceived likelihood of fraud brings with it similar
benefits to other risk reductions perceived by
investors. For example, investors become more willing
to provide funds to corporations that issue public
securities, resulting in a reduction in the cost of capital
for those firms. Other things being equal, improved
credibility should also lead to more investment by
public companies and an overall expansion of the
corporate sector. Again, however, any such gain must
be weighed against the corresponding costs.
Is there any reason to believe that a private
market for corporate finance, without any government intervention, would not result in an efficient
level of corporate honesty? Economic theory suggests
that the answer is no. It is true that the production of
information necessary to discover fraud has some characteristics of a public good. For example, many people stand to benefit from an individual’s efforts in
investigating a company. While public goods can
impede the efficiency of private market outcomes,
the benefits of information production accrue to a

market for corporate finance, without any
government intervention, would not result in
an efficient level of corporate honesty?

”

Economic theory suggests that the answer is no.

20
20

well-defined group of market participants in this
case. Companies subject to heightened investigative
scrutiny enjoy lower costs of capital.
In principle, one can imagine this type of
investigative activity being undertaken by a private
membership organization. Companies that join
would voluntarily subject their accounting reports to
close review. Failure to comply with the organization’s
standards could be punished with expulsion. This
organization could fund its activities through membership fees paid by the participating companies.
It would only attract members if the benefits of
membership, in the form of reduced costs of capital,
exceeded the cost of membership. That is, such an
organization would be successful if it could improve
at low cost the credibility of its members’ reported
information. Still, even if successful, the organization
would most likely not eliminate the potential for
fraud among its members. There would always be
some circumstances in which the short-run gain from
reporting false numbers would outweigh the risk of
discovery and expulsion.
Before the stock market crash of 1929, the New
York Stock Exchange was operating in some ways much
like the hypothetical organization just described.
Investigations after the crash, which uncovered
instances of misleading or fraudulent reporting by
issuers of securities, found relatively fewer abuses
among companies issuing stock on the NYSE.20 One
might reasonably conjecture that through such institutions the U.S. financial markets would have evolved into
an efficient set of arrangements for promoting corporate honesty. While consideration of this possibility
would make an interesting intellectual exercise, it is not
what happened. Instead, as often occurs in American
politics, Congress responded to a crisis with the creation
of a government entity. In this case, a government

“

Corporate discipline, whether
from market forces or government intervention, arises when
people outside of the firm incur
the costs necessary to learn

”

some of what insiders know.

22
22

entity charged with policing the behavior of companies that issue public securities. The presence of such
an agency might well dilute private market participants’ incentives to engage in such policing activities.
If so, then reliance on the government substitutes for
reliance on private arrangements.
Have the SEC’s enforcement activities resulted
in an efficient level of corporate honesty? This is a
difficult determination to make. It is true that known
cases of misreporting rose steadily in the 1980s and
1990s and that the events of 2002 represented
unprecedented levels of both the number and the
size of companies involved. It is also true that over
the last two decades, as activity in securities markets
grew at a very rapid pace, growth in the SEC’s budget
lagged, limiting the resources available for the review
of corporate reports. In this sense, one might argue
that the level of enforcement fell during this period.
Whether the current level of enforcement is efficient
or not, the Sarbanes-Oxley Act expresses Congress’
interest in seeing heightened enforcement so as to
reduce the frequency of fraudulent reports.
How effective is Sarbanes-Oxley likely to be in
changing the incentives of corporations and their
auditors? Many of the act’s provisions set rules and
standards for ways in which firms should behave or
how they should organize themselves and their relationships with auditors. There is reason to be skeptical
about the likely effectiveness of these provisions by
themselves. These portions of the act mandate that
certain things be done inside an issuing firm, for
instance in the organization of the audit committee.
But because these actions and organizational
changes take place inside the firm, they are subject
to the same information problems as all corporate

behavior. It is inherently difficult for outsiders,
whether market participants or government agencies,
to know what goes on inside the firm. The monitoring required to gain this information is costly, and it
is unlikely that mandates for changed behavior will
have much effect without an increase in the allocation of resources for such monitoring of corporate
actions, relationships, and reports.
Other parts of the act appear to call for this
increase in the allocation of resources for monitoring
activities, both by the SEC and by the newly created
PCAOB. Together with the act’s provisions concerning penalties, these portions should have a real effect
on incentives and behavior. Further, to the extent
that these agencies monitor firms’ adherence to the
general rules and standards specified in the act, monitoring will give force to those provisions. If the goal
of the act is to reduce the likelihood of events like
Enron and WorldCom, however, monitoring might
best be applied to the actual review of corporate
reports and accounting firm’s audit engagements.
Ultimately, such direct review of firms’ reports and
audit workpapers is the activity that identifies misbehavior. Uncovering and punishing misbehavior is, in
turn, the most certain means of altering incentives.
Incentives for deceptive accounting will never
be eliminated, and even a firm that follows all of the
formal rules in the Sarbanes-Oxley Act will find a way
to be deceptive if the expected payoff is big enough.
Among the things done by the SEC and PCAOB, the
payoff to deception is most effectively limited by the
allocation of resources to direct review of reported
performance and by bringing penalties to bear
where appropriate. Any hope that a real change in
corporate behavior can be attained without incurring
the costs of paying closer attention to the actual
reporting behavior of firms will likely lead to disappointment. Corporate discipline, whether from
market forces or government intervention, arises
when people outside of the firm incur the costs
necessary to learn some of what insiders know.
This article benefited from
conversations with a number
of my colleagues in the
Research Department and from
careful and critical readings
by Tom Humphrey, Jeff Lacker,
Ned Prescott, John Walter,
and Alice Felmlee.

Endnotes

References

1. Patsuris (2002).

Berle, Adolf, and Gardiner Means. 1932. The Modern Corporation
and Private Property. New York: Commerce Clearing House.

2. Alternative means of tallying the number of cases are found
in Richardson et al. (2002) and Financial Executives Research
Foundation Inc. (2001). By both measures, there was a
marked increase in the number of cases in the late 1990s.
3. From the SEC Web page.
4. Holderness, et al. (1999) present evidence of rising managerial
ownership over time. They find that executives and directors,
as a group, owned an average of 21 percent of the outstanding
stock in corporations they ran in 1995, compared to 13 percent
in 1935.
5. Shleifer and Vishny (1997) provide a survey of this literature.

