What’s troubling about Enron is that it’s not an isolated corporate flameout. Over the past three years scores of high-profile U.S. companies (among them Xerox, Waste Management, Lucent and Cendant) have been investigated for financial irregularities, and 464 firms have had to restate their earnings. Experts say those charged with safeguarding the numbers for investors–outside auditors, analysts and boards of directors–are often not doing their jobs. Is “corruption” too strong a word? “No, I don’t think it’s too strong at all,” says James Chanos, president of Kynikos Associates, a New York firm that specializes in “shorting” stocks (among them, Enron). “There’s all kinds of evidence to suggest that U.S. financial reporting and the audit function that backs it up have gotten increasingly corrupt the last few years.”
Experts say that unless these reporting problems are fixed, the credibility of America’s financial system will suffer. “Accounting problems devastate the confidence of investors in capital markets,” says Michael Young, a partner at the New York law firm Willkie Farr & Gallagher and editor of a book titled “Accounting Irregularities and Financial Fraud.” “The specter of [financial chicanery] causes uncertainty, increases risk and raises the cost of capital.”
Some of this can be blamed on the Internet bubble, when American CEOs were pressed to compete with the skyrocketing shares of the dot-coms. Even the world’s most demanding corporate-governance system was unable to keep up with increasingly aggressive bankers and accountants. During the ’90s, investment analysts began hyping stocks rather than analyzing them, and politicians–flush with donations from the financial sector–watered down attempts by the Federal Accounting Standards Board to toughen certain rules. “We got so greedy that everyone was just looking to make a dollar in the short run, not what would be better [for investors] in the long run,” says Lynn Turner, former chief accountant for the Securities and Exchange Commission and now director of the Center for Quality Financial Reporting at Colorado State University. That mind-set obviously still exists.
Eager to please analysts, many U.S. firms now stray from generally accepted accounting in favor of such exotica as “pro forma” earnings, “mark to market” accounting and so-called special-purpose entities, all of which can be used to paint a rosy–if often misleading–picture of a company’s health. Enron employed these methods. Chanos says that some of these practices were begun with good intentions but have since been bastardized. Congress will now ask whether the system that allows these kinds of dodges needs an overhaul. The SEC last week warned investors to be skeptical of pro forma numbers.
Young says the motive for aggressive accounting is almost always the same: America’s intensely demanding equity culture. “The company has been subjected to considerable pressure for financial performance,” says Young, “and what the CEO feels seeps throughout the organization, and at some point somebody may step over the line.”
American firms are still considered more open and honest than most others, especially those in developing countries. China, for example, concerned about stock-market fraud, is only now starting to require quarterly reports from its companies. Asked to rate the corporate governance of various nations, global investors surveyed by the consultancy McKinsey & Co. in 1999 gave the United States the highest score–4 to 4.5 out of a possible 5. By contrast, Japan and Taiwan rated a 2.5, while Indonesia and Thailand got less than 1. A similar study of developing countries by the brokerage CLSA (formerly Credit Lyonnais) gave eastern European companies the lowest credibility ranking.
In Europe, some companies use pro forma and mark-to-market (also known as fair-value) accounting, but they are somewhat controversial and not as widely used as in the United States. John Grant, an official at the Auditing Practices Board in London, says mark-to-market accounting (which is favored by U.S. commodity-trading companies like Enron because it allows them to include assets at their current value as opposed to historic cost) “brings a more judgmental element” into the accounting process. Still, the EU favors making mark-to-market standard by 2005.
Opinions vary on how America’s reporting system can be tightened. Turner says that the oversight structure must be reformed. He blames big accounting firms for opposing efforts to strengthen their own rules. Young says more-sophisticated Western markets need “real time” reporting systems, which he contends would take pressure off CEOs. “The markets don’t care what happened three months ago,” says Young. “They want to know what happened 10 minutes ago.” As Enron shows, it doesn’t take much longer than that to lose $80 billion in shareholder value.
