Accounting Reform After Enron: Is "Patching Up" Enough?

Introduction

In the wake of the Enron collapse, the chairman of the Securities and Exchange Commission (SEC) repeated his calls for the nation's securities laws to be updated in an effort to avoid another such crisis. In an article published in the Wall Street Journal on December 11, 2001, Harvey Pitt wrote that the Enron collapse underscores the need to update and improve the nation's financial reporting and disclosure laws, which were first developed in the 1930s. Pitt emphasized that investors needed current — not merely quarterly or annual — corporate information.

The current approach to remedying a clearly broken system has been regarded by some observers as too little, too late. Clarke and Oliver, for instance, point out that, "Paradoxically, one of accounting's grandest inventions to achieve financial clarification is its most virile medium for deception. From its introduction, giving special status to a group of related companies and the methods of consolidating its accounts has facilitated financial deception." Rather than engaging in fundamental reforms that address the underlying issues, Clarke and Oliver argue that the responsible regulatory bodies and the accounting profession have preferred to "patch up" consolidation accounting — and that even in the post-Enron reforms, such patching up continues. "Indeed," they say, "there is no evidence that proscribing the group structure and consolidated financial statements has ever been considered seriously."

In order to determine whether the existing piecemeal approach will provide satisfactory reforms, this paper provides a review of the literature to identify the relevant issues, followed by an assessment of the viability of such an approach in view of the scope of the problem. A summary of the research is provided in the conclusion.

In his assessment of the eventual Enron collapse, Edmond Warner reiterates P.T. Barnum's advice that "There's a sucker born every minute": "Derivatives are nothing new, but I doubt whether, 400 years ago, merchants calculated an option price after consideration of its delta, gamma, theta, or rho, but the underlying principles are timeless" (Warner, 2002, p. 5). Warner explains that the majority of trade in "plain vanilla" derivatives — based upon the most popular underlying assets such as major currencies, government bonds, and equity indices — takes place through derivatives exchanges. By providing a standardized framework for contracts, these exchanges create a trading environment that encourages liquidity and thus fine pricing. This "on market" trading of derivatives is not what concerns regulators, because the regulatory audit trail for recognized exchanges is fairly straightforward.

Background and Overview: The Clarke and Oliver Observation

However, in contrast to "on market" exchanges, derivative transactions conducted "off market" — in effect, non-standard direct contracts between bilateral parties — have attracted increasing regulatory attention for good reason: "Over the past decade or so, the volume of such transactions, across a wide swath of asset classes and instruments, has been extraordinary" (Warner, 2001, p. 5). In the market in which Enron competed, schedules of fees for buying and selling securities are not fixed, and dealers derive their profits from the markup of their selling price over the price they paid. An investor may buy directly from a dealer willing to sell stocks or bonds that the dealer owns, or engage a broker who will search the market for the best available price.

This growth in off-market activity reflected an increase in both willing buyers and sellers. Warner notes that the end buyers in these transactions are often "real" businesses seeking ways to balance their risk and revenue streams. Enron's implosion constituted a "stark reminder of counterparty risk." At the time of these transactions, Enron was the world's largest energy trader and stood on the other side of vast numbers of such derivative contracts. "In many, many cases, the only guarantee behind the contract will have been Enron's own name and balance sheet. These are now revealed to be worth nothing" (Warner, 2001, pp. 7–8).

According to Thomas C. William, on the surface at least, the motives and attitudes behind decisions and events leading to Enron's eventual downfall appear simple enough: "...individual and collective greed born in an atmosphere of market euphoria and corporate arrogance. Hardly anyone — the company, its employees, analysts or individual investors — wanted to believe the company was too good to be true. So, for a while, hardly anyone did" (William, 2002, p. 41). Clearly, then, the sufficiency of financial reporting measures that fail to reveal that a company is "cooking the books" is inadequate. Yet the question remains: can there be a "one-size-fits-all" approach to financial disclosure in today's increasingly diverse and globalized marketplace? The consolidated financial statement approach has been tried, but significant problems remain.

According to Walter G. Blacconiere and Patrick E. Hopkins (2002), the overwhelming majority of U.S. public companies report consolidated financial statement information. Accounting Trends and Techniques (American Institute of Certified Public Accountants, 1998) noted that 97.2% of the firms surveyed include "Consolidation Policy" in their footnotes (Blacconiere & Hopkins, 2002). Alexander Sannella (1991) reports that in order to present financial statements in accordance with Generally Accepted Accounting Principles (GAAP), published financial statements must include three basic general-purpose financial statements:

1) The balance sheet, or statement of financial position; 2) The income statement, also known as the statement of profit and loss or statement of operations; and 3) The cash flow statement. In addition, a complete set of financial statements requires full disclosure in the form of footnotes.

