In recent years the financial statements of sev-eral large well-known corporations, mostnotably Enron Corporation and WorldCom,have had to be massively restated. Is this indica-tive of inadequate accounting and auditing rulesor evidence of corporate misgovernance andauditor incompetence? Why did these problemsoccur, and are they widespread? Answers to thoseand other questions are provided in this paper,which examines historical and current evidenceof problems with corporate financial statementsauditing before Enron. To provide a better per-spective, I discuss in detail the traditional histor-ical cost model of accounting and the FinancialAccounting Standards Board’s move away fromthat model and toward a system of fair valueaccounting. A better understanding of account-ing principles will help explain what Enron didwrong and the type and extent of recent mis-statements by other corporations. In case after

case, it appears that fair value accounting that isnot based on reliable market prices was abusedby managers to create misleading financialreports. Given the influence of the Enron scan-dal in shaping public policy and public opinionabout financial reporting, this paper analyzes allthe links in the audit chain that failed to performtheir duties, from the members of the board ofdirectors to the independent auditors to the reg-ulators at the state and federal levels. Finally,three changes to generally accepted accountingprinciples (GAAP)—allowing restatements ofassets and liabilities only to the extent that thoseare based on trustworthy numbers, replacing theU.S. rules-based with a principles-based tradi-tional “matching concept” system, and allowingpublicly traded corporations to use internation-al accounting standards as an alternative to U.S.GAAP—are proposed to restore value to corpo-rate accounting reports.

The Quality of Corporate Financial Statementsand Their Auditors before and after Enron

by George J. Benston

_____________________________________________________________________________________________________

George J. Benston is the John H. Harland Professor of Finance, Accounting, and Economics at the GoizuetaBusiness School, Emory University.

Executive Summary

No. 497 November 6, 2003

C A T O P R O J E C T O N C O R P O R A T E G O V E R N A N C E , A U D I T , A N D T A X R E F O R M

Introduction

The preamble to the Securities ExchangeAct of 1934 states that it was designed “toprovide full and fair disclosure of the charac-ter of the securities sold in interstate com-merce and through the mails, and to preventfraud in the sale thereof.” To that end, corpo-rations with at least $10 million in assets andsecurities held by more than 500 sharehold-ers must file annual and quarterly financialstatements with the Securities and ExchangeCommission. Those statements are preparedby corporate managers’ accountants andmust follow generally accepted accountingprinciples (GAAP). They must also be audit-ed by a registered public accounting firm(RPA) that assures investors that the state-ments were, indeed, prepared in accordancewith GAAP, based on their audit of the cor-poration’s books and records.1 Those are therules.

However, after the discovery of misstate-ments in the audited reports of well-knownand seemingly successful corporations—notably Enron, Adelphia, Global Crossing,WorldCom, Qwest, Rite Aid, IBM, Sunbeam,Waste Management, and Cendant—journal-ists, legislators, and investors have increasing-ly questioned the integrity and usefulness ofthis disclosure-based system. Are the GAAPrules inadequate? Or, were they just not fol-lowed? If not followed, why did their indepen-dent public accountants (IPAs) attest that theywere followed?2 Did the SEC not do its job andascertain that the disclosure and attestationrequirements of the Securities Exchange Actof 1934 were being followed? Are corporationsplaying a “numbers game,” as claimed by for-mer SEC Chairman Arthur Levitt, using “cre-ative” and “aggressive” accounting to bend therules and “reflect the desires of managementrather than the underlying financial perfor-mance of the company”?3 Or is this an over-stated problem, considering the thousands ofcorporations that file financial statementswith the SEC and are not charged with wrong-doing? If it is a systemic problem, what mightbe done to correct it? In any event, what or

who is to blame for the scandals that led tooverwhelming passage by the Congress of theSarbanes-Oxley Act of 2002?

This paper begins with an historical reviewof accounting regulation, which indicatesthat the current criticisms are not new, andthen goes “back to basics” to outline whyaudited financial statements are valued byinvestors. Stewardship and investment deci-sions are the principal reasons for whichtrustworthy numbers, as attested to by RPAfirms, are particularly useful. Although eco-nomic values would be more useful than his-torical costs, these amounts often cannot bemeasured and verified as trustworthy. Indeedthe movement by the Financial AccountingStandards Board and the SEC toward anon–market-based measure of economic val-ues, “fair value,” will make financial state-ments less useful. Traditional accounting-based financial statements, though, are usefulto investors for several reasons. The mostimportant is that they describe the tradition-al accounting measure of net income, the pro-cedures for revenue and expense recognition,and the role of conservatism in determiningthose numbers. This paper will also show whyit is not possible to eliminate managers’opportunities to manipulate reported netincome or cash flows, a situation about whichinvestors should be aware.

Next comes an analysis of what wentwrong at Enron and what lessons might bedrawn from this one very important case.Enron has had great importance in moldingpublic perceptions about accounting state-ments and external auditors and is, to a largeextent, responsible for Sarbanes-Oxley, themost sweeping regulation of accountingsince the early 1930s. Overall, it appears thatEnron’s managers and auditors presentedmisleading financial statements because theydid not follow the prescriptions of basic, tra-ditional accounting and many of the rulescodified in GAAP. Enron’s failure, however,does reveal several shortcomings in GAAP,predominantly with respect to its rule-basedapproach and allowance of fair valueaccounting.

2

The movement by the Financial

AccountingStandards Board

and the SECtoward a

non–market-based measure

of economic values will make

financial statements less

useful.

Enron is not the only or the first corpora-tion to have misstated its financial statements,however. A review of the data reveals substan-tial deficiencies that are the result of corpora-tions not following established generallyaccepted auditing standards (GAAS) andGAAP rules and IPAs not discovering thesedeficiencies or acquiescing to them. On thebasis on those analyses, I consider who is toblame. Among the possible culprits are audit-ing and accounting standards and standardssetters, boards of directors, external auditors(IPAs), and professional IPA associations andstate and federal regulators, particularly theSEC. Finally, three changes to GAAP—allow-ing restatements of assets and liabilities onlyto the extent that those are based on trustwor-thy numbers, replacing the U.S. rules-basedsystem with a principles-based traditional“matching concept” system, and allowingpublicly traded corporations to use interna-tional accounting standards as an alternativeto U.S. GAAP—are suggested.

Putting the Criticism intoPerspective—The Historical

RecordAs harshly criticized as accounting and

accountants are now, such criticism is not atall new. Strident complaints about dishonestand deceptive accounting in the 1920s4 andthe distress of the Great Depression led to thecreation in 1934 of the Securities andExchange Commission, which was given theauthority to prescribe, monitor, and enforceaccounting rules that presumably would helpinvestors to make informed decisions. Ineffect, the SEC’s motto is, “Ye shall know thetruth, and the truth shall make ye rich.”Actually, the preambles to the Securities Act of1933 (which governs new securities issues) andthe Securities Exchange Act of 1934 (whichgoverns periodic financial reporting) call theacts “disclosure statutes.” However, it is notdisclosure, as such, that reigns, because pub-licly traded corporations cannot simply state,“we disclose that we will disclose nothing” or

“we follow international accounting stan-dards,” or some other statement. Rather, theSEC adopted a rule that proclaims: “Wherefinancial statements filed . . . are prepared inaccordance with accounting principles forwhich there is no substantial authoritativesupport, such financial statements will be pre-sumed to be misleading or inaccurate despitedisclosures contained in the certificate of theaccountant or in footnotes to the statementsprovided the matters involved are material.”5

Although the SEC promulgated Regulation S-X in 1940, which specifies what must bereported in filings submitted to it and how thematerial must be reported, it has generally rel-egated the development and codification ofGAAP and GAAS to the public accountingprofession. Its influence on what the profes-sion does, particularly with respect to GAAP,though, is profound and continuing.

In its early years, the SEC adopted a strong-ly conservative stance. It insisted that corporateregistrants use only historical cost–based num-bers and not include intangibles as assets.Appraisals and other estimates of the currentvalue of assets could not be reported in finan-cial statements and goodwill was eliminatedfrom balance sheets. The SEC followed thatconservative approach in response to criticismthat it had allowed corporations to report assetvalues that later evaporated. The AmericanInstitute of Certified Public Accountants, towhich the SEC granted authority to codifyGAAP, emphasized reducing the alternativesfor reporting events that superficially appearedto be the same, such as recording long-termlease obligations either on or off the balancesheet, and providing guidance for reportingnewly important events, such as the invest-ment tax credit.

Over the years, various complaints aboutand scandals related to the inadequacies ofGAAP led to the restructuring of the institu-tions dealing with and promulgating GAAP.The Financial Accounting Standards Boardwas created in 1973 as a well-funded, profes-sionally staffed rulemaking body that is inde-pendent of the public accounting profession.It replaced the Accounting Principles Board,

3

Various complaints aboutand scandalsrelated to theinadequacies ofGAAP led to therestructuring ofthe institutionsdealing with andpromulgatingthose principles.

which was run by the AICPA and staffed withvolunteer partners of CPA firms. The APB, inturn, had replaced the AICPA’s Committeeon Accounting Procedure, which was createdin 1936. The CAP could only suggest ratherthan demand specific practices, while theAPB and the FASB have been able to specifypractices that must be followed by CPAs andcompanies that report to the SEC.

Since the mid-1970s, though, dissatisfac-tion with allegedly irrelevant historical costshas moved the SEC and the FASB towardrequiring companies to report current valuesfor financial assets. Marketable securities thatare regularly traded or are held for sale must beshown at their market values (if these are avail-able) on balance sheets, although revaluationgains and losses that are not realized areincluded in the income statement only fortraded securities. Debt securities held untilmaturity are shown at cost, with their marketvalues reported only in footnotes to the state-ments. Derivatives that do not qualify ashedges (based on a complex set of rules codi-fied in Financial Accounting Statement 133and 138 and interpretations thereof) must bestated at fair values, with changes in these val-ues reported as income or expense in theincome statement. Because these financialassets often are not regularly traded, their val-ues are determined with models rather thanfrom quoted market prices. In addition, con-tracts involving energy and risk managementactivities must be stated at fair values, eventhough these amounts are based on calcula-tions of the present value of the net cash flowsthe assets are expected to generate.

Thus, under current FASB rules corporatebalance sheets are mixtures of past (histori-cal) values, current values based on marketvalues, and fair values estimated by corporatemanagers. An issue that is (or should be)debated is whether financial accountingshould continue moving toward showing allor some assets and liabilities at current valuesand, if so, whether these should be based onlyon market values or on market values andestimates thereof (fair values). Also to bedebated is whether accounting should return

to values based on actual transactions (his-torical costs) or on some combination of val-ues. The answers depend on the purposes forwhich financial statements are useful toinvestors.

The Value of AuditedFinancial Statements

Stewardship and Investment DecisionsInvestors, whether present or prospective

shareholders, benefit from learning abouthow their investments have been and mightbe used by the managers of their companies.Managers render financial reports to theirboards of directors and shareholders. Thosereports are the principal formal means bywhich managers convey how they have man-aged a company’s resources over a period oftime, usually no longer than a year, and thefinancial condition of the company at theend of that period, as determined by theiraccounting records. Prospective investorsrealize that once they have committed theirfunds to a corporation, either by purchasingshares directly or from a shareholder, theyusually have little control over how the cor-poration is managed. Consequently, theyhave reason to be interested in how thosewho are in control of corporate resources usethose assets and the extent to which control-ling persons (senior managers, directors, andother shareholders) have conflicts of interestthat might result in costs being imposed onthem as noncontrolling shareholders. Re-porting in these areas is called the “steward-ship” function of accounting. Financialreports also help to motivate managers tooperate their corporations in the interest ofshareholders. This is called the “agency” or“contracting” function of accounting.

In addition to a report of stewardship,investors want data that help them determinethe present and possible future economicvalue of their investments. If a corporation’sshares are actively traded in a market, share-holders can obtain seemingly unbiased esti-

4

Under currentFASB rules

corporate balancesheets are

mixtures of past values, cur-

rent values basedon market values,

and fair valuesestimated by

corporate managers.

mates of the economic value of their invest-ments from share prices. However, thoseprices are based, in part, on the informationprovided in financial reports. If that informa-tion is not useful and accurate, its receipt willnot provide investors with insights that theywant nor would it change the values ascribedto those shares. Hence, prospective investorsmight have to incur costs to obtain informa-tion elsewhere or discount the amount theyare willing to pay for the shares, given theinformation currently available to them. Thatwould make the shares worth less to them.Thus, present shareholders, including thosewho can exercise some control over the corpo-ration, also benefit from their managers pro-viding all investors with financial reports thatinvestors find trustworthy.