Davis, Harry S., and Megan E. Murray. 2002. “Corporate
Responsibility and Accounting Reform.” Banking and Financial
Services Policy Report 21 (November): 1-8.
Demsetz, Harold, and Kenneth Lehn. 1985. “The Structure of
Corporate Ownership: Causes and Consequences.” Journal of
Political Economy 93 (December): 1155-77.
Financial Executives Research Foundation Inc. 2001. “Quantitative
Measures of the Quality of Financial Reporting.” (7 June).
Holderness, Clifford G., Randall S. Krozner, and Dennis P.
Sheehan. 1999. “Were the Good Old Days That Good? Changes
in Managerial Stock Ownership Since the Great Depression.”
Journal of Finance 54 (April): 435-69.

6. This point is emphasized by Roe (2002).
7. Holmstrom and Kaplan (2001) discuss the role of the leveraged
buyouts of the 1980s in aligning managerial and shareholder
interests.
8. Roe (1994) argues that ownership concentration in the United
States has been constrained by a variety of legal restrictions.
While this argument might temper one’s conclusion that the
benefits of dispersed ownership outweigh the costs, the leveraged
buyout episode provides an example of concentration that was
consistent with the legal environment and yet did not last.
9. Demsetz and Lehn (1985) make this argument.
10. Henry Manne (1965) was an early advocate of the beneficial
incentive effect on the market for corporate control.
11. Classic treatments of agency problems are given by Holmstrom
(1979) for the general analysis of moral hazard and Jensen
and Meckling (1976) for the characterization of corporate
governance as an agency problem.

Holmstrom, Bengt. 1979. “Moral Hazard and Observability.”
Bell Journal of Economics 10 (Spring): 74-91.
____________, and Steven N. Kaplan. 2001. “Corporate
Governance and Merger Activity in the United States: Making
Sense of the 1980s and 1990s.” Journal of Economic Perspectives
15 (Spring): 121-44.
Jensen, Michael C., and William H. Meckling. 1976. “Theory of
the Firm: Managerial Behavior, Agency Costs and Ownership
Structure.” Journal of Financial Economics 3 (October): 305-60.
Lacker, Jeffrey M., and John A. Weinberg. 1989. “Optimal
Contracts under Costly State Falsification.” Journal of Political
Economy 97 (December): 1345-63.
Levitt, Arthur. 2000. “A Profession at the Crossroads.”
Speech delivered at the National Association of State Boards
of Accountancy, Boston, Mass. 18 September.
Manne, Henry G. 1965. “Mergers and the Market for Corporate
Control.” Journal of Political Economy 73 (April): 110-20.

12. Lacker and Weinberg (1989) analyze an agency problem in
which the agent can manipulate the performance measure.

Patsuris, Penelope. 2002. “The Corporate Scandal Sheet.”
Forbes.com (25 July).

13. Levitt (2000) discusses this point.

Richardson, Scott, Irem Tuna, and Min Wu. 2002. “Predicting
Earnings Management: The Case of Earnings Restatements.”
University of Pennsylvania Working Paper (October).

14. Richardson, et al. (2002).
15. Seligman (1982), p. 44.

Roe, Mark J. 1994. Strong Managers, Weak Owners: The Political Roots
of American Corporate Finance. Princeton: Princeton University Press.

16. Ibid., p. 100.

____________. 2002. “Corporate Law’s Limits.” Journal of Legal
Studies 31 (June): 233-71.

17. United States Senate, Committee on Governmental Affairs (2002).
18. A summary of the act is found in Davis and Murray (2002).

Seligman, Joel. 1982. The Transformation of Wall Street: A History of
the Securities and Exchange Commission and Modern Corporate Finance.
Boston: Houghton Mifflin.

19. Firms preparing audit reports for more than one hundred
companies per year will be inspected annually.

Shleifer, Andrei, and Robert W. Vishny. 1997. “A Survey of
Corporate Governance.” Journal of Finance 52 (June): 737-83.

20. Seligman (1982), p. 46.

United States Senate, Committee on Governmental Affairs. 2002.
“Financial Oversight of Enron: The SEC and Private-Sector
Watchdogs.” Staff report (8 October).

23
23

Financial

Statements

Management Assertion

33

Reports of Independent Accountants

34

Comparative Financial Statements

36

Notes to Financial Statements

39

The firm engaged by the Board of Governors for the audits
of the individual and combined financial statements of
the Reserve Banks for 2002 was PricewaterhouseCoopers
LLP (PwC). Fees for these services totaled $1.0 million.
In order to ensure auditor independence, the Board of
Governors requires that PwC be independent in all matters
relating to the audit. Specifically, PwC may not perform
services for the Reserve Banks or others that would place
it in a position of auditing its own work, making management decisions on behalf of the Reserve Banks, or in
any other way impairing its audit independence. In 2002,
the Bank did not engage PwC for advisory services.

Management Assertion
December 31, 2002
To the Board of Directors:
The management of the Federal Reserve Bank of Richmond (“FRB Richmond”) is
responsible for the preparation and fair presentation of the Statement of Financial
Condition, Statement of Income, and Statement of Changes in Capital as of
December 31, 2002 (the “Financial Statements”). The Financial Statements have
been prepared in conformity with the accounting principles, policies, and practices
established by the Board of Governors of the Federal Reserve System and as set forth
in the Financial Accounting Manual for the Federal Reserve Banks (“Manual”), and
as such, include amounts, some of which are based on judgements and estimates of
management. To our knowledge, the Financial Statements are, in all material
respects, fairly presented in conformity with the accounting principles, policies,
and practices documented in the Manual and include all disclosures necessary for
such fair presentation.
The management of the FRB Richmond is responsible for maintaining an
effective process of internal controls over financial reporting including the safeguarding of assets as they relate to the Financial Statements. Such internal controls
are designed to provide reasonable assurance to management and to the Board of
Directors regarding the preparation of reliable Financial Statements. This process
of internal controls contains self-monitoring mechanisms, including, but not limited
to, divisions of responsibility and a code of conduct. Once identified, any material
deficiencies in the process of internal controls are reported to management, and
appropriate corrective measures are implemented.
Even an effective process of internal controls, no matter how well designed,
has inherent limitations, including the possibility of human error, and therefore
can provide only reasonable assurance with respect to the preparation of reliable
financial statements.
The management of the FRB Richmond assessed its process of internal controls
over financial reporting including the safeguarding of assets reflected in the Financial
Statements, based upon the criteria established in the “Internal Control – Integrated
Framework” issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO). Based on this assessment, we believe that the FRB Richmond
maintained an effective process of internal controls over financial reporting including
the safeguarding of assets as they relate to the Financial Statements.
33
Federal Reserve Bank of Richmond
J. Alfred Broaddus, Jr.
President
Walter A. Varvel
First Vice President
James D. Reese
Senior Vice President and
Chief Financial Officer

