Journal of Accounting and Public Policy 21 (2002) 137145 www.elsevier.

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Enron: sad but inevitable

Lawrence Revsine
*
The J.L. Kellogg School of Management, Accounting Information and Management, Northwestern University, 2001 Sheridan Road, Evanston IL 60208-2002, USA

In 1991 I published an essay on nancial reporting entitled The Selective Financial Misrepresentation Hypothesis (Revsine, 1991). While that essay preceded the events at Enron by a decade, I think major portions of its message and implications are still relevant. For convenience, I will summarize its basic points: 1. It is sometimes in the best interests of one or more of the various nancial reporting partiesmanagers, shareholders, auditors, standard-setters, regulators, lawmakers or academicsto engage deliberately in what I termed selective nancial misrepresentation. For example, these misrepresentations allow managers to achieve bonus goals, shareholders to benet from higher share prices, auditors to placate clients, standard-setters, regulators and lawmakers to satisfy political goals, and academics to curry favor from university department contributors and consulting clients. 2. To achieve misrepresentation, the parties prefer accounting standards that incorporate latitude: latitude in choosing between diverse alternatives (e.g., the current rate versus the temporal method in accounting for foreign subsidiaries), latitude in determining when economic events are recognized in net income (e.g., percentage of completion versus completed contract method for long-term construction projects), latitude in determining the amount of reported income (e.g., methods like LIFO which facilitate purposeful dipping into selected LIFO inventory pools),

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latitude in keeping assets and debt o the balance sheet (e.g., special purpose entities, operating leases and joint venture accounting).

3. The largely arbitrary, contrived and exible reporting rules that constitute GAAP are not an accidentthey are a deliberate consequence of the desires of the various nancial reporting parties. The Enron debacle represents an extreme example of the selective nancial misrepresentation mentality It is extreme for two reasons: (1) the wide scope of the misrepresentation activities, and (2) the misrepresentations often exceeded the exibility allowed by GAAP. While extreme, something like Enron was inevitable in the existing nancial reporting environment. In the 1991 essay, I oered some palliatives (pp. 2325). But I also said that a real remedy was highly unlikely. In retrospect, even this pessimistic appraisal was too optimistic! Things have deteriorated signicantly in the intervening years. Examples include a continual onslaught of accounting irregularities and audit failures (CUC International, Livent, Mercury Finance, Sunbeam, and Waste Management, among others), as well as Congressional intrusions into the nancial reporting/auditing process (Senator Liebermans Accounting Standards Reform Act of 1994 (S. 2525, 1994)) and the pressure which forced Arthur Levitt to soften the SECs stance regarding auditing/consulting conicts). 1 Public condence in the nancial reporting/attestation process is now justiably low. Change is neededand quickly. My proposals for change encompass four areas: (1) auditor independence, (2) governance and oversight, (3) the standard-setting mechanism, and (4) the education of those who prepare, audit, or analyze corporate nancial reports. Most of my attention in this editorial will focus on items 3 and 4.

1. Auditor independence One benet of the Enron scandal is that it convinced Congress and the general public that drastic improvements are needed to ensure auditor independence. Momentum here seems irreversible. Proposals to prohibit auditors from conducting certain non-audit related consulting services for audit clients are under consideration by Congress. 2 Even the Big Five and the AlCPA no longer object (at least openly). The widespread anger about the Enron events
1 In describing the pressure, Levitt is quoted as follows: I have never been subjected to a more intensive and venal lobbying campaign (see Labaton, 2002). 2 See Schroeder (2002).

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make it likely that consulting restrictions will ensue. Nuances will need to be negotiated. For example, if tax and registration-related consulting are deemed not to be a conict, are there any others? But, clearly, the biggest impediments to independence seem destined for repair. Frequent reassignment of in-charge audit partners and periodic rotation of audit rms themselves are also under serious consideration. So are restrictions on the hiring of key audit personnel by the auditee. Reassignment and rm rotation convey large independence benets with seemingly tolerable costs and appear desirable, in my view. Restricting the timing of personnel movements from audit rm to audit client is more problematic but still feasible. On the whole, signicant improvements in auditor independence seem to be attainable if these reforms are adopted (which appears likely at this timemid March 2002). One aw that remains is the training of auditors, and that is discussed later.

