More Than Just Hanky Panky

Mark Takla
Director, Events for FT Knowledge

As President Bush stepped up to deliver his State of the Union Address earlier this year, one could readily be forgiven for thinking that a single issue would dominate it, the ongoing war against international terrorism. Whilst this did largely prove to be the case, a very different kind of modern tragedy also warranted a mention.

“Through stricter accounting standards and tougher disclosure requirements, corporate America must be made more accountable to employees and shareholders and held to the highest standards of conduct”.

The President was of course referring to the repercussions of the demise of Enron. 90 years after the real thing, corporate America had discovered its very own Titanic, a seemingly indestructible vessel of the future. Rarely, if ever, before has the subject of accounting standards demanded so much newspaper print or television airtime. Certainly one would not expect the President of the United States to consider it a matter of national urgency. So, what is different now? Enron is by no means the first, and most definitely will not be the last, corporate giant to spectacularly implode. However, it is perhaps the first to be so publically exposed and vilified for deceiving and impacting the lives of so many ‘ordinary’ people. Even the President’s own mother-in-law was a victim. Employees and shareholders alike stored great faith in a company that promised them great riches in return for a little loyalty and a lot of investment. Riding the Enron wave was the experience of a lifetime. However, it soon became apparent that nobody was looking out for the iceberg until it was too late.

Mr. Bush’s statement during the Address was a very public slap on the wrists for the authorities that set and regulate American accounting standards. Only a matter of weeks earlier, US GAAP was considered by many to be the most comprehensive and thorough set of standards in the world. Today a number of critical observers have called for the system to be discarded altogether and replaced with a fresh, modern set of rules. Frits Bolkstein of the European Commission, stated that the Enron scandal was more to do with just ‘hanky panky’ from within but that the very nature of US GAAP was also at fault. The media have ensured that we have become well versed on the ‘hanky panky’ of Messrs Lay and Skilling. However, what of US GAAP? Even when taking into account the dubious book balancing of the Enron hierarchy, shareholders have a right to demand that the system be watertight enough to protect their investments. How could the standard setters have failed to spot the flaws that allowed a catastrophe the size of Enron to occur? Sadly for many it seems that they did.

“Even before the Enron tragedy, we were alerting all who would listen that our system showed signs of age, and needed significant improvements.”
Harvey Pitt, Chairman, Securities and Exchange Commission

The italics in the Chairman’s comment, made to the Federal Bar Council, are my addition as I feel that the highlighted words clearly convey the real problem that lies at the heart of Enron (and possibly many other scandals that preceded it). Yes, the authorities recognised that the system was flawed, yes they wanted to do something about it and yes they were trying to get the right people to take notice. However, did anyone really listen until it was too late?

Even though their warnings were falling on deaf ears, the standard setters were in fact making steps in the right direction. In October 2000, the SEC introduced Regulation Fair Disclosure, forcing companies to provide material information to both analysts and the public at the same time. Consequently I would venture that the new regulations that are supposedly being implemented as a knee jerk reaction to Enron would have materialised in due course. However, I am not as confident that they would have proved of as much interest to the politicians and public if Enron were still successfully operating its façade of profitability.

So what are these alleged flaws in US GAAP? The reason that the standards had been so highly regarded was because of the rigid rules that embodied them. Guidelines were detailed and specific, designed to ensure that the user was aware of exactly what they could and could not do. This now appears to be the crux of the problem. US GAAP has been referred to as ‘cookbook’ accounting. Follow the recipe instructions, stir when appropriate, bake for an hour and out comes the cake (unfortunately those at the top of Enron also seemed intent on eating it). Similarly, the standards have been criticised for their ‘check box’ approach, which have been blamed for allowing companies’ to hide their true financial situation from the glare of prying and inquisitive eyes. Why then you may ask was US GAAP structured in this way when it was so obviously open to abuse? In short, the answer is because the public gets what the public wants. FASB’s constituents, the users of the standards, demanded that the rules be detailed and specific, the argument being that this would reduce the chance of any transactional uncertainties. The cynic may argue that it also made the users’ jobs more straightforward. In the ideal world this rigidity would lead to the desired and intended outcome of clear and reliable financial statements. However, in the real world in which we operate it allows the creative abuser to use it to their own and their companies’ advantage. If it doesn’t say anywhere that they can’t do something then they will ‘assume’ that they can and feign ignorance if they are ever challenged. This is how the numbers at Enron were manipulated and, potentially, could also be common practice in a number of equally high profile and apparently legitimate companies. As we know, the SEC are currently carrying out a series of investigations and, no doubt, shareholders are crossing their fingers that they do not have a financial interest in ‘The Next Enron’.

Moving forward, there is majority agreement of a need for change. However, a general concensus on which direction the American accounting standards system should move is not as clear-cut. In March, the European Parliament confirmed that all EU listed companies will have to follow rules as set out by the International Accounting Standards Board in their consolidated financial statements by 2005, spelling the end for local GAAP. The Board has spent a number of years identifying the best standards from around the world and embodying them into one set of principles-based financial reporting rules. Sir David Tweedie, the Chairman of the IASB, has called this the ‘gold-standard’ and, in a statement to the US Senate, declared that it would “constitute the highest common denominator…convergence to the highest level”. However, whilst Europe, and much of Asia, has embraced IAS, the United States, has been opposed to shifting from US GAAP. Understandably the largest capital market in the world has argued that it does not need outsiders influencing the way in which it conducts its business. The IASB, whilst clearly a multinational organisation in its make up and structure, has its head office in London. The US authorities may therefore have been opposed to what could be interpreted as taking their orders from the UK. Post-Enron though the IAS bandwagon is becoming increasingly busy as the search for a solution to the present uncertainty goes on. One factor, which may prove decisive, is that large sections of IAS have been heavily influenced by areas of US GAAP (hopefully the right areas!) so converting to the new rules may not be as problematic and painful as previously feared.

The main challenge to the ideal of a single set of global accounting standards, used and understood by all, is in persuading national regulators to give up a considerable amount of control over what goes on at home in exchange for a degree of influence on the international scene. Whether this is achievable or not remains to be seen. Regardless, one lesson learnt from Enron is that the authorities will never be able to enjoy the luxury of thinking that they have got it absolutely right. For all we know, the next Titanic may have already set sail.