Report of Independent Accountants

To the Board of Directors of the Federal Reserve Bank of Richmond:
We have examined management’s assertion that the Federal Reserve Bank of
Richmond (“FRB Richmond”) maintained effective internal control over financial
reporting and the safeguarding of assets as they relate to the Financial Statements as
of December 31, 2002, based on criteria described in “Internal Control – Integrated
Framework” issued by the Committee of Sponsoring Organizations of the Treadway
Commission included in the accompanying Management’s Assertion. The assertion
is the responsibility of the FRB Richmond’s management. Our responsibility is to
express an opinion on the assertions based on our examination.
Our examination was made in accordance with standards established by the
American Institute of Certified Public Accountants, and accordingly, included
obtaining an understanding of the internal control over financial reporting, testing,
and evaluating the design and operating effectiveness of the internal control, and
performing such other procedures as we considered necessary in the circumstances.
We believe that our examination provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control, misstatements due to
error or fraud may occur and not be detected. Also, projections of any evaluation of
the internal control over financial reporting to future periods are subject to the risk
that the internal control may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assertion that the FRB Richmond maintained
effective internal control over financial reporting and over the safeguarding of assets
as they relate to the Financial Statements as of December 31, 2002, is fairly stated, in all
material respects, based upon criteria described in “Internal Control – Integrated
Framework” issued by the Committee of Sponsoring Organizations of the Treadway
Commission.

34

Washington, D.C.
March 3, 2003

Report of Independent Accountants

To the Board of Governors of the Federal Reserve System and
the Board of Directors of the Federal Reserve Bank of Richmond:
We have audited the accompanying statements of condition of the Federal Reserve
Bank of Richmond (the “Bank”) as of December 31, 2002 and 2001, and the related
statements of income and changes in capital for the years then ended, which have
been prepared in conformity with the accounting principles, policies, and practices
established by the Board of Governors of the Federal Reserve System. These financial statements are the responsibility of the Bank’s management. Our responsibility
is to express an opinion on the financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 3, the financial statements were prepared in conformity
with the accounting principles, policies, and practices established by the Board of
Governors of the Federal Reserve System. These principles, policies, and practices,
which were designed to meet the specialized accounting and reporting needs of
the Federal Reserve System, are set forth in the “Financial Accounting Manual for
Federal Reserve Banks” and constitute a comprehensive basis of accounting other
than generally accepted accounting principles.
In our opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of the Bank as of December 31, 2002 and
2001, and results of its operations for the years then ended, in conformity with the
basis of accounting described in Note 3.

35
Washington, D.C.
March 3, 2003

Statements of Condition

in millions

Federal Reserve Bank of Richmond

2001

2002

As of December 31,

ASSETS
Gold certificates
Special drawing rights certificates
Coin
Items in process of collection
Loans to depository institutions
U.S. government and federal agency securities, net
Investments denominated in foreign currencies
Accrued interest receivable
Prepaid expense – interest on Federal Reserve
notes to the U.S. Treasury
Interdistrict settlement account
Bank premises and equipment, net
Other assets

$

819
147
144
917
—
49,847
4,048
425

$

741
147
165
174
1
33,556
3,544
341

—
—
246
129

13
13,211
232
101

Total assets

$ 56,722

$ 52,226

45,349
1,645

45,208
—

1,381
57
808
137
3,052
89
58

3,191
76
109
—
—
83
45

52,576

48,712

Capital:
Capital paid-in
Surplus

2,073
2,073

1,757
1,757

Total capital

4,146

3,514

$ 56,722

$ 52,226

LIABILITIES AND CAPITAL
Liabilities:
Federal Reserve notes outstanding, net
Securities sold under agreements to repurchase
Deposits:
Depository institutions
Other deposits
Deferred credit items
Interest on Federal Reserve notes due U.S. Treasury
Interdistrict settlement account
Accrued benefit costs
Other liabilities
Total liabilities
36

Total liabilities and capital

The accompanying notes are an integral part of these financial statements.

Statements of Income

in millions

Federal Reserve Bank of Richmond

2002

For the years ended December 31,

2001

INTEREST INCOME
Interest on U.S. government and
federal agency securities
Interest on investments denominated in
foreign currencies
Interest on loans to depository institutions

$ 1,834

$ 1,756

65
—

80
1

1,899

1,837

1

—

1,898

1,837

Income from services
Reimbursable services to government agencies
Foreign currency gains (losses), net
U.S. government securities gains, net
Other income

80
36
498
5
4

78
34
(354)
19
6

Total other operating income (loss)

623

(217)

Salaries and other benefits
Occupancy expense
Equipment expense
Assessments by Board of Governors
Other credits

214
30
79
81
(91)

203
26
76
92
(59)

Total operating expenses

313

338

$ 2,208

$ 1,282

Dividends paid to member banks
Transferred to surplus
Payments to U.S. Treasury as interest on
Federal Reserve notes

$

$

1,772

1,101

Total distribution

$ 2,208

$ 1,282

Total interest income
INTEREST EXPENSE
Interest expense on securities sold under
agreements to repurchase
Net interest income
OTHER OPERATING INCOME (LOSS)

OPERATING EXPENSES

Net income prior to distribution
DISTRIBUTION OF NET INCOME

The accompanying notes are an integral part of these financial statements.

120
316

103
78

37

Statements of Changes in Capital

in millions

Federal Reserve Bank of Richmond

For the years ended December 31, 2002
and December 31, 2001

Capital
Paid-in

Surplus

Total
Capital

Balance at January 1, 2001
(33.6 million shares)

$ 1,679

$ 1,679

$ 3,358

Net income transferred to surplus

—

78

78

Net change in capital stock issued
(1.5 million shares)

78

—

78

1,757

1,757

3,514

Net income transferred to surplus

—

316

316

Net change in capital stock issued
(6.3 million shares)

316

—

316

$ 2,073

$ 2,073

$ 4,146

Balance at December 31, 2001
(35.1 million shares)

Balance at December 31, 2002
(41.4 million shares)

The accompanying notes are an integral part of these financial statements.

38

Notes to Financial Statements
Federal Reserve Bank of Richmond

1. Structure

2. Operations and Services

The Federal Reserve Bank of Richmond (“Bank”) is
part of the Federal Reserve System (“System”) created
by Congress under the Federal Reserve Act of 1913
(“Federal Reserve Act”) which established the central
bank of the United States. The System consists of the
Board of Governors of the Federal Reserve System
(“Board of Governors”) and twelve Federal Reserve
Banks (“Reserve Banks”). The Reserve Banks are chartered by the federal government and possess a unique
set of governmental, corporate, and central bank characteristics. The Bank in Richmond, Virginia, and its
branches in Baltimore, Maryland, and Charlotte, North
Carolina, serve the Fifth Federal Reserve District, which
includes Maryland, North Carolina, South Carolina,
Virginia, the District of Columbia, and a portion of
West Virginia. Other major elements of the System are
the Federal Open Market Committee (“FOMC”) and
the Federal Advisory Council. The FOMC is composed
of members of the Board of Governors, the president
of the Federal Reserve Bank of New York (“FRBNY”)
and, on a rotating basis, four other Reserve Bank presidents. Banks that are members of the System include
all national banks and any state chartered bank that
applies and is approved for membership in the System.

