Following the Money: The Enron Failure and the State of Corporate Disclosure

Chapter 2. What's Wrong--and Right--with Corporate Accounting and Auditing in the United States

2 What’s Wrong—and Right— with Corporate Accounting and Auditing in the United States Criticism of corporate accounting is not new. Strident complaints about dishonest and deceptive accounting in the 1920s1 and the distress of the Great Depression led to the creation in 1933 of the Securities and Exchange Commission. The SEC was given the authority to prescribe, monitor, and enforce accounting rules that presumably would help investors make informed decisions. The SEC quickly delegated its rulemaking function, first to the American Institute of Certified Public Accountants (AICPA) in 1936, and then in 1973 to the Financial Accounting Standards Board, but the commission remained responsible for monitoring and enforcing accounting standards. The Enron affair and the other recent accounting scandals demonstrate only too well that accounting problems remain. But before “fixes” are made, it is essential to know what exactly is wrong with accounting—and with corporate disclosure more broadly. We begin by describing the major purposes and limitations of accounting information—specifically the numbers embodied in financial state18 02-0890-CH 2 1/30/03 9:34 AM Page 18 ’ —   ments. To instill and maintain investor confidence, such information must be trustworthy. That in turn requires —that the financial figures be reported according to a well-accepted convention (Generally Accepted Accounting Principles, or GAAP); —that the figures be reliable, in that they are verified by an independent accounting expert with data derived from relevant market transactions, in accordance with a well-accepted convention (Generally Accepted Auditing Standards, or GAAS); and —that the reporting and auditing conventions be effectively enforced by market forces or an appropriate government or industry agency. We then argue that the common element in the Enron and the other recent accounting scandals was not a major flaw in the standards themselves , but primarily a failure either of the company to comply with the standards or of the regulator to enforce them. Indeed, what was perhaps most surprising about the entire Enron affair is how the many so-called “gatekeeping ” institutions set up to ensure proper disclosure all failed to do their jobs. These gatekeeping mechanisms include effective and timely guidance on accounting standards by the FASB and the SEC; fiduciary responsibilities imposed on management and directors; auditors; regulators of the accounting profession (state and federal, and the AICPA); and the threat of legal liability. The Enron case has exposed, however, a major trend in accounting standards both in the United States and at the international level—a movement toward “fair-value accounting”—that we believe is disturbing and inconsistent with the reliability objective of good accounting standards. This issue has received relatively little attention among analysts, and we intend to give it more in this chapter. The standards issue that has received much greater public attention—appropriate accounting for special purpose entities —is of secondary concern, or at least is not resolved one way or the other by the Enron episode. Enron’s other major failing was inadequate reporting of and accounting for a conflict of interest accepted by its board of directors. In short, the Enron affair does not, in our view, justify a full-scale assault on current accounting standards. Nonetheless, for reasons that predated Enron and that continue to be valid, those standards do have their limitations. 02-0890-CH 2 1/30/03 9:34 AM Page 19  ’ —  Furthermore, the standard-setting process in the United States has several major flaws, in our view. We identify these at the end of this chapter and propose possible solutions in chapter 3. The Value of Audited Financial Statements to Shareholders The securities laws in the United States were established largely to ensure that investors have as much information as they need, and when they need it, to make informed decisions about whether to buy, hold, or sell shares in publicly traded and widely held corporations. Accordingly, it is something of conventional wisdom that disclosure serves the interests of investors. But why? Most prospective investors realize that once they have committed their funds to a corporation, either by purchasing shares directly or from a shareholder , they will have little control over how the corporation is managed. Consequently, they usually are interested in how those who do have control use corporate resources, and the extent to which controlling persons (including senior managers) have conflicts of interest that might result in costs being imposed on noncontrolling shareholders. Reporting in these areas is called the...