Because the corporate managers who pre-pare their firms’ financial reports have incen-tives to misreport the performance and finan-cial condition of their enterprises, financialstatement users have reason to question thetrustworthiness of those statements. Assuringthat figures are reliable and presented accord-ing to GAAP is the principal purpose of auditsby IPAs—for example, Certified Public Ac-countants (U.S.), Chartered Accountants(UK), or Wirtschaftsprüfer (Germany). IPAs’attestations of the validity of the numbers pre-sented provide surety that they have examinedthe corporate records in a manner that isexpected to be sufficient to uncover materialmisstatements and omissions and that theyhave conducted an audit that conforms toGAAS.

Trustworthiness of Financial Statementsand IPAs’ Attestations

For a substantial portion of stewardship, itis sufficient for the numbers presented to betrustworthy and the audits designed touncover and reveal misuse of corporateresources, misstatement of income andexpenses, overstatement of assets, and under-statement of liabilities. Only an audit can pro-vide this information.

For evaluating managers’ performance andfor investment decisions, it would be desirable

for financial statements to report the value toinvestors of their corporation’s resources atthe beginning- and end of an accounting peri-od. Net income or loss for the period, then,would be the difference between the begin-ning- and end-of-period values, adjusted fordistributions to and additional investmentsby shareholders. For those purposes, econom-ic values for assets and liabilities, rather thanhistorical costs, would be most relevant.Indeed, that is an important motivation forthe increasing inclusion of market values and,where these are not available, “fair values”(which proxy for market values) in place of his-torical costs in the accounting standardsadopted by the FASB and the InternationalAccounting Standards Board .

A fair value is the amount for which anasset presumably could be (but hasn’t been)exchanged or a liability settled betweeninformed, willing parties on an arm’s-lengthbasis. That amount may be computed frommanagement’s estimates of the present valuesof expected cash flows (as described in theFASB’s Statement of Financial AccountingConcept 7). The problem is that fair values (asdistinct from market values) must often bederived from estimates rather than actualmarket values. Unfortunately, a financialreport based on fair values can rarely beachieved within the requirement that thenumbers also be trustworthy. It often is saidthat there is a trade-off between trustworthi-ness and relevance, but information is relevantand useful for decisionmaking to the degreethat it is accurate and unbiased (where the biasis not known). Therefore trustworthy num-bers are more relevant than fair values that arenot based on market prices, because fair valuesare much more subject to managerial manip-ulation than are historical costs. Investors andothers who want to know the economic mar-ket value of the enterprise must and can lookto other sources of information apart from acompany’s financial statements. For example,fair values could be presented to investors insupplementary schedules and even attested toby IPAs as having been derived from models orsources that the IPAs find acceptable.

5

The problem isthat fair valuesmust often bederived from estimates ratherthan actual market values.

Can Economically Meaningful andTrustworthy Numbers Be Obtained?

One problem in determining economic val-ues stems from the cost and difficulty—oftenimpossibility—of measuring the value of assetsto an enterprise (value-in-use) and, hence, to aninvestor. That is the present value of the netcash flows expected from an asset’s use (includ-ing disposal) by the enterprise in combinationwith other assets and liabilities. This is very dif-ficult to estimate, even subjectively. Further-more, the estimates are likely to change overtime, as other enterprise operations, marketconditions, and general and specific priceschange. Although managers make formal orinformal estimates of the present values ofassets before their purchase, these estimatesneed only indicate that the present value of netcash flows exceeds the cost of the asset.Furthermore, this analysis (called “capital bud-geting”) often requires data that are not rou-tinely available, such as current and expectedprices and amounts related to asset purchaseand use. Repeating these analyses for each peri-odic balance sheet would be very costly. Fixedassets, such as buildings, equipment, and landused for operations, provide prime examples ofthese valuation difficulties. Even more difficultto estimate are the values of intangible assetsthat are produced by the enterprise.

In addition, the value of an enterprise to aninvestor is almost always greater than the sumof the values of its assets less the sum of its lia-bilities. That is one of the principal reasonsthat companies exist. Their owners obtainrents (positive externalities) from the combi-nation of assets and liabilities that comprisethe company, which increase expected netcash flows above the amounts these assets andliabilities separately or in other combinationswould have generated. (If the whole were notworth more than the sum of the parts, thecompany should be liquidated, in which eventthe value-in-use would be the net disposalvalue.) Thus, for almost all corporations, evenif investors and IPAs were willing to accept astrustworthy the managers’ estimates of theeconomic values of individual assets and lia-bilities, the amount shown as “fair-value

shareholders’ equity” would not equal the eco-nomic value of the enterprise. Nor would thechange in shareholders’ equity (adjusted fordistributions to and additions by sharehold-ers) provide a valid measure of shareholders’net economic income.

A second and more important problem isthat the only economic values that can bemeasured are rarely trustworthy unless theyare based on relevant and reliable market val-ues rather than managerially determined fairvalues. In this light there should be great con-cern about the FASB’s move to require restate-ment of all financial assets to fair values, evenwhen these amounts are not based on trust-worthy market prices, with the changes inthose values shown as current income (orloss). Managers who want to make it appear asif they had done well in a particular account-ing period can readily increase the fair value ofassets and, thereby, increase reported netincome. All they have to do is increase theirestimates of cash inflows, decrease their esti-mates of cash outflows, or decrease the ratethat discounts the net cash flows to obtainpresent (fair) values. They can easily workbackward toward the numbers they want, con-structing a rationale for the estimates theymake that IPAs would find difficult or impos-sible to refute. If the cash flows they estimatedturn out to be incorrect (as they inevitably will,even if the managers sought only to makeunbiased estimates), the managers can arguethat conditions have changed (as theyinevitably do). They can argue further thatthey could not reasonably have predicted thechanges or that they did correctly predict arange of outcomes with associated probabili-ties, and that the outcome was within thisrange, although not equal to the expectedamount. This lack of trustworthiness led theSEC in its early years to disallow estimates andappraisals.

The Usefulness of Financial Statementsto Investors Considering the Limitationsof Reporting Trustworthy EconomicValues

Although financial statements that report

6

The value of anenterprise to an

investor is almostalways greater

than the sum ofthe values of

its assets less thesum of its liabilities.

the economic position of an enterprise at theend of an accounting period and changes inthat position over the previous period cannotbe reliably produced by managers and audit-ed by IPAs, the statements nevertheless havegreat value to investors. In addition to provid-ing evidence of an audit and revealing thepresence or absence of significant conflicts ofinterests and misappropriation of resources(stewardship), financial statements provideinvestors with five additional valuable bene-fits.

One benefit is disclosure of importantnumbers, the values of which investors cantrust to be accurate. These presently includecash and marketable securities, accounts andnotes receivable, prepaid expenses, current lia-bilities, floating-rate interest-bearing assetsand liabilities and fixed-rate obligations wheninterest rates have not changed, and the phys-ical presence, if not the economic values, ofinventories, plants, equipment, and land.GAAP could be changed to have many inven-tories and fixed-interest-bearing assets andliabilities reliably stated at economic (market)values. Even then, however, in volatile marketsthe numbers reported as of the balance sheetdate may not reflect current prices.

A second value is assurance that all thenumbers presented in financial statementsare consistent with GAAP. Even though manyof these numbers (e.g., some long-term tangi-ble and most, if not all, intangible assets) donot reflect economic values well, at leastinvestors can readily understand the rulesunder which they are recorded. For example,when trustworthy valuations cannot bemade, GAAP should not permit managers toincrease the value of buildings or decrease theamount of depreciation to give investors theimpression that the reported numbers actual-ly measure the value of their investments orthat accounting net income was greater.Revenue should not be recorded unless thecorporation has substantially completed all itmust do to be entitled to future cash inflows.Indeed, even though the income statement isnot (and cannot be) a report of the change inshareholders’ wealth embodied in the corpo-

ration over a period, net of dividends and newinvestments, it provides investors with a gen-erally useful indicator of periodic changes inwealth. Because this is the statement that hasbeen (and will continue to be) of greatestinterest to investors, the next section outlineshow it could be improved.

The third benefit is confirmation of earlierannouncements by managers of a company’sfinancial condition and earnings. By the timeaudited financial statements are published,market participants have usually learned andacted on information about the corporations’financial condition and changes over the peri-od. This information often comes from cor-porate announcements, such as current andexpected earnings, write-offs of discontinuedfacilities, and changes in earnings prospectsas the result of new or revised contracts,employee lay-offs, and management changes.Much of this information is also reported inthe financial statements. Because the state-ments are attested to by IPAs, both seniormanagers and investors can be assured thatthe announcements that reflect or affect thenumbers in the statements are unlikely to befabrications. That assurance improves theefficiency of share transactions, such that thecost of information is lower and share pricesvery quickly reflect changes in the economicvalue of corporate shares.

The fourth benefit, the usefulness of thenumbers presented for analyses of trends, fol-lows from the other benefits. As long as ana-lysts and investors have assurance that thenumbers presented are consistently pro-duced, they can use these data to identifytrends—such as growing or shrinking salesand profit margins, inventories, capitalinvestments, and income and expense ratiosto sales and assets—and changes therein, thathelp them evaluate and predict company per-formance.

The fifth benefit is provision of a usefulmeasure of economic performance—the tradi-tional accounting definition of net incomefrom operations. Deliberate violation by man-agers of this measurement has been the great-est problem for public financial accounting.

7

Revenue shouldnot be recordedunless the corporation hassubstantiallycompleted all itmust do to beentitled to futurecash inflows.

The AccountingMeasurement of Net

Income

Revenue RecognitionDetermining net income involves two key

steps. The first is recognition of revenue,which has two essential requirements: timingand reliable measurement. Revenue may berecorded when a corporation has essentiallyfulfilled its obligations to the purchaser inwhole or in part. When the transaction iscomplete, title to the product should havepassed to the purchaser. When the product isdelivered contractually over more than oneaccounting period, the proportion of revenuecalled for in the contract that is completed ina period should be reported as revenue inthat period. That point of recognition isoften called the “critical event.” For example,although the conversion of materials, labor,and overhead into finished goods availablefor sale usually increases their value above thesum of the resources expended, revenue isnot recognized until the critical event, whichis the sale to a customer. When there is a firmcontract that essentially transfers title to thegoods when they are manufactured, however,their completed manufacture is the criticalevent. In contrast, a consignment would notbe treated as producing revenue to a compa-ny, because the critical event is sale of theconsigned goods by the recipient and itsacceptance of an obligation to pay the com-pany. A similar situation is a sale that isfinanced by the seller, either directly with aloan or indirectly with a guarantee of a loanmade to the buyer by a third-party lender(e.g., a bank) where the prospect that thebuyer will pay for the goods as promised isunclear. The critical event is the paymentsreceived from the buyer or the buyer’s repay-ment of the loan and release of the seller’sobligation. In effect, this is an “installmentsale,” and revenue should be recognized asthe payments are made, not when the prod-uct was transferred. (Alternatively, the

account or note receivable could be reducedto the amount of expected repayment.) These“rules” for revenue recognition are well estab-lished, although they often are violated whenmanagements seek to manipulate and mis-state net income.

Reliable measurement is necessary to deter-mine the value of assets received or liabilitiesextinguished in exchange for goods and ser-vices, and hence the amount of revenueearned. The amount of revenue earned shouldbe determined by the value of the assetreceived. Where the market values of assetsreceived in exchange cannot be reliably mea-sured, revenue should not be recorded untilreliably measured values can be determined.For example, if a company receives inexchange for its product the product of thepurchasing company, the revenue amountshould be no greater than the amount that theproduct received could be sold in an arm’s-length transaction. Thus, an Internet compa-ny that “sold” time on its website in exchangefor time on another internet company’s web-site should record as revenue no more thanthe amount for which it could sell the timereceived. If either or both of the companieshave surplus time that they cannot sell inarm’s-length transactions for cash or otherassets that can be reliably valued, the “sale” hasno value and no revenue should recorded.

Another, often encountered example is atied sale, where a company sells its productfor a reliably measured asset, such as cash ora receivable, but agrees to purchase thebuyer’s product, perhaps at an inflated price.In that and other situations, the issue iswhether the asset purchased is valued at anarm’s-length price. If the price paid is greaterthan the arm’s-length price, the differenceactually is a discount of the sales price, whichshould be recorded as a reduction of revenue.