The System performs a variety of services and operations. Functions include: formulating and conducting
monetary policy; participating actively in the payments
mechanism, including large-dollar transfers of funds,
automated clearinghouse (“ACH”) operations and
check processing; distributing coin and currency;
performing fiscal agency functions for the U.S.
Treasury and certain federal agencies; serving as the
federal government’s bank; providing short-term
loans to depository institutions; serving the consumer and the community by providing educational
materials and information regarding consumer laws;
supervising bank holding companies and state
member banks; and administering other regulations
of the Board of Governors. The Board of Governors’
operating costs are funded through assessments on
the Reserve Banks.

Board of Directors
In accordance with the Federal Reserve Act, supervision and control of the Bank are exercised by a Board
of Directors. The Federal Reserve Act specifies the
composition of the Board of Directors for each of the
Reserve Banks. Each board is composed of nine members serving three-year terms: three directors, including
those designated as Chairman and Deputy Chairman,
are appointed by the Board of Governors, and six
directors are elected by member banks. Of the six elected by member banks, three represent the public and
three represent member banks. Member banks are
divided into three classes according to size. Member
banks in each class elect one director representing
member banks and one representing the public. In any
election of directors, each member bank receives one
vote, regardless of the number of shares of Reserve
Bank stock it holds.

The FOMC establishes policy regarding open
market operations, oversees these operations, and
issues authorizations and directives to the FRBNY for
its execution of transactions. Authorized transaction
types include direct purchase and sale of securities,
matched sale-purchase transactions, the purchase of
securities under agreements to resell, the sale of securities under agreements to repurchase, and the lending of U.S. government securities. The FRBNY is also
authorized by the FOMC to hold balances of and to
execute spot and forward foreign exchange (“F/X”)
and securities contracts in, nine foreign currencies,
maintain reciprocal currency arrangements (“F/X
swaps”) with various central banks, and “warehouse”
foreign currencies for the U.S. Treasury and
Exchange Stabilization Fund (“ESF”) through the
Reserve Banks.

3. Significant Accounting Policies
Accounting principles for entities with the unique powers
and responsibilities of the nation’s central bank have
not been formulated by the Financial Accounting
Standards Board. The Board of Governors has developed
specialized accounting principles and practices that it
believes are appropriate for the significantly different
nature and function of a central bank as compared to
the private sector. These accounting principles and
practices are documented in the Financial Accounting
Manual for Federal Reserve Banks (“Financial Accounting

39

Federal Reserve Bank of Richmond

40

Manual”), which is issued by the Board of Governors.
All Reserve Banks are required to adopt and apply
accounting policies and practices that are consistent
with the Financial Accounting Manual.
The financial statements have been prepared in
accordance with the Financial Accounting Manual.
Differences exist between the accounting principles
and practices of the System and accounting principles
generally accepted in the United States of America
(“GAAP”). The primary differences are the presentation of all security holdings at amortized cost, rather
than at the fair value presentation requirements of
GAAP, and the accounting for matched sale-purchase
transactions as separate sales and purchases, rather
than secured borrowings with pledged collateral, as is
generally required by GAAP. In addition, the Bank has
elected not to present a Statement of Cash Flows. The
Statement of Cash Flows has not been included as the
liquidity and cash position of the Bank are not of primary concern to the users of these financial statements.
Other information regarding the Bank’s activities is
provided in, or may be derived from, the Statements of
Condition, Income, and Changes in Capital. Therefore,
a Statement of Cash Flows would not provide any additional useful information. There are no other significant differences between the policies outlined in the
Financial Accounting Manual and GAAP.
Effective January 2001, the System implemented
procedures to eliminate the sharing of costs by Reserve
Banks for certain services a Reserve Bank may provide on
behalf of the System. Major services provided for the
System by the Bank, for which the costs will not be redistributed to the other Reserve Banks, include Standard
Cash Automation and the Currency Technology Office.
The preparation of the financial statements in
conformity with the Financial Accounting Manual
requires management to make certain estimates and
assumptions that affect the reported amounts of assets
and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements, and the
reported amounts of income and expenses during the
reporting period. Actual results could differ from those
estimates. Unique accounts and significant accounting
policies are explained below.

a. Gold Certificates
The Secretary of the Treasury is authorized to issue
gold certificates to the Reserve Banks to monetize gold
held by the U.S. Treasury. Payment for the gold certificates by the Reserve Banks is made by crediting equivalent amounts in dollars into the account established for
the U.S. Treasury. These gold certificates held by the

Reserve Banks are required to be backed by the gold of
the U.S. Treasury. The U.S. Treasury may reacquire the
gold certificates at any time and the Reserve Banks
must deliver them to the U.S. Treasury. At such time,
the U.S. Treasury’s account is charged and the Reserve
Banks’ gold certificate accounts are lowered. The value
of gold for purposes of backing the gold certificates is
set by law at $42 2/9 a fine troy ounce. The Board of
Governors allocates the gold certificates among
Reserve Banks once a year based upon average Federal
Reserve notes outstanding in each District.

b. Special Drawing Rights Certificates
Special drawing rights (“SDRs”) are issued by the
International Monetary Fund (“Fund”) to its members
in proportion to each member’s quota in the Fund at
the time of issuance. SDRs serve as a supplement to
international monetary reserves and may be transferred
from one national monetary authority to another.
Under the law providing for United States participation
in the SDR system, the Secretary of the U.S. Treasury is
authorized to issue SDR certificates, somewhat like gold
certificates, to the Reserve Banks. At such time, equivalent amounts in dollars are credited to the account
established for the U.S. Treasury, and the Reserve
Banks’ SDR certificate accounts are increased. The
Reserve Banks are required to purchase SDRs, at the
direction of the U.S. Treasury, for the purpose of
financing SDR certificate acquisitions or for financing
exchange stabilization operations. At the time SDR
transactions occur, the Board of Governors allocates
SDR certificate transactions among Reserve Banks
based upon Federal Reserve notes outstanding in each
District at the end of the preceding year. There were
no SDR transactions in 2002.

c. Loans to Depository Institutions
The Depository Institutions Deregulation and
Monetary Control Act of 1980 provides that all depository institutions that maintain reservable transaction
accounts or nonpersonal time deposits, as defined in
Regulation D issued by the Board of Governors, have
borrowing privileges at the discretion of the Reserve
Banks. Borrowers execute certain lending agreements
and deposit sufficient collateral before credit is extended. Loans are evaluated for collectibility, and currently
all are considered collectible and fully collateralized. If
loans were ever deemed to be uncollectible, an appropriate reserve would be established. Interest is accrued
using the applicable discount rate established at least
every fourteen days by the Boards of Directors of the
Reserve Banks, subject to review by the Board of
Governors. Reserve Banks retain the option to impose a
surcharge above the basic rate in certain circumstances.

