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