Such would not be the case, however, inanother fairly common situation that ofteninvolves commodities, where companiesinflate their sales with largely offsetting salesand purchases to each other. For example,Company S sells electricity contracts toCompany B for a reliably specified amount

8

Revenue shouldnot be recorded

until reliablymeasured values

can be determined.

but, in exchange, informally agrees to buy thesame or similar amount of Company B’s elec-tricity contracts for almost the same price.These may be “sham” sales, but they are verydifficult to distinguish from legitimate salesthat may have been undertaken to diversifyrisk. Unless IPAs can determine that such salesreally are shams, they have no alternativeexcept to attest that the companies’ financialstatements accord with GAAP. Financial state-ment users should recognize this and otherbasic limitations of auditing and financialaccounting. They can often discover andadjust for such situations by examiningwhether increases in revenue are associatedwith decreases in gross margins.

It also is important for managers to distin-guish between revenue earned from the opera-tions of the enterprise and income derivedfrom the sale and revaluation of assets and lia-bilities. Many financial statement users (par-ticularly investors) base their calculations of acompany’s prospects on its past performance,as reflected by its revenue and net incomefrom its continuing operations. In the past,accountants sought to limit the income state-ment to those numbers, with nonoperatingand extraordinary revenue and expenses takendirectly to shareholders’ equity in the balancesheet (then called “earned surplus”). However,experience revealed that managers tended toexclude the effect of many unfavorable eventsfrom the income statement. Consequently,the accounting profession adopted the “cleansurplus” approach, whereby almost all incomeand expense is reported in the income state-ment. Hence, it is important that revenue (orsales) and the associated expenses include onlythe results of the ordinary operations of anenterprise.

A very important task for the IPA, then, isto determine that the requirements for recog-nizing and classifying revenue have, in fact,been met. (Indeed, as explained later, this hasbeen perhaps the most prevalent and impor-tant aspect of misreporting that has not beencaught and corrected by external auditors.)An important part of this determination isthe GAAP requirement that the financial

records must be presented in a manner con-sistent with earlier reports, unless otherwisenoted and explained. Thus, a consistentlyapplied recognition rule would tend to pre-vent managers from recording, say, a substan-tial increase in revenue from one previouslyspecified source in a particular period to coverup losses or a substantial revenue declinefrom a different previously specified source.For example, a company should not report as“revenue or cash flows from operations” thegains or amounts received from its sale of asegment of its business.

Expense RecognitionThe second key step is matching the

expenses incurred (whether beneficially ornot) to obtain the revenue recognized. Theseare the costs of acquiring the revenue less theireconomic value at the end of the accountingperiod. This is the “matching concept” thathas served accounting very well over a longtime. Some expenses, such as the cost of resoldmerchandise and salespersons’ commissions,can readily be matched with revenue. Manyexpenses, though, are incurred before or afterthe associated revenue is recognized. In gener-al, accruals are designed to deal with this situ-ation. Expenditures for tangible assets thatwill generate revenue in future periods, such asbuildings and equipment, are “capitalized”and charged against revenue (i.e., as deprecia-tion expense) over the period of their estimat-ed useful economic lives. Expenses incurred togenerate currently reported revenue that willnot be paid for until future periods, such asthe cost of warranties and pension benefits,are charged against that revenue and a liabilityfor the future expected expenditure is created.(The charge should be for the present value ofthe liability, preferably discounted at no high-er rate than the yield on the company’s debt,since the pension liability is a preferred obliga-tion.) Expenses that are predominantly time-related, such as administrative and propertyexpenses, are generally charged against rev-enue in the period in which they are incurred.The rationale is that the resources created,such as going concern value and other intan-

9

It is importantthat revenue (orsales) and theassociatedexpenses includeonly the resultsof the ordinaryoperations of anenterprise.

gibles, rarely can be reliably measured and, ifthey were recorded as assets, would be untrust-worthy and subject to manipulation by man-agers.

Similar reasoning, however, has not beenapplied to manufactured inventory, perhapsbecause it is a tangible rather than an intangi-ble asset. Overhead expenses that are fixed (i.e.,do not vary with inventory produced) are allo-cated to inventory with arbitrary but not read-ily manipulated procedures (e.g., per dollar orhour of direct labor). Those fixed amounts,though, ought to be charged to the period inwhich they were incurred, based on theassumption that the opportunity value of theinventory in process of manufacture or fin-ished goods is the cost to replace it—the vari-able costs that were incurred. (Where theinventory cannot be replaced at variable costbecause the plant is operating at capacity, theasset value of the inventory would be the lowerof the estimated replacement cost or net real-izable value.)

As suggested by E. Edwards and P. W. Bellin 1961,6 assets and liabilities that can be val-ued reliably as of the end of the accountingperiod should be recorded and the differencebetween those values and the recorded valuesshould be reported as income (or expense)from holding gains (or losses). The importantelement is trustworthiness. In general, thismeans that the amounts are those that are or,if based on accepted independent valuations,would be based on prices determined fromarm’s-length market transactions.

Conservatism“Conservatism” refers to the bias in tradi-

tional accounting to delay the recognition ofincome and speed up the recognition ofexpense when there is substantial uncertain-ty about both the timing and the amountsinvolved. For example, if a construction firmhas undertaken a contract spanning severalyears, where the amount it will eventuallygain cannot be determined until the contractis completed, revenue is not reported until itis clear that it has been earned and will be (orhas been) received. Expenses incurred to earn

that revenue will be similarly delayed (thematching concept), although if they exceedthe expected revenue, they will be reported asexpenses (reductions in equity) in the currentperiod.

Accountants necessarily must estimatesome items of revenue and expense. For exam-ple, the amount of revenue that will be earnedon a project and employees’ pensions that willnot be paid until some future time can only beestimated. The estimated revenue, though,will rarely be reported until there is reliable evi-dence of its amount and that it has, indeed,been earned and will be received. The estimat-ed expense, though, will be reported currently.

The essential reason for the conservativebias is accountants’ long-term experiencethat people get very upset when they learnthat events are worse than they believe theywere led to expect, but usually are happywhen events are better than expected. Hence,it is better to delay the good news until it islikely to occur and recognize the bad newsearlier rather than later.

Eliminating Some Managerial Discretionto Manipulate Reported Net Income IsNot Possible

The traditional accounting measure of netincome (with or without the change suggestedthat would incorporate trustworthy currentvalues of inventories and other assets and lia-bilities) must necessarily be derived, to someextent, from assumptions and judgments,which give managers some ability to affectreported net income. For example, theamount of depreciation of plant, equipment,and other fixed assets is determined byassumptions about the useful economic life ofthose assets and the rate at which their costsare written off as expenses. The relevant mea-sure would be the reduction (or possiblyincrease) in the value-in-use of depreciatingassets. However, those measurements are gen-erally unreliable and often subject to deliber-ate misrepresentation. Accountants, therefore,have used predetermined procedures, such asstraight-line or accelerated allocations of thehistorical cost of fixed assets, to determine

10

GAAP does notallow IPAs to

accept numbersthat are inconsis-

tently determinedfrom period to

period.

periodic depreciation expenses. As long asfinancial statement users understand that, atbest, those numbers only approximate thecost to equity holders of holding and usingdepreciable assets, they can make adjustmentsto the reported net income numbers, includ-ing ignoring depreciation as a meaningfulmeasure of economic user cost.

Liabilities that must be estimated also givemanagers an opportunity to affect reportednet income. For example, a company’s liabilityfor warranties and employee retirement bene-fits is based on assumptions about expectedfuture cash flows and discount rates. Theamounts that are charged as current-periodexpenses can vary considerably, depending onthose assumptions.

Managers can also time transactions andtake advantage of alternative accrual proce-dures to alter revenue recognition and expenseincurrence. For example, they can delay orspeed up revenue recognition betweenaccounting periods by specifying when titlepasses to a purchaser. Period expenses that arenot inventoried as part of manufacturedgoods—such as advertising, research and devel-opment, and maintenance—can be reduced,delayed, or incurred earlier than need be inorder to affect the amount charged against rev-enue in an accounting period. IPAs cannotobject to those actions, because they representthe effect of actual events. Newly appointedCEOs can decide that the value of substantialassets are impaired and write them off (a pro-cedure known as the “big bath”), therebyreducing future expenses. IPAs can and shouldexamine the rationale for such write-offs forconformity with the matching concept.

However, the ability of opportunistic man-agers to manipulate reported net income withtiming and accrual assumptions is limited bythree factors. One is the self-correcting natureof accruals. Earlier revenue recognition thatoverstates net income in a period results inunderstated net income, usually in the nextperiod. Direct charges of “extraordinary”events to retained earnings that bypass theincome statement are not self-correcting and,thus, rarely are (or should be) accepted by

IPAs. The second is managers’ decisions toadvance or delay the acquisition, purchase,and use of resources. Unfortunately for share-holders, this form of manipulation is morethan cosmetic; it can be detrimental to eco-nomic performance. This detriment, though,limits the extent to which these manipula-tions of expenses can be made, because theirnegative effect will be reflected by such actualevents as lower sales and higher expenses.Third, GAAP does not allow IPAs to acceptnumbers that are inconsistently determinedfrom period to period. Hence, although man-agers can, say, initially reduce depreciationexpense by assuming a longer economic lifefor a fixed asset, in the future the depreciationexpense must be greater.

Nevertheless, users of financial statementsshould be aware of possible managementmanipulations of financial accounting datathat are accepted by IPAs. IPAs might acceptthe data because they conform to GAAP rulesand could accurately reflect the operations ofa company, or because the IPAs are not com-petent or have been (perhaps unknowingly)suborned. Users should and can evaluate andinterpret the reported data.7

To summarize, net income should be theamount that can be reliably reported as hav-ing increased the claim of equity holders overthe assets of their corporation, althoughsome of the numbers are derived from esti-mates and judgments. The balance sheetshould only partially reflect the economicmarket values of individual assets and liabili-ties as of the balance sheet date. To someextent, managers can manipulate the num-bers presented in the income statement. Thatis the best that accounting can do, and, whenthe numbers reported are trustworthy, that isvery valuable to investors and other users offinancial statements.

The Role of Auditing and AccountingStandards

Standards governing audits (GAAS) andthe content and presentation of financialaccounting data (GAAP) in formal state-ments (balance sheets, income statements,

11

To some extent,managers canmanipulate the numbers presented in theincome statement.

and statements of cash flow) substantiallyimprove the usefulness of financial reports.Users of those reports can efficiently deter-mine the extent to which the attesting IPAshave examined the books and records of theirclients. Users also should be able to readilydetermine the meaning and validity of thenumbers presented in the statements, partic-ularly if IPAs have done their jobs well.Consequently, it is very important that IPAsdetermine that the financial statements reallywere prepared in accordance with GAAP.

Standards provide substantial benefits toIPAs as well, who are likely to be under pres-sure from some managers to overlook oreven accept misrepresentations of poor per-formance. Codified accounting concepts andstandards and auditing procedures can pro-vide IPAs with guidance and protect themfrom demands by clients to attest to num-bers that might mislead financial statementusers. They can rightly claim that there is nopoint for the client to go to another IPA whomight be more compliant, because all IPAsmust adhere to the same general standards.

What Went Wrong atEnron?

Enron’s bankruptcy has generated sub-stantial concern about inadequacies of GAASand GAAP, probably because Enron becamebankrupt so very quickly after having been sohighly regarded. Its stock price, which hadincreased from a low of about $7 in the 1990sto a high of $90 a share in mid-2000, plungedto less than $1 by the end of 2001, wiping outshareholders’ equity by almost $11 billion.That decline was preceded by an announce-ment, on October 16, 2001, that the companywas reducing its after-tax net income by $544million and its shareholders’ equity by $1.2billion. On November 8, it announced that,because of accounting errors, it was restatingits previously reported net income for theyears 1997 through 2000. These restatementsreduced previously reported net income as fol-lows: 1997, $28 million (27 percent of previ-

ously reported income of $105 million); 1998,$133 million (19 percent of previously report-ed income of $703 million); 1999, $248 mil-lion (28 percent of previously reported incomeof $893 million); and 2000, $99 million (10percent of previously reported income of $979million). These changes reduced stockholders’equity by $508 million. Thus, within a month,Enron’s stockholders’ equity was lower by $1.7billion (18 percent of previously reported equi-ty of $9.6 billion at September 30, 2001). OnDecember 2, 2001, Enron filed for bankruptcyunder Chapter 11 of the United StatesBankruptcy Code. With assets of $63.4 billionit was the largest corporate bankruptcy in U.S.history until WorldCom declared bankruptcyin 2002.8 Not only did investors and employ-ees, whose retirement plans included largeamounts of Enron stock, lose wealth, butEnron’s long-time auditor, Arthur Andersen,was destroyed, and the U.S. system of financialaccounting was severely questioned, withstrong and insistent calls for reform that cul-minated in the enactment of the Sarbanes-Oxley Act of 2002.