Federal Reserve Bank of Richmond

d. U.S. Government and Federal Agency
Securities and Investments Denominated
in Foreign Currencies
The FOMC has designated the FRBNY to execute open
market transactions on its behalf and to hold the resulting securities in the portfolio known as the System
Open Market Account (“SOMA”). In addition to authorizing and directing operations in the domestic securities market, the FOMC authorizes and directs the
FRBNY to execute operations in foreign markets for
major currencies in order to counter disorderly conditions in exchange markets or to meet other needs specified by the FOMC in carrying out the System’s central
bank responsibilities. Such authorizations are reviewed
and approved annually by the FOMC.
In December 2002, the FRBNY replaced matched
sale-purchase (“MSP”) transactions with securities sold
under agreements to repurchase. MSP transactions,
accounted for as separate sale and purchase transactions, are transactions in which the FRBNY sells a security and buys it back at the rate specified at the commencement of the transaction. Securities sold under
agreements to repurchase are treated as secured borrowing transactions with the associated interest expense
recognized over the life of the transaction.
The FRBNY has sole authorization by the FOMC
to lend U.S. government securities held in the SOMA
to U.S. government securities dealers and to banks
participating in U.S. government securities clearing
arrangements on behalf of the System, in order to facilitate the effective functioning of the domestic securities
market. These securities-lending transactions are fully
collateralized by other U.S. government securities. FOMC
policy requires FRBNY to take possession of collateral
in excess of the market values of the securities loaned.
The market values of the collateral and the securities
loaned are monitored by FRBNY on a daily basis, with
additional collateral obtained as necessary. The securities loaned continue to be accounted for in the SOMA.
F/X contracts are contractual agreements
between two parties to exchange specified currencies,
at a specified price, on a specified date. Spot foreign
contracts normally settle two days after the trade date,
whereas the settlement date on forward contracts is
negotiated between the contracting parties, but will
extend beyond two days from the trade date. The
FRBNY generally enters into spot contracts, with any
forward contracts generally limited to the second leg of
a swap/warehousing transaction.
The FRBNY, on behalf of the Reserve Banks,
maintains renewable, short-term F/X swap arrangements with two authorized foreign central banks. The

parties agree to exchange their currencies up to a prearranged maximum amount and for an agreed upon
period of time (up to twelve months), at an agreed
upon interest rate. These arrangements give the
FOMC temporary access to foreign currencies that it
may need for intervention operations to support the
dollar and give the partner foreign central bank temporary access to dollars it may need to support its own
currency. Drawings under the F/X swap arrangements
can be initiated by either the FRBNY or the partner
foreign central bank, and must be agreed to by the
drawee. The F/X swaps are structured so that the
party initiating the transaction (the drawer) bears the
exchange rate risk upon maturity. The FRBNY will
generally invest the foreign currency received under
an F/X swap in interest-bearing instruments.
Warehousing is an arrangement under which the
FOMC agrees to exchange, at the request of the
Treasury, U.S. dollars for foreign currencies held by the
Treasury or ESF over a limited period of time. The purpose of the warehousing facility is to supplement the
U.S. dollar resources of the Treasury and ESF for
financing purchases of foreign currencies and related
international operations.
In connection with its foreign currency activities,
the FRBNY, on behalf of the Reserve Banks, may
enter into contracts which contain varying degrees of
off-balance sheet market risk, because they represent
contractual commitments involving future settlement
and counter-party credit risk. The FRBNY controls
credit risk by obtaining credit approvals, establishing
transaction limits, and performing daily monitoring
procedures.
While the application of current market prices
to the securities currently held in the SOMA portfolio
and investments denominated in foreign currencies
may result in values substantially above or below their
carrying values, these unrealized changes in value
would have no direct effect on the quantity of reserves
available to the banking system or on the prospects
for future Reserve Bank earnings or capital. Both the
domestic and foreign components of the SOMA portfolio from time to time involve transactions that can
result in gains or losses when holdings are sold prior
to maturity. Decisions regarding the securities and foreign currencies transactions, including their purchase
and sale, are motivated by monetary policy objectives
rather than profit. Accordingly, market values, earnings, and any gains or losses resulting from the sale of
such currencies and securities are incidental to the
open market operations and do not motivate its activities or policy decisions.

41

Federal Reserve Bank of Richmond

42

U.S. government and federal agency securities
and investments denominated in foreign currencies
comprising the SOMA are recorded at cost, on a settlement-date basis, and adjusted for amortization of premiums or accretion of discounts on a straight-line basis.
Interest income is accrued on a straight-line basis and
is reported as “Interest on U.S. government and federal
agency securities” or “Interest on investments denominated in foreign currencies,” as appropriate. Income
earned on securities lending transactions is reported as
a component of “Other income.” Gains and losses
resulting from sales of securities are determined by specific issues based on average cost. Gains and losses on
the sales of U.S. government and federal agency securities are reported as “U.S. government securities gains,
net.” Foreign-currency-denominated assets are revalued
daily at current foreign currency market exchange
rates in order to report these assets in U.S. dollars.
Realized and unrealized gains and losses on investments denominated in foreign currencies are reported
as “Foreign currency gains (losses), net.” Foreign currencies held through F/X swaps, when initiated by the
counter-party, and warehousing arrangements are revalued daily, with the unrealized gain or loss reported by
the FRBNY as a component of “Other assets” or “Other
liabilities,” as appropriate.
Balances of U.S. government and federal agency
securities bought outright, securities sold under agreements to repurchase, securities loaned, investments
denominated in foreign currency, interest income and
expense, securities lending fee income, amortization of
premiums and discounts on securities bought outright,
gains and losses on sales of securities, and realized and
unrealized gains and losses on investments denominated in foreign currencies, excluding those held under
an F/X swap arrangement, are allocated to each
Reserve Bank. Income from securities lending transactions undertaken by the FRBNY are also allocated to
each Reserve Bank. Securities purchased under agreements to resell and unrealized gains and losses on the
revaluation of foreign currency holdings under F/X
swaps and warehousing arrangements are allocated to
the FRBNY and not to other Reserve Banks.