2. Regulatory oversight and corporate governance As details of the Enron situation become known, public reaction also makes signicant oversight and governance improvements easier. Proposals to increase the SECs budget signicantly are included in pending legislation 3 and have a good chance of passage. These increased resources will make it easier for the SEC to monitor and enforce existing (or augmented) disclosure rules and ensure that audit committee responsibilities are fullled. Clear improvements in the nancial reporting process should result. Auditing standards are currently set by the American Institute of Certied Public Accountants. I see no immediate need to change this. Auditors themselves possess the expertise necessary to develop appropriate guidelines. Surely, the AICPA now understands that tougher rules and stringent procedures are in the long-run interests of its membership. The general oversight mechanism which monitors adherence to auditing rules and guidelines needs changing. Industry self-regulation by the Public Oversight Board did not work. A reformatted self-regulatory body cannot be the vehicle that restores investor trust. The conicts are too great and public service suers. On this, Arthur Levitt said, The industry, from my point of view, has rarely focused on the public interest, only its own parochial business concerns. 4 So a truly independent oversight board which reports to the SEC must be established. This board must be independent in both thought and funding. Its members must be outsiders conversant with audit and nancial
3 4

See Schroeder (2002). As quoted in Kahn (2002).

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reporting issues. Fees levied on security market transactions could fund its activities. And with an increased budget, the SEC is uniquely capable of monitoring both the new oversight board as well as the AICPAs formulation of audit procedures. So it appears that forces already set into motion by the Enron events are likely to improve auditor independence, regulatory oversight and corporate governance. The most challenging and dicult facets of the nancial reporting reform agenda are standard setting and education, which are addressed next.

3. The standard-setting mechanism The FASB has been subjected repeatedly to intense lobbying, outside intrusions, threats, and a lack of support on key issues even from sponsoring organizations. The process which led to SFAS No. 123 Accounting for StockBased Compensation vividly illustrates these inuences. 5 So how can we protect the FASB from future interference by outsiders on other contentious issues? The pervasive motivation for selective nancial misrepresentation and power of the players (e.g., corporate lobbying groups and the US Congress) indicate that protective devices are useless. Furthermore, standard-setters are themselves subject to regulatory capture, 6 thus exacerbating the problem. So I reluctantly conclude that developing robust nancial reporting standards is futile. In the 1991 essay, I contended that resources are wasted in the pursuit of unattainably good standards. I suggested instead that existing standards could eectively be frozen and used as the basis for all future contracting and reporting. 7 Recent events now lead me to an even stronger proposal: that reporting entities be allowed to use whatever reporting standards they wish (US GAAP, IASB rules, or any others, e.g., current cost accounting). Financial reporting regulation would center on broad disclosure rules developed and

5 Readers unfamiliar with the political pressures directed against the FASB on the stock options issue should read Case 15-2 A Study in Political ProcessesFinancial Reporting for Executive Stock Options, in Revsine et al. (2002). 6 See Stigler (1971). Regulatory capture exists because regulators are often selected from the group to be regulated. This inuences their perspective. So the beneciaries of regulation are often the regulatees rather than the general public. 7 Revsine (1991, pp. 2324). In this proposal, the only place reporting standards would be needed is for enterprises whose performance can lead to direct economic losses for those who are neither owners nor direct transactors. Banks, S&Ls and insurance companies are examples. An example of the potential losses to be prevented are the per capita losses borne by US taxpayers because of the S&L bailout in the 1980s.