Enron’s Accounting Errors andShortcomings

The role of accounting misstatementsand corrections in causing, rather thanreflecting, Enron’s demise still is unclear.9

Over time, as congressional, SEC, bankrupt-cy court, and other investigations proceedand lawsuits against Enron’s officers anddirectors, accountants, and lawyers unfold,we should learn more. Nevertheless, fivegroups of issues may be delineated: (1) thefailure to account properly for and invest-ments in special purpose entities (SPEs—organizations sponsored by and benefitingEnron but owned by presumably indepen-dent outside investors) and Enron’s dealingswith them, (2) Enron’s income recognitionpractice of recording as current income feesfor services rendered in future periods andrecording revenue from sales of forward con-tracts, which were, in effect, disguised loans,(3) fair-value accounting resulting in restate-ments of “merchant” investments that were

12

The role ofaccounting

misstatementsand corrections in

causing, ratherthan reflecting,Enron’s demisestill is unclear.

not based on trustworthy numbers, (4)Enron’s accounting for its stock that wasissued to and held by SPEs, and (5) inade-quate disclosure of related party transactionsand conflicts of interest and their costs tostockholders. All but one of these issues (thethird, fair value accounting) involved viola-tions of the provisions of GAAP and GAAS.One other (inadequate accounting for SPEs)appears to have violated the spirit, if not theletter, of GAAP, and has resulted in a changein GAAP adopted by the FASB.10

Accounting for and Associated with Investmentsin SPEs. Enron sponsored hundreds (perhapsthousands) of SPEs with which it did busi-ness.11 Many were used to shelter foreign-derived income from U.S. taxes. The SPEs forwhich its accounting has been criticized,though, were domestic and were created toprovide a means whereby Enron could avoidreporting losses on some substantial invest-ments.12 The structure and activities of thespecific SPEs in question are quite compli-cated, in part because the SPEs themselvescreated other SPEs that dealt with Enron.13

Outside investors held all of the equity inEnron’s SPEs, usually amounting to no morethan the minimum of 3 percent of assets estab-lished by the accounting authorities (SEC andthe FASB) for a sponsoring corporation toavoid consolidating the SPEs into its financialstatements. The balance of the assets was pro-vided from bank loans guaranteed, directly orindirectly, by Enron or with restricted Enronstock and options to buy Enron stock at lessthan market value, for which Enron got areceivable from that SPE. Had Enron account-ed for transactions with these SPEs in accor-dance with the spirit as well as the letter ofGAAP requirements on dealings with relatedenterprises and disclosure of contingent liabil-ities for financial guarantees, nonconsolida-tion, as such, should not have been an issue.

Six accounting problems are associatedwith Enron’s SPEs, all of which appear to haveinvolved violations of GAAP as it existed at thetime. First, in some important instances, theminimum “3 percent rule” was violated, butthe affected SPEs were not consolidated.

When Arthur Andersen realized that this wasnot done, it required Enron to restate itsfinancial statements. Second Enron failed tofollow the dictates of FAS 5, the accountingstandard that deals with contingencies, andreport in a footnote the amounts and condi-tions of financial contingencies for which itwas liable as a result of its guaranteeing theSPEs’ debt. Had that been done, analysts andother users of Enron’s statements would havebeen warned that the corporation could beliable for a very large amount of debt. Indeed,the bankruptcy court examiner found thatEnron’s debt of $10.23 billion reported as ofDecember 31, 2000 would have increased by$1.35 billion.14 In this regard, Enron’s not con-solidating the SPEs was not the problem.Indeed, where Enron did not own or controlthe SPEs, it should not have consolidatedthem. Third, Enron did not but should haveconsolidated the SPEs that, in fact, it con-trolled, because they were managed by its chieffinancial officer (CFO), Andrew Fastow, or hisemployees. Fourth, although Enron con-trolled some SPEs through its CFO, transac-tions with them were treated as if the SPEswere independent enterprises; Enron shouldnot have recorded net profits from thosetransactions. Fifth, Enron funded some SPEswith its own stock or in-the-money options onthat stock, taking notes receivable in return.That violated a basic accounting procedure,under which companies should not record anincrease in stockholders’ equity unless thestock issued was paid for in cash or its equiva-lent. Reversal of this error resulted in a $1.2 bil-lion reduction in shareholders’ equity inOctober 2001. Sixth, Enron used a put optionwritten by an SPE to avoid having to record aloss in value of previously appreciated stockwhen its market price declined, without recog-nizing that the option was secured by theSPE’s holding of unpaid-for Enron stock andloans guaranteed by Enron.

Incorrect Income Recognition. Several of theSPEs paid Enron fees for guarantees on loansmade by the SPEs. Although GAAP and thematching concept require recognition of rev-enue only over the period of the guarantees,

13

Six accountingproblems areassociated withEnron’s SPEs, allof which appearto have involvedviolations ofGAAP as it exist-ed at the time.

Enron recorded millions of dollars of up-frontpayments as current revenue. It also appears tohave engineered several sizeable sham “sales,”where the buyers simultaneously or after apre-arranged delay sold back to Enron thesame or similar assets at close to the pricesthey “paid.” This allowed Enron to reportprofits on the sales and, almost simultaneous-ly, increase the book value of some assets.

In addition, Enron recorded as “sales”transfers of assets to SPEs even though it stillcontrolled and substantially kept the risksand rewards derived from the assets. Enronfirst transferred the assets to subsidiaries,then exchanged nonvoting stock in the sub-sidiaries to SPEs in exchange for funds thatthe SPEs borrowed. Simultaneously, Enronswapped rights to the cash flow from theassets for an obligation to pay the bankloans. Thus, in essence Enron still owned theassets and had borrowed funds from banks,but recorded the transaction as sales and didnot record the debt.15

Fair Value Restatements of “Merchant” Invest-ments Not Based on Trustworthy Numbers. TheAICPA’s Investment Company Guide requiresinvestment, business development, and ven-ture-capital companies to revalue financialassets held (presumably) for trading to fair val-ues, even when these values are not deter-mined from arm’s-length market transac-tions. In such instances, the values can bebased on “independent” appraisals and onmodels using discounted expected cash flows.The models allow managers who want tomanipulate net income the opportunity tomake “reasonable” assumptions that wouldgive them the gains they want to record. Enrondesignated various projects and investmentsin subsidiaries as “merchant” investments,which allowed it to restate these investmentsat fair values in accordance with AICPA’sInvestment Company Guide.

A particularly egregious example is Enronbroadband investment and joint venture withBlockbuster, Inc., which was called Braveheart.Enron invested more than $1 billion onbroadband and reported revenue of $408 mil-lion in 2000, much of it from sales to Fastow-

controlled SPEs. In addition, on July 19, 2000,Enron entered into a 20-year agreement withBlockbuster, Inc., to provide movies ondemand to television viewers. The problemwas that Enron did not have the technology todeliver the movies and Blockbuster did nothave the rights to the movies to be delivered.Nevertheless, Enron, as of December 31, 2000,assigned a fair value of $125 million to itsBraveheart investment and a profit of $53 mil-lion from increasing the investment to its fairvalue, even though no sales had been made.Enron recorded additional revenue of $53 mil-lion from the venture in the first quarter of2001, although Blockbuster did not recordany income from the venture and dissolvedthe partnership in March 2001. In October,Enron had to reverse the $110.9 million inprofit it had earlier claimed, an action thatcontributed to its loss of public trust and sub-sequent bankruptcy.

How could Enron have so massively mises-timated the fair value of its Braveheart invest-ment, and how could Arthur Andersen haveallowed Enron to report those values and theirincreases as profits? Indeed, the examinerfinds that Arthur Andersen prepared theappraisal of the project’s value.16 Andersenassumed the following: (1) the business wouldbe established in 10 major metro areas within12 months, (2) eight new areas would beadded per year until 2010 and those wouldeach grow at 1 percent per year, (3) digital sub-scriber lines (DSLs) would be used by 5 per-cent of the households, increasing to 32 per-cent by 2010, and those would increase inspeed sufficient to accept the broadcasts, and(4) Braveheart would garner 50 percent of thismarket. After determining (somehow) a netcash flow from each of these households anddiscounting by 31 percent to 34 percent, theproject was assigned a fair value.

Another example is the Eli Lilly transac-tion.17 On February 26, 2001, Enron an-nounced a $1.3 billion 15-year agreementwith Lilly for energy management services.The fair value of the project was determinedby estimating the energy savings that Lillywas projected to achieve over 15 years and

14

Although GAAPand the matching

concept requirerecognition of

revenue only overthe period of the

guarantees,Enron recorded

millions of dollars of

up-front pay-ments as current

revenue.

discounting those amounts by 8.25–8.50 per-cent. That yielded a present value of $39.7million. Within two years, this contract wasconsidered worthless.

Accounting for Stock Issued to and Held bySPEs. GAAP and long-established accountingpractice do not permit a corporation torecord income from increases in the value ofits own stock or to record stock as issuedunless it has been paid for in cash or its equiv-alent. Nevertheless, that is what Enron did, tothe tune of $1 billion. For reasons that are notclear, Arthur Andersen did not discover thoseaccounting errors or, if it did, it allowedEnron to proceed. Correction of the errors inOctober 2001 contributed to concerns aboutEnron’s accounting.

Inadequate Disclosure of Related Party Transac-tions and Conflicts of Interest. Enron disclosedthat it had engaged in transactions with a relat-ed party, identified in its proxy statements (butnot its SEC 10K report) as Andrew S. Fastow,its chief financial officer. Enron asserted infootnote item 16 of its 2000 10K that “theterms of the transactions with the RelatedParty were reasonable compared to thosewhich could have been negotiated with unre-lated third parties.”18 However, those transac-tions do not appear to have been at arm’slength. Indeed, the Powers Report, commis-sioned by the Enron board of directors toinvestigate Fastow’s activities, concludes thathe obtained more than $30 million personallyfrom his management of the SPEs that didbusiness with Enron, and other employees whoreported to Fastow got over $11 million more.Furthermore, a detailed analysis of the Fastow-controlled SPEs indicates that the outsideinvestors solicited by Fastow obtained multiplemillions from investments on which they tooklittle risk and that provided Enron with fewbenefits, other than providing a vehicle to over-state income and delay reporting losses anddebt. The requirements of FASB Statement 57and SEC’s Regulation S-X item 404 for disclo-sure of transactions exceeding $60,000 inwhich an executive officer of a corporation hada material interest were not followed, except inthe most general of ways.

The Implications of the EnronExperience for Changes in GAAS andGAAP

Thus, except for fair value accounting andEnron’s use of financial engineering to obviatethe intent of traditional accounting GAAPwhile technically conforming to or aggressivelyinterpreting the rules, most of Enron’s misstat-ed and misleading accounting resulted fromviolations of GAAP. Based on the public infor-mation available at this time, one must con-clude that Arthur Andersen violated the basicprescriptions of GAAS in conducting an auditthat would allow it to state, as it did: “In ouropinion, the financial statements referred toabove present fairly, in all material respects, thefinancial position of Enron Corp. and sub-sidiaries . . . in conformity with accounting prin-ciples generally accepted in the United States.”19

The Enron experience indicates that onlytwo changes in GAAP are necessary. One is arule that fair values should not be included infinancial statements unless they are based ontrustworthy information—prices determinedby arm’s-length market transactions. The sec-ond is that the traditional accounting defini-tion of revenue and expenses described earli-er should govern and, if necessary, overriderules specified in authoritative (FASB andSEC) pronouncements and interpretations.

The destruction of Arthur Andersen as afirm should serve as a sufficient lesson toother IPA firms. Moreover, as is discussedbelow, more effective punishment of individ-ual IPAs who materially violate GAAS andGAAP might serve to motivate them to actmore effectively as gatekeepers.

Major Financial StatementProblems Associated with

Other CorporationsThe accounting problems revealed by

Enron’s bankruptcy should be put into per-spective. Enron, after all, was only one of thou-sands of publicly traded corporations. A broad-er view can be obtained from recently publishedresearch that describes financial misstatements

15

Most of Enron’smisstated andmisleadingaccountingresulted fromviolations ofGAAP.

and frauds over several years. These studies andthe more recent highly publicized restatementsby such companies as WorldCom, GlobalCrossing, and Quest show that many ofEnron’s accounting issues were not unique toEnron. Similar to Enron, most misstatementsare violations of basic GAAP requirements (par-ticularly involving revenue recognition) thatIPAs should have found and dealt with effec-tively. From the studies, it does not appear thatthese problems have been widespread or indica-tive of a systemic breakdown.

In their book The Financial Numbers Game,Charles Mulford and Eugene Comiskeydescribe many creative and fraudulentaccounting practices employed in recentyears. The authors base their discussion onan examination of reports by the SEC, thepress, and corporate financial filings.20 Manyof the violations they found are identified asfrauds, most of which involved misstate-ments of revenue. These include fictitioussales and shipments, booking revenue imme-diately for goods and services sold overextended periods, keeping the books openafter the end of an accounting period torecord revenue on shipments actually madeafter the close of the period, recording saleson goods shipped but not ordered andordered but not shipped, recognizing rev-enue on aggressively sold merchandise thatwas returned (“channel stuffing”), recordingrevenue in the year received even though theservices were provided over several years,booking revenue immediately even thoughthe goods were sold subject to extended peri-ods when collectibility was unlikely, makingshipments to a reseller who was not finan-cially viable, and making sales subject to sideagreements that effectively rendered salesagreements unenforceable. Another distor-tion is misclassification of a gain from thesale of a substantial investment as other rev-enue rather than nonoperating income.

Expenses also were misrecorded. Someinvolved booking promotion and marketingexpenses to a related, but not consolidated,enterprise and recognizing revenue on ship-ments, but not the cost and liability of an

associated obligation to repay purchasers forpromotion expenses. Several corporationstook “big bath” write-offs when a new CEOtook over. Warranty and bad debt expenseswere understated. Aggressive capitalizationand extended amortization policies wereused to reduce current-period expenses.

Assets were overstated by such means asrecording receivables for which the corpora-tion had established no legal right, such asclaims on common carriers for damagedgoods that were not actually submitted andthose that it probably could not collect.Inventories were overstated by over counts andby delaying write-downs of damaged, defec-tive, overstocked, and obsolete goods. Declinesin the fair market values of debt and equitysecurities were delayed, even though thechances of recovery were remote. Liabilitieswere understated, not only for estimatedexpenses (such as warranties), but also foraccounts payable, taxes payable, environmen-tal clean-up costs, and pension and otheremployee benefits.

Additional insights can be obtained fromthree other studies. Thomas Weirich exam-ined the SEC’s Accounting and AuditingEnforcement Releases (AAERs), which criticizeaudits of registrant corporations, issuedbetween July 1, 1997, and December 31,1999.21 Of the 96 AAERs issued against Big 5audit firms and their clients, 38 cases, or 40percent, involved misstated revenue andaccounts receivable.

Mark Beasley et al. studied all AAERsissued between 1987 and 1997 that chargedregistrants with financial fraud.22 Their analy-sis of 204 randomly selected companies (ofnearly 300) revealed, among other things, thatthe companies were relatively small (78 per-cent had assets less than $100 million) andhad weak boards of directors and that thefraud involved senior officers (72 percentnamed the CEO, 43 percent the CFO). Halfthe instances involved improper revenuerecognition, resulting largely from recordingfictitious revenue and premature revenuerecognition. An overlapping 50 percent over-stated assets, 18 percent understated expenses

16

The number ofrestatements hasincreased, largely

because ofchanges in SECpractices, but is

still quite small inrelation to theapproximately

12,000 corpora-tions that report

to the SEC.

and liabilities, and 12 percent misappropriat-ed assets. The SEC explicitly named externalauditors in 56 cases, of which only 10 involvedauditors from the major IPA firms. Auditors,of whom 9 (35 percent) were from major IPAfirms, were charged with performing a sub-standard audit in 26 of the 56 cases (46 per-cent). A minority of the corporations and theirsenior officers paid fines and made monetarysettlements to plaintiffs (30 and 35 corpora-tions, respectively) and the officers of some 76corporations lost their jobs and were barredfrom working for another SEC registrant for aperiod of time (54 corporations); only 31 werecriminally prosecuted and 27 were jailed. ButBeasley et al. do not report any actions againstthe individual IPAs or their firms.

Finally, the General Accounting Officesearched Lexis-Nexis for mentions of restate-ments between January 1, 1997, and June 30,2002. The GAO found that 845 public compa-nies announced material restatements involv-ing accounting irregularities. The numberincreased each year, from 83 in 1997 to 195 in2001 and 110 in the first six months of 2002.Over this period, the percentage of publiclytraded corporations that restated their finan-cial statements increased substantially, from0.89 percent in 1997 to 2.95 percent in 2002, inpart because the number of corporations listedon the exchanges decreased from 9,275 to7,446. The GAO also found that the propor-tion of large corporations (those with assets ofmore than $1 billion) among those that restat-ed increased from about 25 percent in 1997 toover 30 percent in 2001. Consistent with otherstudies, the most important reason for restate-ments was improper revenue recognition (38percent). This reason is followed by improperrecognition or capitalization of costs orexpenses (16 percent). The GAO studied theeffect of 689 of the restatements on the stockprices of the affected corporations. It found athree-day loss (adjusted for changes in the mar-ket) of 10 percent of those corporations’ capi-talization, or a total of $95.6 and $14 billion forthe 689 and 202 restatements. This loss,though, is only 0.11 percent of the total marketcapitalization of listed corporations.23

Thus, the several studies of financial state-ment restatements yield similar findings.24 Thenumber of restatements has increased, largelybecause of changes in SEC practices, but is stillquite small in relation to the approximately12,000 corporations that report to the SEC.Until recently, smaller companies tended torestate their financial statements more oftenthan larger companies. The most pervasive rea-son for restatement is misstatement of rev-enue. A substantial minority of companies thatrestate financial statements and a smallernumber of their auditors are sued. Losses toinvestors who hold diversified portfolios,which may result from misstatements that arecorrected, are small overall, although the lossescan be substantial (particularly recently) forinvestments in those companies.

Who Is to Blame?

Auditing and Accounting Standards andStandard Setters

There do not appear to be published stud-ies showing why external auditors did not dis-cover and prevent managers of companiesfrom substantially misstating financialreports. In particular, we do not as yet knowhow, for several years, the chief financial offi-cer of Global Crossing could have gotten awaywith capitalizing billions of dollars of currentexpenses, thereby massively overstating netincome and total assets. Nor has it beenrevealed how the auditors of Tyco apparentlywere unaware that its senior officers personal-ly took hundreds of millions of dollars. Nordid the authors of the studies reviewed earlierindicate whether accounting misstatementswere due to failures of external auditors to dis-cover the “errors” because the auditing proce-dures mandated by GAAS were inadequate,because the auditors failed to conduct auditsthat complied with GAAS, or because theauditors colluded with managers. Conse-quently, I cannot draw conclusions about thenecessity of changing auditing standards.From my personal experience with two large

17

The most pervasive reasonfor restatement ismisstatement ofrevenue.

corporate failures in which auditors werecharged with gross negligence—ContinentalIllinois Bank and Phar-Mor—I determinedthat auditors’ failure to use statistical sam-pling to determine whether the records sub-stantially reflected the correct valuation ofimportant assets (loans and inventory) wasthe principal reason that the auditors did notdiscover the misstatements.25

Accounting standards in the UnitedStates, more than in Europe, tend to be rulebased rather than principle based, in partbecause the former offers greater protectionagainst potential plaintiffs, who are morelikely to bring lawsuits in this country than inEurope. Consequently, at least some man-agers have viewed GAAP as a set of rules thatthey must meet only minimally, even if (and,in many cases such as Enron, particularlybecause) it results in misleading financialreports of net income.26

Given the rules-based system, some blameshould be placed on the Financial AccountingStandards Board. The FASB has been consid-ering a restatement of consolidation policyregarding SPEs for more than 20 years.27 TheSPE situation as exemplified by Enron couldhave been avoided had the FASB done its jobexpeditiously. The Sarbanes-Oxley Act of2002 (§401[j]), now requires disclosure of “allmaterial off-balance sheet transactions,arrangements, obligations (including contin-gent obligations), and other relationships ofthe issuer with unconsolidated entities orother persons, that may have a material cur-rent or future effect on financial condition,changes in financial condition, results ofoperations, liquidity, capital expenditures,capital resources, or significant componentsof revenues or expenses.” In addition, as dis-cussed earlier, the FASB’s move toward fairvalue accounting has given opportunisticmanagers the means to grossly overstatereported net income.

The FASB also should be criticized for giv-ing in to pressure from which it was supposedto be immune. For example, pressure fromcommercial banks led to its curious decisionto have debt securities not restated at market

values, even though their market values canbe reliably measured when the securities aredesignated as “held to maturity.” Morerecently, pressure from the Business Round-table and the CEOs of high-tech companies(among others) apparently has kept the FASBfrom requiring corporations to show asexpenses the economic values of compensa-tion in the form of options granted to execu-tives, even though options have economicvalue and, thus, constitute compensation inthe same way that compensation thatincludes physical goods given to employeesrather than cash for their services. The prob-lem is that stock options often cannot bereadily valued. But, then, neither can employ-ee pensions and future health benefits.Indeed, options often can be more easily val-ued with a model (e.g., the Black-Scholesoptions-pricing model),28 by independentexperts (such as investment bankers), or usingmarket prices. Market prices (which usuallyprovide the best estimate) could be obtainedfrom similar options that corporations couldsell directly or distribute to shareholders asdividends or rights offerings. These pricesshould be reduced to reflect the effect ofrestrictions placed on employee-grantedoptions.29 Consistent with the matching con-cept, the cost of the employee stock optionsshould be charged against revenue in thesame periods that the revenue, presumablygenerated by the employee, is reported, andnot extend beyond the time when the optionsvest. Similar to amortization generally, thecost to the corporation of the options couldbe charged as an expense in equal periodicamounts.

With these exceptions, the inadequate,misleading, and even fraudulent financialreporting that has been revealed in recentyears is due primarily to failures in enforcingthe rules. Individual investors should be ableto rely on several “gatekeepers” to see thatfinancial statements were, in fact, producedin accordance with GAAP and GAAS. Thosegatekeepers include corporate boards ofdirectors, IPAs and their professional associa-tions, and state and federal regulators.

18

Given the rules-based system,

some blameshould be placedon the Financial

AccountingStandards Board.

Boards of DirectorsThe initial gatekeeper is the board of direc-

tors. Company accountants prepare financialstatements for the benefit of shareholders,investors, and others who are expected to usethose statements.30 The board of directors issupposed to represent the shareholders. It isboards that must and, in many cases, did,approve granting CEOs and other senior man-agers substantial compensation in the form ofstock options. These options, which offermanagers enormous gains if the price of theircorporations’ shares increase, may have giventhem strong incentives to manage reportedearnings in order to meet or exceed stock ana-lysts’ expectations, in the belief that this wouldincrease share prices.31 In 2003, though, theSEC approved rules adopted by the NYSE andNasdaq requiring listed corporations to sub-mit to stockholder approval equity compensa-tion plans, including stock options, repricings,and material plan changes.

The audit committee of the board has par-ticular responsibility for the reliability of thefinancial statements and the audits (bothinternal and external) that should be designedto assure that reliability of the statements. TheNew York Stock Exchange and Nasdaq adopt-ed a requirement in 2002 (amended in 2003,subject to approval by the SEC) that a majori-ty of the board of directors, and all membersof its nominating and corporate governancecommittees, its compensation committee, andits audit committee must be independent oftheir corporation and its CEO, including nothaving been an employee of the company orits affiliates or auditors within the previousfive years. The Sarbanes-Oxley Act of 2002(§301) also requires that all members of theaudit committee be independent directorsand makes them responsible for the appoint-ment, compensation, oversight, and dismissalof external auditors. The law also allows theaudit committee to engage independent coun-sel or other advisers, as it determines neces-sary, to carry out its duties, supported byappropriate corporate funding. These changesmight make the boards of directors moreeffective gatekeepers.

External Auditors IPAs who attest to the financial statements

are the most important gatekeepers. As notedearlier, external audit firms have strong incen-tives to be effective gatekeepers, by not allow-ing their partners and employees to grosslyviolate the prescriptions of GAAS and GAAP.If, to satisfy one or a few clients, they are noteffective gatekeepers, they risk losing their rep-utations and their other clients, a cost thatshould greatly exceed any benefits they mighthave achieved. That said, Arthur Andersen dida poor job as a gatekeeper for several publiclyimportant corporations, for which it paid avery heavy price. What might explain its inef-fectiveness as a gatekeeper and that of otherexternal audit firms?

One explanation is the alleged weakeningin 1995 of federal securities laws governingauditor liability. Specifically, did the PrivateSecurities Litigation Reform Act of 1995,which generally made it more difficult forclass action plaintiffs to sue public firms foraccounting abuses, and the SecuritiesLitigation Uniform Standards Act of 1998,which abolished state court class actionsalleging securities fraud, increase plaintiffs’difficulty in suing accounting firms so muchthat these firms decided to risk the cost ofbeing successfully sued for larger audit andother fees?32 Columbia University law profes-sor John C. Coffee Jr., among others, pointsto that legislation and two court cases thatmade bringing lawsuits against IPAs morecostly to plaintiffs as possible explanationsfor the presumed weakening of auditing per-formance. Although he supports the changesthat reduced the auditors’ proportionate lia-bility and would support a ceiling on theirtotal liability, he concludes that “their collec-tive impact was to appreciably reduce the riskof liability.” 33

However, the legislation cannot be blamedfor the recent rise in earnings restatementsand accounting abuses. For one thing, asnoted earlier, a substantial portion of theincrease in the numbers of earnings restate-ments is attributable to changes in SEC prac-tices. More significantly, the PSLRA did not

19

Arthur Andersendid a poor job asa gatekeeper forseveral publiclyimportant corpo-rations, for whichit paid a veryheavy price.

exempt IPAs from liability; it only eliminatedtheir joint-and-several liability for accountingmisdeeds when there are several defendantsbefore the court.34 The PSLRA also raisedpleading standards and restricted the exten-sion of the statute designed to punish orga-nized crime (the RICO statute) by treblingdamages. These reforms were enacted to pre-vent plaintiffs from digging into the deepestpockets among a group of defendants, regard-less of the degree of culpability of individualdefendants, and from bringing extortionistlawsuits against IPAs in the hope of a settle-ment. Furthermore, the SLASA only abolishedstate court class actions alleging securitiesfraud; federal class actions can still be broughtagainst accountants. Indeed, no accountingfirm named as a defendant in any large recentaccounting controversies has been excusedfrom liability in any of these actions because ofthe legislation. To underline the point, plain-tiffs have not been dissuaded from suingArthur Andersen for liability in Enron andother cases.

Another alleged cause of IPAs having beeninadequate gatekeepers is fear of losing sub-stantial fees from consulting services provid-ed to their audit clients. Critics have pointedto Arthur Andersen’s having received $29million in consulting fees in addition to $27million in audit fees from Enron in 2000.However, no evidence has been presentedshowing that these collateral activities havebeen more prevalent at corporations thatexperienced reporting problems, failures, orfrauds. It also seems likely that IPAs whocould be suborned with the consulting feescould as easily be influenced with higheraudit fees. Indeed, the audit partner getsdirect credit for the audit fee, and only indi-rect credit for net revenue earned from collat-eral business with the client.35 Furthermore,if consulting services provided by audit firmswere banned, economies of scope from IPAfirms providing both audit and consultingcould no longer be achieved. Theseeconomies include lower business develop-ment costs on the part of consultants andsearch costs on the part of corporations,

because the audit firm already is known andtrusted. Operations costs for both the auditfirm and its client are likely to be lower,because the audit firm already understandsthe client’s financial system and problems.Nevertheless, the Sarbanes-Oxley Act of 2002(§ 201) has made it unlawful for a publicaccounting firm to provide virtually anynonaudit service to a corporation it audits,with the exception of tax-related services. Theresult will be higher audit costs that, neces-sarily, will be paid by shareholders. Thesehigher costs are likely to exceed the savingsfrom better audits, particularly for investorswho hold diversified portfolios.

Professional IPA Associations and Stateand Federal Regulators

Several bodies oversee both individualauditors and the firms they work for, and allseem to have failed in their duties. The audit-ing profession’s “self-regulatory” body is theAmerican Institute of Certified PublicAccountants, which has a committee that issupposed to discipline wayward auditors.The reality, however, has been quite different.As reported in a study conducted by theWashington Post of more than a decade of SECprofessional misconduct cases againstaccountants, the AICPA took disciplinaryaction against fewer than 20 percent of thoseaccountants already sanctioned by the com-mission.36 Moreover, even when the AICPAfound that sanctioned accountants had com-mitted violations, it closed the vast majorityof ethics cases without taking disciplinaryaction or publicly disclosing the results, butinstead issuing confidential letters directingthe offenders to undergo training. Clearly,“self-regulation” by the AICPA has not beenvery effective, nor can it be expected to be: themost stringent penalty the AICPA can applyis simply to expel the offending memberfrom the organization.

The record of the state accountancy agen-cies that issue and can withdraw CPA certifi-cates is not much better. By and large, thoseagencies are not well-funded or staffed withsufficient numbers of highly trained individ-

20

Clearly, “self-regulation”

by the AICPA has not been

very effective, nor can it be expected

to be.

uals to both ferret out and investigateaccounting misconduct. This is especiallytrue for complex accounting matters of thekinds revealed in some of the large corporatescandals of recent years. In general, the agen-cies tend to act after a client or other govern-ment agency has successfully brought a legalaction against a CPA. Indeed, the WashingtonPost study of a decade of SEC enforcementaction finds: “The state of New York, whichhad the most accountants sanctioned by theSEC, as of June had disciplined [only] 17 of49 New York accountants.”37

The SEC, though, has the staff, theauthority, and the responsibility to investi-gate and discipline IPAs who attest to state-ments filed with it. Unfortunately, it has notbeen an effective gatekeeper; indeed, it hasrarely used its authority to discipline IPAs. A2002 GAO study of 689 restatements foundthat from January 2001 to February 2002, 39CPAs were suspended or denied the privilegeof appearing or practicing before the SEC, 23of those for three years or less. In addition,one non–Big Five accounting firm was per-manently barred, one Big Five and one otherwere given cease-and-desist orders, and oneBig Five firm was censured. A reading of theGAO’s “case study” descriptions of restate-ments by 16 major corporations, each ofwhich includes information on civil andcriminal actions taken against the auditors,indicates that the penalties were inadequatefor the crime.

The 16 “case studies” in the GAO reportdetail the reasons for, effects of, and actionstaken by the SEC as a consequence of these cor-porations restating their financial reports.38 Inthree cases the violations of GAAP were discov-ered by the auditor and in three the restate-ments resulted from changed interpretationsof GAAP requirements. Ten cases involvedimportant and substantial violations of GAAP(e.g., liabilities not reported, improper recogni-tion of income, expensing costs that shouldhave been capitalized, falsification of expenses,and rampant self-dealing by management). Inthree of these cases the SEC took actionagainst the individual auditors. In the case of

Sunbeam, the auditor was charged with havinghis firm, Arthur Andersen, sign unqualifiedstatements, even though he knew about themisstatements. He faces trial. In WasteManagement, Arthur Andersen issued unqual-ified statements, even though its auditors hadidentified and quantified the improperaccounting practices. It was fined $7 million.Two of the firm’s three auditors were fined$50,000 and $40,000 and barred from practicebefore the SEC for five years; the other wasbarred for one year. The GAO states that theycontinued to be active partners of ArthurAndersen. In the Enron case, Arthur Andersenwas charged with destroying documents inadvance of an SEC investigation, and, in a jurytrial, was found guilty. No mention is made ofAndersen’s partner in charge of the audit, whodestroyed the documents. The GAO does notindicate any actions taken by the SEC againstthe audit firms or the CPAs who conducted theaudits of the seven other corporations wherethere were serious errors, misclassifications,and omissions that substantially overstatedreported net income and assets and understat-ed liabilities.39

SEC action is important because it cantrigger several consequences: private lawsuitsagainst company officers and directors fornegligence or even willful commission offraud or misrepresentation; similar lawsuitsagainst accounting firms; and, if the factswarrant, criminal fraud investigations by theDepartment of Justice. Because these conse-quences have been apparent for some time,the puzzle is why the consequences have notdone more to deter the kind of accountingabuses that seem to have become more fre-quent in recent years. One reason may be thatlawyers, who may find financial statementsboring, dominate the SEC. Indeed, the SEChas reviewed only about 2,300 annual 10Kreports in recent years.

In part because the SEC had failed, theSarbanes-Oxley Act of 2002 (§101) was enactedto do what the SEC could have done. The actestablished a Public Company AccountingOversight Board, which reports to the SEC, butis largely independent of it. The PCAOB has its

21

In part becausethe SEC hadfailed, theSarbanes-OxleyAct of 2002(§101) was enacted to dowhat the SECcould have done.

own very well paid “financially literate” mem-bers (only two of which shall be or have beenCPAs) and staff, and the power to impose feeson SEC-registered corporations (in addition tothe fees charged by the SEC).40 It will registerpublic accounting firms, establish standardsrelated to the preparation of audit reports, con-duct inspections of registered public account-ing firms every three years (annually if theyaudit more than 100 issues), and conductinvestigations and disciplinary proceedings. Itthen may impose appropriate sanctions, pre-sumably against both firms and individualIPAs. It also has authority to establish stan-dards related to auditing, quality control,ethics, independence, and other standardsrelated to the preparation audit reports.

Sanctions imposed by the PCAOB, togeth-er with fear that what happened to ArthurAndersen might happen to them, probablywill be successful (although costly to share-holders) in getting external audit firms to beeffective gatekeepers. But, this mechanism islikely to be seriously incomplete unless it isapplied to individual external auditors, par-ticularly those whose salaries and bonusesdepend on how much business they bring in(or work on) and whose liability costs may becovered by insurance or the firm (or both).Individual partners of large IPA firms who arein charge of a single very large client have con-siderable incentives to accede to the demandsof those clients. If they do not and lose theaccount for the firm, they stand to lose a sub-stantial amount of their personal income, ifnot their positions in the firm. If they do,there are three possibilities. First, the mis-statements might not be discovered. Second,if discovered, the partner-in-charge may notbe blamed. Third, if blamed, the other part-ners are likely to defend the errant partner toavoid having to assume substantial damages.

Considering the externalities that accom-pany major audit failures and the possibilitythat the costly new procedures might yet beinadequate, it is critical that there be an insti-tutional mechanism for applying discipline toindividual external auditors who fail to live upto their professional responsibilities. This was

(and still is) the responsibility of the SEC.Although it has had the authority under Rule201.102 (e) to discipline IPAs who attest tofinancial statements that violate GAAP orGAAS, it has used that power sparingly. Onecan understand why the Commission hasrarely used its ultimate weapon—prohibitingan offending firm from attesting to financialstatements of public companies—the mostnotable exception being Arthur Andersen. Butit is baffling why the Commission has sorarely sanctioned individual auditors whohave attached their names to the financialstatements that included the substantial viola-tions outlined above.41 If individual CPAs hadreason to believe that their professionalcareers and personal wealth were seriously injeopardy, they would be much more likely torisk losing a client than to agree to that clients’demands for inadequate audits and overlyaggressive or significantly misleading ac-counting. The Public Company AccountingOversight Board should now fulfill the rolelargely abdicated by the SEC.42

Additional Changes That Should Be Made

Changes to GAASIn 2003 the PCAOB took over the develop-

ment of auditing standards that had been leftto the AICPA. This change in responsibilitycan be both negative and positive forinvestors. The negative prospect is that thedevelopment of auditing standards and pro-cedures will pass from the professional IPAswho must balance the costs of auditingagainst the value of audits, as determined byinvestors’ representatives, the audit commit-tees of corporate boards of directors. If thestaff of the PCAOB acts similarly to the staffof the FASB, investors are likely to have topurchase more extensive audits than is costeffective. As noted earlier, the prohibitionagainst concurrent consulting work by IPAfirms is likely to increase the costs of auditseven more.

22

There must be amechanism

for applying discipline to

external auditorswho fail to live

up to their professional

responsibilities.This was (and

still is) theresponsibility of

the SEC.

