The Biggest Casualty of Enron's Collapse: Confidence
The New York Times
February 10, 2002
By ALEX BERENSON
SPECIAL purpose vehicles.
Credit derivatives.
Gain-on-sale treatment.
Off-balance sheet financing.
Enron may have collapsed, but
the market for esoteric
accounting is still booming. And
that is bad news.
Securities markets are all about
numbers, from sales and profits
to debt outstanding. If investors
cannot believe the figures put out
by public companies, they will be
much less willing to risk their
money on stocks.
For two generations, a rigorous
system of private disclosure and public oversight has given
American investors confidence that they will not be
fleeced when they buy stocks. As a result, far more
Americans than Europeans or Japanese own stocks, and
the United States stock markets are the world's largest.
This has provided the American economy with a constant
pool of cheap capital, which has made it the most flexible
and innovative in the world, and contributed greatly to the
1990's boom.
But Enron's collapse has put that hard-won confidence at
risk. Enron is not the first big company to be felled by bad
accounting. Well before it collapsed, regulators and some
professional investors worried that the system of oversight
was breaking down. But the fact that a company as large
and well-known as Enron could essentially be vaporized in
a matter of months has shaken even the most cynical
investors on Wall Street.
Accounting lapses were not the only reason Enron failed,
but it is only one of many corporations that has used
accounting to inflate profits or hide losses. Too often,
accounting at big companies is impenetrable, or flat-out
deceptive, experts say. And unless that changes, public
confidence in the markets could slowly erode, driving
small investors away from stocks. If that happens, the
economy will lose one of its biggest advantages - and the
sense that ordinary Americans have of being able to
participate in and profit from the same economic system
as the wealthy could weaken.
So when Paul A. Volcker Jr., the former chairman of the
Federal Reserve, said last week, "Accounting and auditing
in this country is in a state of crisis," he was not just
speaking to men in green eyeshades, but to the millions
of Americans who hope to pay for their retirement or their
children's educations by investing in stocks.
History suggests what could happen. After the 1929
crash, said Charles Geisst, a finance professor at
Manhattan College and author of "Wall Street: A History,"
a series of Congressional hearings revealed that
companies routinely failed to disclose important facts
about their finances and that corporate insiders routinely
profited at the expense of small investors.
Many Americans simply stopped buying stock, Professor
Geisst said. Not until the 1950's did ownership recover.
Then, slowly, ownership increased, and today about half
of all Americans own stock either directly or through
mutual funds. In the wake of Enron, that trend may
reverse, Professor Geisst said: "It wouldn't surprise me to
see a flattening out of the number of households that are
in the market." Until Enron's implosion, many investors,
both individual and professional, ignored accounting
issues. Wall Street's conventional wisdom held that while
a few companies might be inflating their profits, the
market as a whole was essentially honest.
THAT is now in doubt. In 1998, a survey of 160 chief
financial officers at public companies found that
two-thirds of them had been asked by other executives to
misrepresent their companies' results. Twelve percent
admitted giving in to the pressure.
Last year, a study by Financial Executives International, a
trade group for corporate executives, found that public
companies had revised their financial results 464 times
between 1998 and 2000, nearly as many restatements as
in the 20 previous years combined, and the problem
probably worsened last year.
Some of the world's best-known companies, including
I.B.M. and AOL Time Warner, are on the list of companies
that allegedly use aggressive accounting practices to lift
their earnings.
"You have to wonder how much this kind of fooling around
has become generalized," said Joel Seligman, dean of the
Washington University School of Law in St. Louis and
co-author of an 11-volume work on securities law. "There
are some major corporations which have some pretty fuzzy
disclosures."
No single event fully explains the breakdown in financial
reporting standards, experts say. Accountants, Wall
Street, securities lawyers, Congress and the companies
themselves all share the blame.
"The system of checks and balances has let investors
down," said Arthur Levitt, the former chairman of the
Securities and Exchange Commission.
Corporate executives have enormous financial incentives
to stretch or break accounting rules, and accountants and
lawyers, who are supposed to give their clients honest
advice, too often sign off. And even when they are capable
of deciphering the tricks companies have used to inflate
their results, Wall Street analysts and money managers
often look the other way, Mr. Levitt said.
"The business community tends to look at these things in
terms of what can we get away with, rather than what's
right," he said. "Optics has replaced ethics."
Meanwhile, the S.E.C., the last line of defense for
investors, is badly understaffed, said Ira Lee Sorkin, a
securities lawyer who formerly headed the agency's New
York office. With 3,000 employees, the agency must
supervise 500,000 brokers and tens of thousands of
stocks and mutual funds, Mr. Sorkin said. "Do you want
the S.E.C. with 3,000 people to find everything?" he
asked. "You've got to be nuts."
Despite all the problems, the core of the system remains
strong, said Mr. Seligman, the dean of Washington
University. But this crisis needs to be resolved before
investors lose faith in the integrity of the markets.
Already, even a hint of an accounting irregularity can
cause Wall Street to flee a company's bonds and stocks en
masse.
In the last month, shares in Tyco International, a giant
Bermuda-based conglomerate, have fallen 50 percent on
questions about Tyco's accounting, even though Tyco has
said it is not under S.E.C. investigation and continues to
be supported by PricewaterhouseCoopers, its auditor.
To restore confidence in American markets, Congress and
regulators need to take specific steps to strengthen the
disclosure regime, Mr. Levitt said. Funding for the S.E.C.
needs to be increased so that additional staff can be hired.
And financial statements need to be simplified so they can
be understood by even small investors. Wall Street
analysts need to disclose more clearly whether they own
the stocks they recommend, and whether their pay is
based on the investment-banking work their firms provide
for the companies they write about. In addition,
accounting firms should not provide consulting services
for the companies they audit.
PROFESSOR GEISST and other experts said even more
steps are possible. