NEW YORK (MONEY Magazine) - Ever since Enron's house of lies collapsed late last year, revelations of corporate abuses haven't let up.

Insider trading charges at ImClone. Allegations of accounting fraud at Global Crossing and Tyco. Actual fraud at WorldCom -- possibly the biggest in history.

"Grossly bad behavior," says John C. Bogle, founder of the Vanguard Group.

The outrages and the resulting crisis in investor confidence have prompted an unprecedented effort to bolster corporate governance -- the checks and balances that are supposed to make publicly traded companies accountable to shareholders.

Until broad changes take place, it is important for investors to understand how companies are run. To help, MONEY Magazine, with proxy data service Investor Responsibility Research Center (IRRC), crafted a series of tests to assess the 50 biggest stocks. The tests focus on three hot-button topics: board independence, overuse of stock options and manipulation of accounting rules to make earnings look good.

Investors rely on directors to represent their interests and oversee the top execs. "They are stewards of our capital," says Neuberger Berman Guardian co-manager Rick White.

How friendly is your stock?       MONEY Magazine put the 50 largest companies to the test -- see how your stock rates.

A board stacked with management and chums, however, may be too reluctant to attack mediocre performance and too eager to lard the CEO's pay package. That's why many professional investors prefer boards with a healthy majority of directors who are independent of the company.

Bogle says he'd like to see requirements for an independent board chairman (now the chairman is usually the CEO) who is responsible for the company's governance. "Shareholders have paid a big price for collegiality at the board level," Bogle says.

Big investors, including TIAA-CREF, have focused on the three most important committees on any board: the audit committee, the compensation committee and the nominating committee, which selects director candidates. Each should be 100 percent independent, no exceptions.

"If the insiders have the ability to nominate the independent directors, then the ones they nominate become beholden to them," notes Linda Selbach, head of governance for Barclays Global. The New York Stock Exchange agrees: Its most recent proposals require that a majority of the board be independent and that each listed company have nominating and compensation committees that are entirely independent.

All but six of the 50 megacaps we reviewed had boards where more than 50 percent of directors were classified as independent. Laggards include Fannie Mae, United Parcel Service and Kraft.

But your analysis should not end there: 22 of the 50 don't have fully independent nominating committees, and nine don't have fully independent compensation committees. The latter include General Electric, Bank of America and DuPont.

Who is considered "independent"? Not current and former employees. Not relatives of executive officers. According to IRRC, directors are also considered "affiliated" if they or their employers provide professional services to the company (say, legal advice) or are a major customer. IRRC also looks for what's called an interlock -- when two execs sit on the boards of each other's companies.

Investors can read the proxy's director biographies and its "related transactions" section to determine director independence. But the dry details of a director's résumé probably don't reveal personal ties to management -- what Patrick McGurn of Institutional Shareholder Services calls "soft ties."

To see how hard it can be to measure independence, consider the board of AOL Time Warner, the parent company of MONEY and CNN/Money. Although IRRC describes the board as 60 percent independent, there are a variety of soft ties.

Director James Barksdale, for instance, was CEO of Netscape in 1999 when America Online acquired it. Director Frank Caufield's venture-capital firm reportedly counts AOL Time Warner chairman Steve Case among its investors. Meanwhile, AOL Time Warner CEO Richard Parsons sat on the Philip Morris board while Michael Miles, now an AOL Time Warner director, was Philip Morris' CEO. Parsons also sat on Fannie Mae's board with its current chief, Franklin Raines, now also an AOL Time Warner director.

IRRC considers all those directors -- Barksdale, Caufield, Miles and Raines -- independent. An AOL Time Warner spokeswoman says, "We drew the conclusion that none of these relationships are material to our company."

When evaluating boards, also consider whether the company staggers its elections. Most major companies hold elections for all directors annually. But some employ terms of several years, "staggering" elections so that investors vote only on a minority of the board at any one time.

Companies with staggered elections, like Morgan Stanley, say they provide stability and foster better long-term planning. But such boards also insulate companies from takeovers -- and from angry blocs of investors who might want to toss out all the directors.

A final board yardstick: Does the company require directors to own stock? Governance experts believe that directors who own significant stakes in their companies are more apt to get involved in the business and challenge management. Stock options and stock given as part of the director's compensation aren't always sufficient. "Usually, $100,000 invested in the company is enough to make them pay attention," says Nell Minow, a veteran shareholder activist.

Surprisingly few companies (seven of the 50) require directors to sink money into the stock. DuPont, for example, instituted guidelines in January requiring directors to own stock worth at least five times their annual retainer. (Some companies may have such policies but not disclose them; call investor relations to ask.) For individual director ownership, check the proxy. Make sure to read the footnotes to see how many shares are simply options.

Stock options are a cheap way to compensate employees because companies don't have to report them as an expense on their income statements. But options cost shareholders plenty: Every option that's exercised adds to total outstanding shares, thereby "diluting" the stake of existing shareholders. In effect, managers who dole out options too freely are gradually giving away the company.

In addition, some money managers have come to believe that options have not lived up to their billing. The idea was that options would align top executives' interests with those of the shareholders. But they also give executives incentive to use questionable techniques to lift the stock -- often a short-term boost so they can cash out. "The trouble with options," gripes Christopher Davis of Davis Selected Advisors, "is that they allow management to get rich even if shareholders do lousy."

Two yardsticks can help you determine if a company is being overly generous.

Option overhang This measures option grants as a percentage of the total shares outstanding, which can provide a rough indicator of the potential for options to dilute earnings.

To calculate overhang, first add up all the shares that have been made available to employees through option grants -- the number of options given to employees but not yet exercised, plus the number of shares set aside for future options grants (available in the footnotes of the annual 10-K filing). Then divide that sum by the total number of shares outstanding.

Institutional investors like Fidelity want to see option overhang of no more than 10 percent for most companies. (Some managers accept a 20 percent overhang for high-tech and biotech companies.) According to IRRC, average overhang for the S&P 500 is 14.3 percent. And 13 of the 50 largest companies had overhang higher than the average.

Financial stocks Wachovia and J.P. Morgan Chase, for instance, sport overhangs of around 20 percent. Microsoft and Intel are above 25 percent. Morgan Stanley is tied with Dell Computer for highest at 36 percent.

Option Run Rate This is a more current indicator of dilution. Add up the option grants for the past three years (also in the 10-K footnotes), divide by three, then divide by the number of shares outstanding.

Davis argues that handing out an average of more than 1 percent of outstanding shares a year in options is giving away too much of shareholders' money -- and 3 percent is a bright red flag. "At that point," he says, "we feel like increasingly any incremental growth in the business is being transferred from the owners, the shareholders, to the people they've hired to run the business."

Why? Take Cisco Systems, whose option run rate of 3.9 percent is highest in our survey. Let's assume that its earnings grow 7 percent a year and the stock rises a corresponding 7 percent annually. According to our calculations, if Cisco continues to grant options at its current rate every year, after 10 years, employees would have gained $32 billion. Meanwhile, the actual earnings added by those employees over that same decade amount to just $14.8 billion.

Think of it this way: For each additional earnings dollar accumulated for shareholders, employees earn nearly $2.

It's no surprise that tech companies ladle out options, but it turns out that financial firms can be quite generous too; for example, Bank of America and American Express have option run rates of 3.6 percent and 3 percent, respectively.

Other things to look for are whether a company reprices its options after a stock plunge renders them worthless (it must report a repricing in financial statements) and whether the CEO gets an excessive share of total option grants. Anything over 5 percent is considered piggish, yet several of the best-known and most respected companies follow this practice: Freddie Mac, AIG, Fannie Mae and Wells Fargo top the list of megacaps, with their chiefs commanding 10.9 percent, 10.6 percent, 7.4 percent and 5.6 percent of the companies' latest annual options grants, respectively.

The corporate blowups of the past year have highlighted how companies can bend accounting rules to make earnings look good. Without an accounting degree, it can be difficult, if not impossible, for investors to decipher the numbers and figure out if a company's accounting is appropriate. Although publicly traded companies must have their books audited, Enron and Arthur Andersen showed how little that safeguard can be worth.

That's why reformers are calling for stronger board audit committees, changes to accounting rules that close loopholes and uniform standards for reporting earnings and balance sheets so that investors can better understand what's really going on.

Still, there are clues that can tip off investors to aggressive accounting. One involves the company's pension plans. Companies that offer pension plans deduct the costs of the pension benefits that they pay out annually and book income that they earn from the plan's assets (usually invested in stocks and bonds).

Here's the trick: Accounting rules allow companies to estimate their expected annual return on those investments and record that amount as income -- whether or not the investments earn that amount.

Bogle's criticism is that companies have been overestimating their expected long-term return on assets to increase the amount of pension income that shows up in earnings calculations.

How else, he asks, can companies justify estimating long-term returns of 10 percent when the stock market's historical return is around 8 percent and most pension plans aren't even invested completely in stocks? Plus, he says, the average pension plan earns roughly 80 percent of the market return because of plan costs and turnover. "It might be reasonable to expect returns in the range of 7 percent to 8 percent," he argues. "But 9.5 percent or 10 percent can't be justified." Investors can find expected pension returns in the 10-K footnotes. Of the 50 companies we examined, 24 estimated pension returns above 9 percent in 2001, including Eli Lilly, PepsiCo and Pfizer.