On the positive side, if inadequate auditshave resulted in externalities from reducedinvestor confidence in equity securities gen-erally and IPAs particularly, changes mandat-ed or suggested by the PCAOB that improveaudits can reduce the externalities. One suchimprovement would be the mandated use ofstatistical sampling, which at present is onlysuggested and inadequately used or evenunderstood by many IPAs.43 Without sam-pling, it is difficult to see how in manyimportant situations IPAs have a meaningfulbasis for determining the extent to which acorporation’s statements are materiallyincorrect and that corporate resources havenot been stolen or grossly misused. ThePCAOB might be able to establish an under-standing and acceptance of the reality that, atbest, audits provide a high, but not 100 per-cent, probability that all material irregulari-ties have been uncovered.

Changes to GAAPFair-Value Accounting. The accounting

authorities (SEC, FASB, and IASB) haveattempted to make accounting statementsmore relevant by adopting fair value account-ing for financial assets and liabilities. Theirargument is that investors would want toknow the current values of assets and liabilities,rather than the amounts originally expendedor obligated. What they do not appear to rec-ognize sufficiently is that numbers that arelikely to be manipulated by opportunistic oroveroptimistic managers are considerablyworse for investors than numbers that are notcurrent. Consequently, the authorities haverequired fair values, at least for financial assets,even when they are not based on reliable mar-ket values, As the Enron situation revealed,substantially misleading reporting of netincome is likely to be the result.

It might appear that the FASB has limited“fair value” reporting to financial assets andliabilities. This presumed limitation yieldsseveral important disadvantages. First, mostcorporations hold other assets that can bereliably measured and that are more impor-tant to investors than financial assets. In par-

ticular, as noted earlier, inventories can oftenbe valued at their opportunity cost, particu-larly when they will be replaced. In this event,their value can be measured at their replace-ment cost, numbers that are usually knownbefore the financial statements are pub-lished. Second, fair-value accounting hasbeen applied inconsistently, with debt instru-ments identified as “held to maturity” notbeing marked to market, even though readilyand reliably measured gains and losses intheir value accrue to the benefit of share-holders and creditors, whether or not theassets are sold. Third, trustworthy values can-not be obtained for many financial assets,which allows for substantial misstatementsof both assets and net income. This is a veryserious situation that compromises the relia-bility and usefulness of published financialaccounting numbers, and thus merits discus-sion in greater detail.

Enron was able to increase the unrealized(and, as it turned out, unrealizable) values oflarge-scale nonfinancial assets to what itsmanagers’ decided were “fair values” byrecording as income the increase in those val-ues. The company did this by declaring that itsinvestments in large-scale projects were “mer-chant” investments for which the provisionsof the AICPA’s Investment Company Guide per-mit (indeed, mandate) fair value accounting.Section 1.32 of the guide states: “In theabsence of a quoted market price, amountsrepresenting estimates of fair values usingmethods applied consistently and determinedin good faith by the board of directors shouldbe used.” According to the FASB, this is howfair values are to be measured:

If a quoted market price is not available,the estimate of fair value should bebased on the best information availablein the circumstances. The estimate offair value should consider prices for sim-ilar assets or similar liabilities and theresults of valuation techniques to theextent available in the circumstances.Examples of valuation techniques in-clude the present value of estimated

23

One suchimprovementwould be themandated use ofstatistical sampling, whichat present is onlysuggested andinadequatelyused or evenunderstood bymany IPAs.

expected future cash flows using dis-count rates commensurate with therisks involved, option-pricing models,matrix pricing, option-adjusted spreadmodels, and fundamental analysis.44

Corporations can also use the followingprocedure (as did Enron) to extend “fair value”accounting to many non-financial assets. First,either develop a new product, facility, or busi-ness in a wholly owned subsidiary or transferthe assets the managers want to restate at “fairvalues” into a subsidiary. Call it FV Inc. Thecorporation now owns FV Inc.’s stock, which isa financial asset. Large corporations can dothis many times and have a series of sub-sidiaries—FV1 Inc., FV2 Inc., and so forth. Thenexchange the stock in the FVs for stock inanother subsidiary that is designated a securi-ties broker–dealer or an investment company(e.g., venture capital or business developmentcompany). Because the FV Inc. shares are nottraded, these values must come from the cor-porate managers’ estimates of the fair values ofthe underlying assets, including intangibles.Finally, because the subsidiaries are 100 per-cent owned, they must be consolidated withthe parent, which now puts the revalued assetson the corporation’s consolidated financialstatements. Voilá—almost any group of assetscan be revalued to what the managers say theyare worth, and changes in those valuations(usually increases) are reported as part ofincome.

The evidence on corporate and industrypractices, the Enron experience, and the logi-cal possibilities for manipulation or overopti-mistic estimation of “fair values” leads me toconclude that allowing corporate managersto value assets and liabilities in situationswhere trustworthy market values are not pre-sent and cannot be verified should not bepermitted by GAAP. The AICPA has takenone step in the right direction with its pro-posal to limit fair valuation of nontradedsecurities to registered investment compa-nies and legally and actually separate invest-ment companies, no owner of which owns 20percent or more of its financial interests.45

However, it is likely that clever corporatemanagers will figure out a way around thislimitation. Furthermore, managers can stillmanipulate income through “fair valuation”of derivatives and energy contracts.

Principles-Based Rather Than Rules-BasedGAAP. Under the current rules-based ap-proach, managers and their consultantsdesign accounting procedures that are in tech-nical accordance with GAAP, even thoughthose procedures tend to mislead investorsand violate the substance or spirit of GAAP.Enron provides an excellent example of thatapproach. Accountants not only find it diffi-cult to challenge the use of such procedures;they often propose or assist in their design. Inthis sense, the practice of public accountinghas become similar to tax practice, with clientsdemanding and accountants providing exper-tise on ways to avoid the substantive require-ments of GAAP while remaining in technicalcompliance.

There are several reasons for this rules-based approach. First, auditors believe thatthey can avoid losing lawsuits if they can showthat they did in fact follow the rules. Second,there is the fear of losing a client by refusing toattest to an accounting procedure that does,after all, technically conform to GAAP. Third,government agencies such as the SEC tend toestablish or support rules and then demandstrict adherence to them. This protects theagencies from claims of favoritism and arbi-trariness, forestalling political interference.Last, but by no means least, GAAP has beencriticized because it permits managers somedegree of choice under some circumstances.As noted earlier, the FASB was created in 1973largely in response to concern about excessiveaccounting flexibility. Its well-funded profes-sional staff and directors have fulfilled theirmandate and have developed a very large set ofdetailed rules designed to limit alternativemeans of compliance with GAAP.

However, the rules-based approach is clear-ly not working. Accounting firms are suedwhen a company they audited goes bankrupt,or even when the company’s share price dropsfor some reason. Courts have not accepted as a

24

The rules-basedapproach is

clearly not working.

sufficient defense that specific GAAP ruleswere followed or not explicitly violated. TheSEC and FASB have been severely criticized forallowing companies and accounting firms toviolate the spirit of GAAP. Of greatest impor-tance, users of financial statements, who havereason to believe that the numbers presentedtherein are at least not deliberately deceptive,have at times been misled.

The principles of accounting are clearenough. Revenue should not be recognizeduntil there is objective and reliable evidencethat it has been earned. Expenses should bematched to the associated earnings or to thetime periods in which assets are determinedto have lost future value. Most important,the numbers reported in financial state-ments should be trustworthy, as verified byindependent public accountants who haveconducted audits and ascertained that thenumbers reported accord with the basic prin-ciples embodied in GAAP. Having satisfiedthese conditions, the traditional incomestatement would be a fair and consistentrecord of a company’s operations and wouldtherefore fulfill the stewardship function ofpublic accounting.

Competition among Accounting Standards.46 Acentral problem with any monopoly standard-setter—whether the FASB, the IASB, or anyother similar body—is that it has no incentive torespond quickly to market forces, let alone actin a manner free from political influence. As inprivate markets, the solution to monopoly iscompetition. As is the situation for privateenterprises, quasi-governmental agencies seekacceptance of their products and modify thoseproducts to meet substitutes produced by otheragencies. Consequently, at a minimum, theCongress or the SEC should permit corpora-tions with publicly traded stock to base theirfinancial accounting statements on either U.S.or international accounting standards. 47

Conclusion

Investors should recognize the inherentlimitations of financial information reported

in audited financial statements. Accountingcannot yield both trustworthy and complete-ly adequate measures of the economic per-formance and the condition of an enterprise.Managers to some extent do manipulate thereported numbers by timing expendituresand choosing among reasonable assump-tions. Notwithstanding those limitations,financial statements can be very useful.GAAS should ensure that audits conductedby IPAs result in corporations presentingnumbers that investors can trust.

The misstatements in the financial reportsof Enron and other corporations were by andlarge the result of violations of GAAP and inad-equate audits. Many, perhaps most, of thosemisstatements could and should have beencaught and stopped by auditors if they hadbeen more diligent in examining and evaluat-ing their clients’ records and financial state-ments, as required by GAAS. The one majorexception is the GAAP requirement that com-panies revalue assets classified as traded finan-cial assets (to which many assets can be con-verted) at their fair values, a measure that givesmanagers too much scope for manipulation.

The SEC has had the authority under Rule201.102 (e) to discipline IPAs who attest tofinancial statements submitted to it, once itbecomes known that those statements includegross violations of GAAP or GAAS. Neverthe-less, it appears that the SEC has rarely disci-plined the IPAs who attached their names tothe financial statements that included thesubstantial violations outlined above.

The Sarbanes-Oxley Act of 2002 nowoffers the possibility that individual IPAswho are grossly derelict in fulfilling their pro-fessional responsibilities will be sanctioned.In addition to punishing the few IPAs whofail in their duties, the authorities could helprestore trust in and respect for the account-ing industry by empowering IPAs to with-hold unqualified opinions when they findreporting that violates the spirit of GAAP,even if the letter is followed.

However, the bureaucracy and regulationestablished by the Sarbanes-Oxley Act of 2002is likely to be quite costly to shareholders. The

25

At a minimum,the Congress or the SECshould permitcorporationswith publiclytraded stock tobase their financialaccounting statements oneither U.S. orinternationalaccounting standards.

board’s costs will be met by fees imposed on reg-istered corporations in proportion to theirequity market capitalization. The fees nowimposed by the SEC on registrants will not bereduced. In addition, public corporations willhave to pay higher auditing fees to offset thecosts and risks imposed on their external audi-tors and their own internal costs to meet therequirements of the act. Shareholders necessar-ily will bear these costs. Whether those costs willexceed the benefits that shareholders mightgain from better audits is unclear at this time.

GAAP should be improved by an overall rulethat the numbers reported be trustworthy andthat the matching concept be followed. Theoverall rule proposed here would change GAAPto include reporting as operating or as nonoper-ating income (depending on the asset or liabili-ty) changes in values that can be reliably mea-sured. Expenses that were incurred in a period,such as managerial compensation in the form ofstock options, would have to be recorded.

“Fair value” accounting, which allows man-agers to restate many financial assets and liabil-ities to their managerially estimated values evenwhen these values are not based on reliable mar-ket transactions, is subject to misstatement byopportunistic or overly optimistic managers, asshown by the Enron disaster. Only numbersthat are trustworthy should be used for finan-cial accounting statements that are attested toby IPAs.

Although these proposals, if adopted bythe FASB and SEC, would improve account-ing, there are differences in opinion aboutwhat should be included in GAAP as well assignificant political costs that would makechanges difficult to effect. Therefore, a com-petitive system that would allow corporationsto prepare their financial statements in accor-dance with alternative GAAPs, such as theInternational Accounting Standards that havebeen adopted by the European Community,should be adopted in the United States.

Notes1. The designation “registered public accountingfirm” was established by the Sarbanes-Oxley Act

of 2002, which limits audits of public companiesto independent auditors who are registered withthe Public Company Accounting OversightBoard, also established by the Act.

2. IPAs is the general designation for independentauditors. I use this title, rather than RPA, becausethe latter did not exist prior to the Sarbanes-OxleyAct, or CPA, because CPAs need not be employedby external auditors. Indeed, they often workdirectly for companies or, like myself, are teacherswho no longer practice public accounting.

3. See Arthur Levitt, “The Numbers Game,” Re-marks to the New York University Center for Lawand Business, September 28, 1998, www.sec.gov/news/speeches/spch/220.txt.

4. See, in particular, William Z. Ripley, Main Streetand Wall Street (Boston: Little Brown, 1927).

5. See Securities and Exchange Commission, Ac-counting Series Release 4, 1938, emphasis added.

6. See Edgar O. Edwards and Philip W. Bell, TheTheory and Measurement of Business Income (Berkeleyand Los Angeles: University of California Press,1961).