e. Bank Premises, Equipment, and Software
Bank premises and equipment are stated at cost less
accumulated depreciation. Depreciation is calculated
on a straight-line basis over estimated useful lives of
assets ranging from 2 to 50 years. New assets, major
alterations, renovations and improvements are capitalized at cost as additions to the asset accounts.
Maintenance, repairs and minor replacements are

charged to operations in the year incurred. Costs
incurred for software, either developed internally or
acquired for internal use, during the application development stage are capitalized based on the cost of direct
services and materials associated with designing, coding, installing, or testing software.

f. Interdistrict Settlement Account
At the close of business each day, all Reserve Banks and
branches assemble the payments due to or from other
Reserve Banks and branches as a result of transactions
involving accounts residing in other Districts that
occurred during the day’s operations. Such transactions may include funds settlement, check clearing and
ACH operations, and allocations of shared expenses.
The cumulative net amount due to or from other
Reserve Banks is reported as the “Interdistrict settlement account.”

g. Federal Reserve Notes
Federal Reserve notes are the circulating currency of
the United States. These notes are issued through the
various Federal Reserve agents (the Chairman of the
Board of Directors of each Reserve Bank) to the
Reserve Banks upon deposit with such agents of certain
classes of collateral security, typically U.S. government
securities. These notes are identified as issued to a specific Reserve Bank. The Federal Reserve Act provides
that the collateral security tendered by the Reserve
Bank to the Federal Reserve agent must be equal to the
sum of the notes applied for by such Reserve Bank. In
accordance with the Federal Reserve Act, gold certificates, special drawing rights certificates, U.S. government and federal agency securities, securities purchased under agreements to resell, loans to depository
institutions, and investments denominated in foreign
currencies are pledged as collateral for net Federal
Reserve notes outstanding. The collateral value is equal
to the book value of the collateral tendered, with the
exception of securities, whose collateral value is equal
to the par value of the securities tendered, and securities purchased under agreements to resell, which are
valued at the contract amount. The par value of securities pledged for securities sold under agreements to
repurchase is similarly deducted. The Board of
Governors may, at any time, call upon a Reserve Bank
for additional security to adequately collateralize the
Federal Reserve notes. The Reserve Banks have entered
into an agreement which provides for certain assets of
the Reserve Banks to be jointly pledged as collateral for
the Federal Reserve notes of all Reserve Banks in order
to satisfy their obligation of providing sufficient collat-

Federal Reserve Bank of Richmond

eral for outstanding Federal Reserve notes. In the event
that this collateral is insufficient, the Federal Reserve
Act provides that Federal Reserve notes become a first
and paramount lien on all the assets of the Reserve
Banks. Finally, as obligations of the United States,
Federal Reserve notes are backed by the full faith and
credit of the United States government.
The “Federal Reserve notes outstanding, net”
account represents the Bank’s Federal Reserve notes
outstanding reduced by its currency holdings of $9,023
million, and $10,230 million at December 31, 2002 and
December 31, 2001, respectively.

h. Capital Paid-in
The Federal Reserve Act requires that each member
bank subscribe to the capital stock of the Reserve Bank
in an amount equal to 6 percent of the capital and surplus of the member bank. As a member bank’s capital
and surplus changes, its holdings of the Reserve Bank’s
stock must be adjusted. Member banks are those statechartered banks that apply and are approved for membership in the System and all national banks. Currently,
only one-half of the subscription is paid-in and the
remainder is subject to call. These shares are nonvoting
with a par value of $100. They may not be transferred
or hypothecated. By law, each member bank is entitled
to receive an annual dividend of 6 percent on the paidin capital stock. This cumulative dividend is paid semiannually. A member bank is liable for Reserve Bank liabilities up to twice the par value of stock subscribed by it.

i. Surplus
The Board of Governors requires Reserve Banks to
maintain a surplus equal to the amount of capital paid-in
as of December 31. This amount is intended to provide
additional capital and reduce the possibility that the
Reserve Banks would be required to call on member
banks for additional capital. Pursuant to Section 16 of
the Federal Reserve Act, Reserve Banks are required by
the Board of Governors to transfer to the U.S. Treasury
excess earnings, after providing for the costs of operations, payment of dividends, and reservation of an
amount necessary to equate surplus with capital paid-in.
In the event of losses or a substantial increase in
capital, payments to the U.S. Treasury are suspended until
such losses are recovered through subsequent earnings.
A portion of the payments made to the U.S. Treasury in
2001 are classified as “Prepaid expense – interest on
Federal Reserve notes to the U.S. Treasury.” Weekly
payments to the U.S. Treasury may vary significantly.

j. Income and Costs related to Treasury Services
The Bank is required by the Federal Reserve Act to
serve as fiscal agent and depository of the United
States. By statute, the Department of the Treasury is
permitted, but not required, to pay for these services.

k. Taxes
The Reserve Banks are exempt from federal, state, and
local taxes, except for taxes on real property, which are
reported as a component of “Occupancy expense.”

4. U.S. Government and
Federal Agency Securities
Securities bought outright are held in the SOMA at the
FRBNY. An undivided interest in SOMA activity and the
related premiums, discounts and income, with the
exception of securities purchased under agreements to
resell, is allocated to each Reserve Bank on a percentage basis derived from an annual settlement of interdistrict clearings. The settlement, performed in April of
each year, equalizes Reserve Bank gold certificate holdings to Federal Reserve notes outstanding. The Bank’s
allocated share of SOMA balances was approximately
7.799 percent and 5.974 percent at December 31, 2002
and 2001, respectively.
The Bank’s allocated share of securities held in
the SOMA at December 31, that were bought outright,
was as follows (in millions):
2002
Par value:
Federal agency
U.S. government:
Bills
Notes
Bonds
Total par value
Unamortized premiums
Unaccreted discounts
Total allocated to Bank

$

2001
1

$

1

17,680
23,233
8,176

10,877
15,887
6,193

49,090
839
(82)

32,958
675
(77)

$ 49,847

$ 33,556

43

Federal Reserve Bank of Richmond

Total SOMA securities bought outright were
$639,125 million and $561,701 million at December 31,
2002 and 2001, respectively.
The maturity distribution of U.S. government
and federal agency securities bought outright, which
were allocated to the Bank at December 31, 2002, was
as follows (in millions):
Par value
Maturities of Securities Held

U.S.
Federal
Government Agency
Securities Obligations

Total

Within 15 days
16 days to 90 days
91 days to 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years

$ 2,140
12,028
11,063
13,474
4,157
6,227

$—
—
1
—
—
—

$ 2,140
12,028
11,064
13,474
4,157
6,227

Total

$ 49,089

$ 1

$ 49,090

As mentioned in footnote 3, in December 2002, the
FRBNY replaced MSP transactions with securities sold
under agreements to repurchase. At December 31,
2002, securities sold under agreements to repurchase
with a contract amount of $21,091 million and a par
value of $21,098 million were outstanding, of which
$1,645 million and $1,645 million, respectively, were
allocated to the Bank. At December 31, 2001, MSP
transactions involving U.S. government securities with a
par value of $23,188 million were outstanding, of which
$1,385 million was allocated to the Bank. Securities
sold under agreements to repurchase and MSP transactions are generally overnight arrangements.
At December 31, 2002 and 2001, U.S. government securities with par values of $1,841 million and
$7,345 million, respectively, were loaned from the
SOMA, of which $144 million and $439 million were
allocated to the Bank.

