Recent months have seen news of accounting and auditing move from the business pages to the front page. The Enron scandal has imposed huge costs on the economy. Many portfolios and retirement accounts have been decimated, and many individuals have lost their jobs. How can some issues of accounting cause so much damage?

    Much of our economy is built on trust—between employers and employees, suppliers and customers, companies and investors. Like reputations, trust takes a long time to build, but can be lost quickly. Once trust is lost, things go downhill rapidly.

    Several institutional features contribute to that trust. Audits performed by CPAs are intended to enhance the credibility of financial reports. An active community of stock analysts and the business press closely follow major companies. Boards of directors are supposed to exercise oversight on behalf of stockholders. With all these processes in place, how do Enron-like situations occur?

    An aggressive management culture is one factor. There is a constant search for "new business models," new competitive approaches and new forms of transactions. Transactions may be created that have little economic substance, but yield the desired accounting. While one wants some degree of aggressiveness and creativity from management, all too often top managers are in a position to "risk the company" with their aggressive tactics. The widespread use of stock options, like a free lottery ticket, encourages excessive risk-taking; managers have much to gain if things go well, but little personal loss if things turn downward.

    Corporate governance, especially as exercised by the board of directors, is supposed to monitor the actions of management. The Enron case showed that, all too often, directors are ceremonial, poorly informed and incapable of monitoring a large, complex organization.

    Limitations of our "accounting model" have been highlighted by Enron. Which assets, debts and income belonged to Enron, and which belonged to some other organization? The accounting rules aren't strong enough here. A part of the Enron

problem was that large debts and large losses that really belonged to Enron were shifted to another, seemingly unrelated, entity. For a long time, this made Enron's performance look a lot better than it really was.

    Valuation is also an issue. One of Enron's major activities was trading energy contracts. The current emphasis in accounting is to value these contracts at their market value, but that market value is subject to guesswork until the contracts are eventually settled. Because the market for these contracts is so small, market value is often whatever management estimates it to be. By estimating optimistically, these trades were reported as very profitable. This is akin to a child trading one baseball card, which he thinks is worth $100, for two others that he thinks are worth $75 each. Maybe there is a profit here, but all he has is a couple of baseball cards of dubious value—no hard cash. Trading derivatives—energy contracts and the like—isn't substantially different.

    Finally, there are inherent limitations to auditing. Audits of financial statements are not adversarial audits, as income tax audits by the IRS might be. The auditor needs to be able to trust the client. Auditors cannot examine every transaction that occurs; they depend on samples to reach their conclusions. Interfering with auditorial impartiality are the too-close relationships between auditors and clients, created by selling the client consulting services as well as audit services, long-standing use of the same auditor and the tendency of many clients to hire financial personnel from the staff of their audit firm.

    The results of the Enron disgrace will be seen on many fronts. Numerous legislative and regulatory initiatives are proposed, though the risk of overreaction is high. The accounting profession and the big CPA firms are reviewing their procedures and their consulting practices relative to auditing. New accounting standards are quickly being developed. Investors now react quickly and negatively to any hint of inaccurate reporting.

    On the education front, students need a more critical analysis of the strengths and weaknesses of accounting practice. Auditing courses will give more attention to fraud detection. Perhaps most importantly, interest in having some accounting knowledge is likely to increase, as accounting is too important to be left to the accountants alone. Virtually everyone is an investor in some form, and needs to have some understanding of the financial side of business. As a department, we are working to find ways to address these emerging needs.