Incentive Problems and the "Panic of '93"

The American Civil War ended in 1865. In the 5 years between 1865 and 1870, most of the railroads in the U. S. were completed; and by 1870 the railroad companies had all hired professional managers to manage the various railroad businesses.

The various railroad companies ordered management to provide the shareholders with annual audited financial statements. As accounting principles were still quite primitive, those financial statements were to be prepared on the cash basis. In other words, revenue was to be recorded as cash was received and expenses were to be recorded as cash payments were made.

Most of those early managers were men with accounting experience; and those men quickly formulated plans to maximize their own personal wealth at the expense of the shareholders.

Their plan was to defer making necessary repairs to the roadbed so that they could to pay huge dividends to the shareholders. Management speculated that the huge dividends would cause shareholders to pay huge year-end bonuses to management; and they speculated that they could continue to follow such a policy for approximately 20 years before the deferred maintenance would create a financial crisis. By the time the deferred maintenance would precipitate a financial crisis, managers speculated that they would have already retired, or at least would have accumulated sufficient wealth to retire comfortably.

By 1890 most of the railroads were reporting huge losses, as maintenance expenses began to exceed revenues, and by 1893 half of all railroad companies were in bankruptcy proceedings.

The so-called "Panic of '93" was a nationwide financial crisis of collapsing stock prices (mostly railroad related), corporate bankruptcies, and failing banks (most of which had loans outstanding to the railroads.)

Discussion questions:

1. Why do you suppose the railroads chose the cash basis of accounting? Apply the concepts of relevance and reliability as outline in Fogelberg's comparison of accounting and finance.

2. How would accrual basis accounting have eliminated the incentive for management to follow a strategy of deferred maintenance?

3. What other techniques are in use today to control the manager-shareholder agency problem?

4. How did the investment banker J. P. Morgan address the problems in 1893? What did he do to restore confidence in the railroad industry? (You can search the internet for citations on Panic of 93, or on the Morganization of the Railroads).