7. Howard Schilit, president of the Center forFinancial Research and Analysis, describes thevarious ways in which managers have usedaccounting to misinform investors. With manyexamples from actual situations, he delineatesseven practices that he calls “shenanigans.” Threeinvolve misreporting revenue: recording revenuetoo soon or of questionable quality, recordingbogus revenue, and boosting income with one-time gains. Three involve violations of the match-ing concept: shifting current revenue to a laterperiod, shifting current expenses to a later or ear-lier period, and shifting future expenses to thecurrent period as a special charge. The seventh isfailing to record or improperly reducing liabili-ties. He shows how analysts can detect these“shenanigans” and offers his proprietary comput-er-based service for detecting these practices. SeeHoward Schilit, Financial Shenanigans: How toDetect Accounting Gimmicks and Fraud in FinancialReports, 2nd ed. (New York: McGraw-Hill, 2002).

8. Texaco, Inc., the third largest, went bankrupt inApril 1997 with assets of $35.9 billion.

9. This section is largely drawn from George J.Benston and Al L. Hartgraves, “Enron: WhatHappened and What We Can Learn from It,”Journal of Accounting and Public Policy 21 (2002):105–27, which is based on our reading of pressreports; and William C. Powers Jr., Raymond S.Troubh, and Herbert S. Winokur Jr., “Report of

26

The bureaucracyand regulation

established by theSarbanes-Oxley

Act of 2002 islikely to be quite

costly to shareholders.

Investigation by the Special Investigation Com-mittee of the Board of Directors of Enron Corp.,”February 1, 2002 (hereinafter the Powers Report),and supplemented by information made public inNeal Batson, “First Interim Report of Neal Batson,Court-Appointed Examiner,” United States Bank-ruptcy Court, Southern District of New York, In reEnron Corp., et al., Debtors, Chapter 11, Case No. 01-16034 (AJG), Jointly Administered, September 20,2002; and Neal Batson, “Second Interim Report ofNeal Batson, Court-Appointed Examiner,” UnitedStates Bankruptcy Court, Southern District ofNew York, In re Enron Corp., et al., Debtors, Chapter11, Case No. 01-16034 (AJG), Jointly Administered,January 21, 2003.

10. Enron’s accounting practices were much morecomplicated than I can describe here. See Benstonand Hartgraves, and the Powers Report for muchmore detailed descriptions. See, also, Batson (2002and 2003) for extensive descriptions and the legalimplications of Enron’s use of SPEs.

11. For a detailed account of SPEs, their origins,and their accounting conventions, see Barbara T.Kavanagh, “The Uses and Abuses of StructuredFinance,” Cato Institute Policy Analysis no. 479,July 31, 2003.

12. For a complete description of the accountingrules governing consolidation of SPEs and otherinvestments see Al L. Hartgraves and George J.Benston, “The Evolving Accounting Standards forSpecial Purpose Entities (SPEs) and Consoli-dations,” Accounting Horizons 16 (2002): 245–58.

13. Because summaries can be found in Benstonand Hartgraves and more detailed descriptions inthe Powers Report and Batson (2002 and 2003), Iwill present here only the essential features.

14. Enron also avoided recording $4.02 billion ofdebt with a complicated series of transactions,called “prepays,” wherein it traded energy con-tracts with organizations established by banks,such that it recorded as prepaid income (a liabili-ty) what, in actuality, were loans from banks forwhich it was liable. These are summarized inBatson (2003, pp. 58–66) and described in detailin Appendix E.

15. See Batson (2002 and 2003) for descriptionsof these FAS 140 transactions.

16. See Batson 2003, pp. 30–31.

17. Ibid., pp. 33–35.

18. See Enron Corp., 2000 Annual Report, 2001, p. 48.

19. Ibid., p. 30.

20. See Charles W. Mulford and Eugene E. Comiskey,The Financial Numbers Game: Detecting CreativeAccounting Practices (New York: John Wiley, 2002).

21. See Thomas Weirich, “Analysis of SEC Account-ing and Auditing Enforcement Releases,” in ThePanel on Audit Effectiveness Report and Recommend-ations, Public Oversight Board, Shaun F. O’Malley,Chair, August 31, 2000, Appendix F, pp. 223–28.

22. Mark S. Beasley, Joseph V. Carcello, and Dana R.Hermanson, “Fraudulent Financial Reporting:1987–1997: An Analysis of U.S. Public Companies,”Research commissioned by the American Instituteof Certified Public Accountants, Committee ofSponsoring Organizations of the Treadway Com-mission, Jersey City, N.J., 1999.

23. A follow-on study of an additional 202 of therestatements found a three-day unadjusted mar-ket price loss of 5 percent, or $14 billion.

24. Three other comprehensive studies of restate-ments are Financial Executives International,“Quantitative Measures of the Quality ofFinancial Reporting,” FEI Research FoundationPowerPoint presentation, 2001, www.fei.org; Zoe-Vonna Palmrose and Susan Scholz, “TheCircumstances and Legal Consequences of Non-GAAP Reporting: Evidence from Restatements,”Contemporary Accounting Research Conference,2002; and Report Pursuant to Section 704 of theSarbanes-Oxley Act of 2002 (analysis of 227 inves-tigations of financial reporting and disclosureviolations over the five years ended July 31, 2002),Securities and Exchange Commission, January2003. All three studies yield similar results to theones summarized in this paper.

25. I was an expert witness for the plaintiffs againstthe external auditors in Continental IllinoisSecurities Litigation (1987) and Phar-Mor SecuritiesLitigation (1995).

26. The Sarbanes-Oxley Act of 2002, §108(d)(1)(A),directs the SEC to “conduct a study on the adop-tion by the United States financial reporting systemof a principles-based accounting system.”

27. This is detailed in Hartgraves and Benston.

28. The Black-Scholes model tends to overpricethe options when stock price volatility is not sta-tionary.

29. Options are still an imperfect form of perfor-mance-based compensation, because managersare rewarded for increases in corporate stockprices due to general upward movements in themarket and stock repurchases rather than divi-dends and are not punished when their corpora-

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tions’ stock prices decrease, except for loss of thevalue of the options. Even then, compliant boardsof directors often reduce the option strike price.More incentive-compatible shareholders’ andmanagers’ rewards could come from compensat-ing managers with actual or phantom stock.

30. The Sarbanes-Oxley Act of 2002 (§ 302)requires principal executive and financial officersto sign and certify that, to their knowledge, theircorporation’s reports “fairly present in all materialrespects the financial condition and results ofoperations of the issuer” and similar collateralstatements.

31. The increased use of options to compensatesenior managers appears to have been driven, atleast in part, by the 1994 Internal Revenue Code §162 (m) disallowance as a deductible expense ofexecutive compensation over $1 million unless itis “performance based.”

32. For an analysis of the effects of the PSLRA onsecurities class actions, see, for instance, Adam C.Pritchard, “Should Congress Repeal Class ActionReform?,” Cato Institute Policy Analysis no. 471,February 27, 2003.

33. In John C. Coffee Jr., “Understanding Enron:‘It’s about the Gatekeepers, Stupid,’” BusinessLawyer 57 (2002): 1403. Coffee cites and discussestwo cases: (1) Lampf, Pleva, Lipkind & Petigrow v.Gilbertson, 501 U.S. 350, 359–61 (1991) (which cre-ated a federal rule requiring plaintiffs to file to oneyear when they should have known of the violationunderlying their action, but in no event to morethan three years after the violation; previously thestate-law-based rule was from five to six years); and(2) Central Bank of Denver, N.A., v. First Interstate ofDenver, N.A., 511 U.S. 164 (1994) (which eliminat-ed private “aiding and abetting” liability in securi-ties fraud cases).

34. In particular, the act assigns joint-and-several lia-bility only where the jury specifically finds that thedefendant knowingly violated the securities laws.

35. Rick Antle and Mark Gitenstein analyzed thefinancial records of the Big Five accounting firmsand found that, while the per-hour rate for consult-ing is higher than the rate for auditing, the presentvalue to IPAs of audit fees is considerably greater,because the net cash flow from audits is steadier andcontinues for a longer time. Antle and Gitenstein,Analysis of Data Requested by the Independence StandardsBoard from the Five Largest Accounting Firms, unpub-lished report presented to the IndependenceStandard Board, February 17, 2000.

36. See David S. Hilzenrath, “Auditors Face ScantDiscipline; Review Process Lacks Resources, Co-

ordination, Will,” Washington Post, A.1 ff, December6, 2001.

37. Ibid.

38. See General Accounting Office, “FinancialStatement Restatements: Trends, Market Impacts,Regulatory Responses, and Remaining Challenges,”GAO-03-138, October 2002, Appendix V, pp.113–235.

39. These corporations (and their auditors) areAdelphia Communications Corporation (Deloitte& Touche), MicroStrategy Incorporated (Pricewater-houseCoopers), Orbital Sciences Corporation(KPMG), Rite Aid Corporation (KPMG), Safety-Kleen Corporation (PricewaterhouseCoopers), SeaView Video Technology, Inc. (Carol McAtee, CPA),and Xerox Corporation (KPMG).

40. Some critics of Sarbanes-Oxley have questionedwhether the creation of the PCAOB, a body that isstructured as a private nongovernmental organiza-tion that has the power to levy taxes (or fees) on allpublicly traded companies, is constitutional. SeePeter J. Wallison, “Acting in Haste on CorporateGovernance,” On the Issues, November 1, 2002.

41. Indeed, the Sarbanes-Oxley Act of 2002 (§703)instructs the SEC to determine the public accoun-tants, public accounting firms, attorneys, and secu-rities professionals who have violated federal securi-ties laws in 1998–2001 and describe their offenses.Section 704 instructs the SEC to “review and ana-lyze all enforcement actions by the Commissioninvolving violations of reporting requirementsimposed under the securities laws, and restate-ments of financial statements,” over the prior fiveyears. The reports were submitted to the Congressin January 2003. See footnote 24 above andSecurities and Exchange Commission, “Study andReport on Violations by Securities Professionals,”Report by the Securities and Exchange Commis-sion pursuant to section 703 of the Sarbanes-OxleyAct of 2002, January 2003. This study covers the cal-endar years 1998–2001, during which periodenforcement actions were taken against 1,713 per-sons or organizations, including 75 “other,” a cate-gory that includes accounting firms, exchanges,investment companies, and persons associated withinvestment companies. No other breakdown isgiven and nothing is mentioned about violations byor actions taken against public accountants or CPAfirms.

42. Two provisions of the Sarbanes-Oxley Actmight additionally reduce individual auditors’willingness to accede to clients’ demands: the leadaudit or coordinating partner and the reviewingpartner must rotate off the audit every five years (§203), a company’s senior financial/accounting

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officer (e.g., CFO) cannot have been employed byits audit firm during the one-year period proceed-ing the audit. I am not aware of any analysis ofwhether the benefits from these rules are likely toexceed their costs to shareholders from higheraudit fees and executive search costs and compen-sation.

43. Statistical sampling procedures that could beapplied to accounting data are outlined inStatement of Auditing Standards (SAS) No. 39 andin many textbooks. From a properly taken sample(random or stratified random), an auditor canassess the probability that the population valuesare within a specified bound. From tables based onsuch samples, auditors can determine the numberof items to examine, given their acceptance of aspecified risk. The results of the examination, then,can provide auditors with a reliable measure of thevalidity of the aggregate number being audited(e.g., accounts receivable) and the necessity of con-ducting a more extensive examination.

44. FAS 140, ¶5.

45. “Clarification of the Scope of the Audit andAccounting Guide Audits of Investment Companiesand Equity Method Investors for Investment inInvestment Companies,” AcSEC’s Proposed State-ment of Position, December 17, 2002. It has beencleared by the FASB. If adopted it would becomepart of GAAP for fiscal years beginning afterDecember 15, 2003.

46. See Chapter 3 of George J. Benston, MichaelBromwich, Robert Litan, and Alfred Wagenhofer,Following the Money: The Enron Failure and the State ofCorporate Disclosure (Washington: AEI-BrookingsJoint Center for Regulatory Studies 2003) for amuch more complete discussion.

47. This suggestion follows that made by RonaldDye and Shyam Sunder in “Why Not Allow FASBand IASB Standards to Compete in the U.S.?”Accounting Horizons 15 (September 2001): 257–71.

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