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monitored by the SEC. In this altered system, disclosure becomes paramount. For example, the disclosure rules might state: 1. Clearly identify what standard your rm selected (i.e., LIFO, straight-line depreciation, operating lease approach, etc.). 2. Does the standard you selected best reect your rms economic circumstances and performance? a. If yes, why? b. If no, what equally acceptable alternative standards were rejected? c. By how much would key nancial gures dier using the equally acceptable alternatives not chosen? 3. What is the justication for the estimates your rm selected to make the standard operational (e.g., useful life estimates by category for depreciation purposes)? Explain, if applicable, any deviations from prevailing industry norms. The onus to explain and justify the reporting methods chosen would rest with the reporting entity. Firms clearly have a strong economic incentive to provide lucid, comprehensive explanations. Confusing or inadequate disclosures would be interpreted as a negative signal. The market will then be the nal arbiter of the representational faithfulness of the rms reportingand reward or punish accordingly. Shifting the nancial reporting emphasis to disclosure mitigates the unavoidable failings of accounting standards themselves. 8 In addition, such a system has automatic safeguards. For example, if rms deliberately choose misleading reporting standards, the accompanying disclosure will be unconvincing to knowledgeable readers and will automatically ag the misrepresentation strategy. These nancial disclosure rules will need to be carefully crafted to ensure that market participants can readily distinguish between high and low quality standards and assumptions. While a disclosure-driven approach is unfamiliar, I believe it is feasible. For example, an airline that depreciates its 757 aircraft over a 25 year life while competitors use a 20 year life would be expected to explain and justify the disparity. Those who fail to provide this information, or who provide an unconvincing explanation, would presumably be penalized by the market. Analysts will need to evaluate the quality of the disclosures and make required adjustments. This is in stark contrast to the uncritical

8 Dye and Sunder (2001) raise the possibility of allowing rms to choose between FASB and IASB standards. My approach broadens rms choice possibilities and makes regulation of disclosures the key oversight mechanism.

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acceptance of reported nancial statement numbers that many analysts have seemingly adopted in the past.

4. Education of current and future market participants The proposals Ive advanced require participantsauditors, managers, shareholders, analysts, regulators and directorsto be literate in nancial reporting. Many are not now. The familiar litany of complaints regarding accounting education apply here. 9 Despite decades of reform eorts, many undergraduate accounting curricula continue to stress technical minutia over economic substance. Hours of classroom time are spent on understanding, say, the retail inventory method but little (if any) attention is paid to compensation incentives, special purpose entities, joint ventures and other o-balance sheet vehicles that drove the Enron distortions. Rules-driven courses are the norm, and they largely ignore the contracts and economic incentives that motivate selective nancial misrepresentation. The boring course content does not hone analytic skills, is not based on real world examples, and drives out many good students. This may lead to what can be called survival of the unttest. Fledgling auditors, bankers and others trudging through these topics are unprepared to analyze the real world of nancial reporting. Accounting literacy is not much better at many MBA programs because intermediate nancial reporting courses are often not oered. Frequently there is no MBA accounting course situated between the introductory nancial reporting course (10 or 15 weeks long) and Financial Statement Analysis. The FSA course usually comprises valuation/forecasting/securities market topics that rely on the previous course for accounting content. Students should be encouraged to approach nancial statement analysis with a healthy degree of skepticismto look behind the numbers to ensure that reported numbers faithfully represent economic conditions and performance. But often the nancial reporting foundation that is the basis for that skepticism consists of a single 1015 week survey course. We should not be surprised at the prevalence of unsophisticated or erroneous nancial analysis from one minute experts. In their brief course, they were barely exposed to even the rudiments of nancial reporting like LIFO versus FIFO. Understanding more complicated footnote disclosures, e.g. income tax reporting, derivatives, and pensions, is beyond the unavoidably shallow coverage they received in the introductory course.

For example, see Demski (2001).