Consolidated Financial Statements Today

These three basic financial statements are considered general purpose because they are designed to satisfy the needs of a wide spectrum of user groups, including investors, creditors, financial and credit analysts, insurance companies, labor unions, employees, and government agencies. While these statements are designed for general use, the majority of financial information is provided to satisfy users with limited ability and authority to obtain additional information. Ordinarily, the primary users are identified as investors and creditors; however, Sannella points out that from a practical perspective, investors will most likely be the primary user group addressed by the accounting profession in published annual reports. The other user groups can generally demand and obtain additional information or request clarification of data included in the annual report. For instance, if a company wants to obtain additional financing, it would typically be willing to satisfy a potential creditor's demand for further information (Sannella, 1991).

The balance sheet is a listing of the assets, liabilities, and capital of the entity at a point in time. From an economic standpoint, the balance sheet presents the stock of wealth of the firm. The assets of the firm have been defined as economic resources owned or controlled by the firm and having future service potential (economic benefit) to the firm. Notably, assets of the firm do not have to be owned outright. As long as the economic resources are controlled and provide future economic benefit, they can be included among the assets of the entity. Under certain conditions, for example, leased equipment can be included among the assets of the firm — that is, "capitalized" — even if not owned (Sannella, 1991).

Liabilities are the debts owed to outsiders — that is, creditors — by the firm. Liabilities are also known as "creditors' equity," or the creditors' claim against the assets of the firm. The capital of the firm represents the owners' wealth, which is a residual claim to the assets of the firm, or owners' equity. Because creditors' claims must be satisfied first, owners' equity has also been called net worth or net assets. The balance sheet is based on the fundamental accounting equation: Assets = Equities, or Assets = Liabilities + Stockholders' Equity (Sannella, 1991).

In the asset section of the balance sheet, assets are listed in the "order of liquidity," where liquidity is defined as the ability to convert an economic resource into cash with minimal risk of loss. It is common practice to report financial position through the use of a classified balance sheet. In the classified balance sheet, assets are classified as current if the economic resource is expected to be used, consumed in operations, or converted into cash within one year from the balance sheet date or one operating cycle, whichever is longer. The operating cycle is considered to be the "cash-to-cash" cycle of the firm. For some types of applications, such as those requiring an aging process, a single operating cycle may extend beyond one year; however, generally speaking, assets that meet the one-year criterion are classified as current. By contrast, if an asset is expected to provide economic benefit for a period longer than one year from the balance sheet date, it would be classified as a long-term or noncurrent asset (Sannella, 1991).

According to Sannella, liabilities are required to be listed in the "order of maturity." It remains common reporting practice to classify liabilities as current if due within one year of the balance sheet date, and noncurrent or long-term if payable in a period greater than one year. In theory, a current liability is properly defined as an obligation whose liquidation will require the use of economic resources classified as current assets or the creation of other current liabilities. While this definition captures the operating cycle concept, the one-year criterion for classifying liabilities is generally sufficient in practice (Sannella, 1991).

The classification of assets and liabilities provides useful information for the analyst in "matching maturities" of assets and liabilities. The excess of current assets over current liabilities — working capital — is an important component for a timely assessment of a company's liquidity in financial statement analysis.

Capital is classified as stockholders' equity on the corporate balance sheet. The stockholders' equity section consists of two major components: contributed or paid-in capital and retained earnings (Sannella, 1991). The contributed or paid-in capital component includes capital stock (either common or preferred) issued by the entity at par or face value, as well as amounts received above par value, known as additional paid-in capital or paid-in capital in excess of par. Retained earnings represent the historical record of earnings or losses that have not been paid out or distributed as dividends (Sannella, 1991).

The income statement is a listing of revenues, expenses, and net income or net loss over a period of time. It presents the change in owners' wealth, or the flow of wealth, for the accounting period — whether one month, one quarter, or one year. The basic model for the income statement is: Net Income (Loss) = Revenues − Expenses (Sannella, 1991).

Because the balance sheet represents the stock of wealth at a point in time, it is a cumulative statement. By contrast, the income statement reflects the flow of wealth, or the change in capital resulting from operations over a particular period. As a result, the balance sheet is a permanent statement while the income statement is only a temporary statement. At the end of each accounting period, the change in owners' wealth reflected in the income statement must be transferred to capital — specifically retained earnings — on the balance sheet (Sannella, 1991).

Further complicating matters is the provision in existing accounting rules that allows companies choosing to expense options to select from three methods of calculating the cost:

The first approach, used by companies including Coca-Cola and Bank One Corp., accrues the expense gradually with new option awards. The second method would include options granted in previous years as well as current grants, creating an even greater reduction to reported earnings. The third method requires companies to include old awards and restate their earnings from previous years as if they had been expensing options all along (Robinson, 2002).

Conclusion

After many years of poor equity returns, a number of investors are questioning whether they can achieve positive returns from the stock market based on the financial information currently being reported. From an investment perspective, however, it is precisely at times like these — when businesses can be acquired at discount prices and investor expectations are at their lowest — that investors should be most optimistic. Historical evidence and empirical observation confirm that the key to making sound investment decisions is to stay with the basics. Time and again, history has shown that investors can only consistently generate above-average returns if they understand the businesses they are investing in, insist on a margin of safety, and invest for the long term, notwithstanding the financial data being reported in consolidated financial statements.