44

Each Reserve Bank is allocated a share of foreign-currency-denominated assets, the related interest
income, and realized and unrealized foreign currency
gains and losses, with the exception of unrealized gains
and losses on F/X swaps and warehousing transactions.
This allocation is based on the ratio of each Reserve
Bank’s capital and surplus to aggregate capital and surplus at the preceding December 31. The Bank’s allocated share of investments denominated in foreign currencies was approximately 23.935 percent and 24.344
percent at December 31, 2002 and 2001, respectively.
The Bank’s allocated share of investments
denominated in foreign currencies, valued at current
foreign currency market exchange rates at December
31, was as follows (in millions):

5. Investments Denominated
in Foreign Currencies
The FRBNY, on behalf of the Reserve Banks, holds foreign currency deposits with foreign central banks and
the Bank for International Settlements, and invests in
foreign government debt instruments. Foreign government debt instruments held include both securities
bought outright and securities purchased under agreements to resell. These investments are guaranteed as to
principal and interest by the foreign governments.

2002
European Union Euro:
Foreign currency deposits
Government debt instruments
including agreements to resell
Japanese Yen:
Foreign currency deposits
Government debt instruments
including agreements to resell
Accrued interest
Total

2001

$ 1,336

$ 1,118

789

656

428

460

1,475
20

1,294
16

$ 4,048

$ 3,544

Total investments denominated in foreign currencies
were $16,913 million and $14,559 million at December
31, 2002 and 2001, respectively.
The maturity distribution of investments denominated in foreign currencies which were allocated to the
Bank at December 31, 2002, was as follows (in millions):
Maturities of Investments Denominated in Foreign Currencies

Within 1 year
Over 1 year to 5 years
Over 5 years to 10 years
Over 10 years

$ 3,737
216
95
—

Total

$ 4,048

At December 31, 2002 and 2001, there were no open
foreign exchange contracts or outstanding F/X swaps.
At December 31, 2002 and 2001, the warehousing
facility was $5,000 million, with zero balance outstanding.

Federal Reserve Bank of Richmond

6. Bank Premises and Equipment
A summary of bank premises and equipment at
December 31 is as follows (in millions):
2002
Bank premises and equipment:
Land
Buildings
Building machinery and equipment
Construction in progress
Furniture and equipment
Accumulated depreciation
Bank premises and equipment, net

2001

$ 19.7 $ 19.7
122.3
122.6
45.6
44.1
1.2
0.3
298.0
292.8
486.8
(240.8)

479.5
(247.5)

$ 1.4
1.0
1.0
0.2
0.0

$ 6.3
6.2
0.4
0.4
0.0
13.3
$ 12.2

2003
2004
2005
2006
Thereafter
Amount representing interest

Bank premises and equipment
Accumulated depreciation

2002
$ 15
(11)

2001
$ 20
(13)

Capitalized leases, net

$

$

7

The Bank leases unused space to outside tenants.
Those leases have terms ranging from one to four
years. Rental income from such leases was $1.4 million
and $1.3 million for the years ended December 31,
2002 and 2001, respectively. Future minimum lease payments under noncancelable agreements in existence at
December 31, 2002, were (in millions):
2003
2004
2005
2006
Thereafter

Capital

Present value of net minimum lease payment

Depreciation expense was $36 million and $31 million
for the years ended December 31, 2002 and 2001,
respectively.
Bank premises and equipment at December 31
include the following amounts for leases that have
been capitalized (in millions):

Operating

$ 3.6

$ 246.0 $ 232.0

4

Rental expense under operating leases for
certain operating facilities, warehouses, and data processing and office equipment (including taxes, insurance and maintenance when included in rent), net of
sublease rentals, was $42 million and $40 million for the
years ended December 31, 2002 and 2001, respectively. Certain of the Bank’s leases have options to renew.
Future minimum rental payments under noncancelable operating leases and capital leases, net of
sublease rentals, with terms of one year or more, at
December 31, 2002, were (in millions):

$ 1.2
1.2
1.3
1.2
0.0
$ 4.9

7. Commitments and Contingencies
At December 31, 2002, the Bank was obligated under
noncancelable leases for premises and equipment with
terms ranging from one to approximately four years.
These leases provide for increased rentals based upon
increases in real estate taxes, operating costs or selected price indices.

(1.1)

At December 31, 2002, the Bank, acting on behalf of
the Reserve Banks, had a contractual commitment
through the year 2007 totaling $92 million, none of
which has been recognized. This contract represents
costs for maintenance of currency processing machines that
will be allocated annually to other Reserve Banks. It is estimated that the Bank’s allocated share will be $8 million.
Under the Insurance Agreement of the Federal
Reserve Banks dated as of March 2, 1999, each of the
Reserve Banks has agreed to bear, on a per incident
basis, a pro rata share of losses in excess of one percent of the capital paid-in of the claiming Reserve
Bank, up to 50 percent of the total capital paid-in of all
Reserve Banks. Losses are borne in the ratio that a
Reserve Bank’s capital paid-in bears to the total capital
paid-in of all Reserve Banks at the beginning of the
calendar year in which the loss is shared. No claims were
outstanding under such agreement at December 31,
2002 or 2001.
The Bank is involved in certain legal actions and
claims arising in the ordinary course of business.
Although it is difficult to predict the ultimate outcome
of these actions, in management’s opinion, based on
discussions with counsel, the aforementioned litigation
and claims will be resolved without material adverse
effect on the financial position or results of operations
of the Bank.