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Accounting educations greatest failure is in training auditors. Statement of Auditing Standards No. 82 (AICPA, 1997) states that in order to perform competent audits auditors must be nancial detectives. But how can they become nancial detectives when they are clueless regarding the economic environment, managerial incentives, strategic gaming and other business realities that were omitted from the rules-driven upper level courses many were exposed to? The auditing rms might (and probably do) try to provide this forensic accounting overlay to newly hired graduates. But if these graduates often represent the survival of the unttest, how successful can the crashcourse overlay be? After all, you cannot easily transform a Yugo or a Trabant into a Formula One racing car. So accounting educators have certainly contributed to the climate of naivet e that fostered Enron. But worse yet, academic accountants often failed to speak out against the independence and reporting deterioration in the 1990s. There were exceptions of course. 10 But there was no plethora of op-ed page pieces on independence conicts or earnings management issues authored by academics. This academic inaction has persisted despite intense reform eorts such as those initiated by the Accounting Education Change Commission. More recent alarm bells (Albrecht and Sack, 2000) have also not had a readily discernible impact. This ought not to be surprising. Junior faculty often cannot be changeagents and senior faculty often refuse to be. Junior faculty at research institutions are preoccupied with earning tenure. To this end, publications matter while course development does not. Valuable time for research is saved by continuing to use inherited course syllabi and prior years notes. Even if they had the power to eect curriculum reform (which they usually do not), there is little incentive for junior faculty to do so. And senior faculty are often comfortable with the familiar and resist change. So achieving accounting education reform is as elusive as achieving good nancial reporting standards. But it is not impossible. Recent events suggest that selective education reforms are beginning to take root. Even before Enrons demise, some academics saw the dangers of a narrowly focused, CPAexam-driven curriculum. They realized that less than 40% of the AICPAs membership is in public accountancy practice 11 and the vast majority of undergraduate business students are not accounting majors. Outreach eorts to these majority groups began. A user, rather than preparer, focus became more

10 Funding arising as a condition of an SEC consent decree did initiate the American Accounting Associations Quality of Earnings Project in 2000. But prior to this external initiative, papers in conferences sponsored by the leading academic journals referred obliquely, if at all, to these controversial topics. Academic silence was the norm. 11 From the AICPAs website, aicpa.org. The gures are as of May 31, 2000.

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commonplace in introductory courses and, more recently, in upper level courses. Indeed, this broader content is often designed to attract increased numbers of nance studentsa sensible strategy in the face of the declining number of accounting majors. And at the MBA level, several prominent schools are planning to reintroduce the long-absent intermediate nancial reporting course. Even before Enron, students heading for careers in investment banking, corporate nance, commercial lending and consulting were clamoring for more technical accounting courses. Since relatively few students major in accounting at the MBA level, nance students are a prime potential constituency. It makes good educational sense to satisfy their needs. So while education lapses contributed to the climate that fostered the Enron failures, there are signs of a nascent reformation. Continued faulty analysis is not inevitable if the primary players (auditors, analysts, board members, etc.) become more literate in nancial reporting under the guidance of innovative and informed educators.

5. Conclusion There is a silver-lining in the Enron cloud. Financial reporting and auditing has been so wounded in the publics eyes that heretofore unthinkable reforms are not only possible but likely. These reforms oer the promise of enhancing auditor independence and strengthening regulatory oversight and corporate governance. Fixing the standard setting and education processes are more dicult. But the stakes are high, and this should provide a strong incentive for reform in these areas as well.

References
Albrecht, W.S., Sack, R.J., 2000. Accounting education: charting the course through a perilous future. American Accounting Association, Sarasota, FL. American Institute of Certied Public Accountants (AICPA), 1997. Statement on Auditing Standards No. 82: Consideration of Fraud in a Financial Statement Audit. AICPA, New York. Demski, J.S., Fall 2001. Presidents Message. Accounting Education News. Dye, R.A., Sunder, S., 2001. Why not allow FASB and IASB standards to compete in the US? Accounting Horizons 15 (3), 257271. Kahn, J., 2002. One plus one makes what? Fortune, January 7. Labaton, S., 2002. Auditing rms exercise power in Washington. The NewYork Times, January 19. Revsine, L., 1991. The selective nancial misrepresentation hypothesis. Accounting Horizons 5 (4), 1627. Revsine, L., Collins, D.L., Johnson, W.B., 2002. Financial Reporting and Analysis, second ed. Prentice Hall, Upper Saddle River, NJ, pp. 806810. S. 2525, 103rd Congress, 2nd Session, 1994.

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Schroeder, M., 2002. Panel plans to introduce legislation creating accounting-oversight body. The Wall Street Journal, February 12. Stigler, G.J., 1971. The theory of economic regulation. Bell Journal of Economics and Management Science 2 (1), 321.