45

Federal Reserve Bank of Richmond

8. Retirement and Thrift Plans
Retirement Plans
The Bank currently offers two defined benefit retirement plans to its employees, based on length of service
and level of compensation. Substantially all of the
Bank’s employees participate in the Retirement Plan
for Employees of the Federal Reserve System (“System
Plan”) and the Benefit Equalization Retirement Plan
(“BEP”) and certain Bank officers participate in a
Supplemental Employee Retirement Plan (“SERP”).
The System Plan is a multi-employer plan with contributions fully funded by participating employers. No
separate accounting is maintained of assets contributed
by the participating employers. The Bank’s projected
benefit obligation and net pension costs for the BEP at
December 31, 2002 and 2001, and for the SERP at
December 31, 2002, and for the years then ended, are
not material.

Thrift Plan
Employees of the Bank may also participate in the
defined contribution Thrift Plan for Employees of the
Federal Reserve System (“Thrift Plan”). The Bank’s
Thrift Plan contributions totaled $8 million and $6 million for the years ended December 31, 2002 and 2001,
respectively, and are reported as a component of
“Salaries and other benefits.”

9. Postretirement Benefits Other Than
Pensions and Postemployment Benefits
Postretirement Benefits Other than Pensions

46

In addition to the Bank’s retirement plans, employees
who have met certain age and length of service requirements are eligible for both medical benefits and life
insurance coverage during retirement.
The Bank funds benefits payable under the medical
and life insurance plans as due and, accordingly, has no
plan assets. Net postretirement benefit costs are actuarially determined using a January 1 measurement date.

Following is a reconciliation of beginning and
ending balances of the benefit obligation (in millions):
2002

2001

$ 77.4

$ 71.0

Service cost-benefits earned
during the period

2.2

2.3

Interest cost of accumulated
benefit obligation

5.5

5.6

Actuarial loss

6.7

12.5

Contributions by plan participants

0.5

0.4

Benefits paid

(4.1)

(3.4)

Plan amendment/settlement

(1.1)

(11.0)

Accumulated postretirement benefit
obligation at January 1

Accumulated postretirement benefit
obligation at December 31

$ 87.1

$ 77.4

Following is a reconciliation of the beginning and ending balance of the plan assets, the unfunded postretirement benefit obligation, and the accrued postretirement benefit costs (in millions):
2002
Fair value of plan assets at January 1
Actual return on plan assets
Contributions by the employer
Contributions by plan participants
Benefits paid

$

— $ —
—
—
3.6
3.0
0.5
0.4
(4.1)
(3.4)

Fair value of plan assets at
December 31

$

Unfunded postretirement
benefit obligation

$ 87.1

Unrecognized prior service cost
Unrecognized net actuarial loss
Accrued postretirement benefit costs

2001

—

11.7
(25.8)
$ 73.0

$

—

$ 77.4
11.6
(20.1)
$ 68.9

Accrued postretirement benefit costs are reported as a
component of “Accrued benefit costs.”
At December 31, 2002 and 2001, the weighted
average discount rate assumptions used in developing
the benefit obligation were 6.75 percent and 7.00 percent, respectively.

Federal Reserve Bank of Richmond

For measurement purposes, a 9.0 percent annual
rate of increase in the cost of covered health care benefits
was assumed for 2003. Ultimately, the health care cost
trend rate is expected to decrease gradually to 5.0
percent by 2008, and remain at that level thereafter.
Assumed health care cost trend rates have a significant effect on the amounts reported for health care
plans. A one percentage point change in assumed
health care cost trend rates would have the following
effects for the year ended December 31, 2002 (in millions):
One Percentage One Percentage
Point Increase Point Decrease

Effect on aggregate of
service and interest cost
components of net
periodic postretirement
benefit costs
Effect on accumulated
postretirement benefit
obligation

$ 0.5

$(0.5)

10. Subsequent Events
7.7

(8.6)

The following is a summary of the components of net
periodic postretirement benefit costs for the years
ended December 31 (in millions):
2002
Service cost-benefits earned
during the period
Interest cost of accumulated
benefit obligation
Amortization of prior service cost
Recognized net actuarial loss
Net periodic postretirement
benefit costs

Postemployment Benefits
The Bank offers benefits to former or inactive
employees. Postemployment benefit costs are actuarially determined and include the cost of medical
and dental insurance, survivor income, disability
benefits, and self-insured workers’ compensation
expenses. Costs were projected using the same discount rate and health care trend rates as were used
for projecting postretirement costs. The accrued
postemployment benefit costs recognized by the
Bank at December 31, 2002 and 2001, were $15.8
million and $13.6 million, respectively. This cost is
included as a component of “Accrued benefit costs.”
Net periodic postemployment benefit costs included
in 2002 and 2001 operating expenses were $3.5
million and $2.6 million, respectively.

2001

$ 2.2

$2.3

5.5
(1.0)
0.9
$ 7.6

5.6
(0.1)
0.3
$8.1

Net periodic postretirement benefit costs are reported
as a component of “Salaries and other benefits.”

In January 2003, the System announced plans to
restructure its check collection operations. The
restructuring plans include streamlining the check
management structure, reducing staff, decreasing
the number of check-processing locations, and
increasing processing capacity in other locations.
The restructuring, which is expected to begin in
2003 and conclude by the end of 2004, will result in
the Bank discontinuing its check operations at the
Charleston, Columbia, and Richmond offices,
increasing its check processing capacity at the
Baltimore and Charlotte offices, and consolidating
its check adjustment function at the Charlotte office.
At this time, the Reserve Banks have not developed
detailed estimates of the cost of the restructuring
plan in the aggregate or for the individual Reserve
Banks affected.
In February 2003, the Bank purchased a building
as a general use facility, at a cost of $15 million.

47

The Federal Reserve Bank of Richmond 2002 Annual Report was
produced by the Research Department, Publications Unit.
Editor
Alice Felmlee
Design Firm
Beatley Gravitt Communications
Illustrator
Bruno Budrovic
Photographers
Larry Cain and Geep Schurman
Printer
Federal Reserve Bank of Richmond
Special thanks to Laura Fortunato
and Elaine Mandaleris.

This Annual Report is also available on the Federal Reserve Bank
of Richmond’s Web site at www.rich.frb.org. For additional print
copies, contact the Public Affairs Department, Federal Reserve
Bank of Richmond, P.O. Box 27622, Richmond, VA 23261.

Fifth Federal Reserve
Richmond
701 East Byrd Street
Richmond, Virginia 23219
(804) 697- 8000
Baltimore
502 South Sharp Street
Baltimore, Maryland 21201
(410) 576-3300
Charlotte
530 East Trade Street
Charlotte, North Carolina 28202
(704) 358-2100
Charleston
1200 Airport Road
Charleston, West Virginia 25311
(304) 353-6100
Columbia
1624 Browning Road
Columbia, South Carolina 29210
(803) 772-1940
www.rich.frb.org

District Offices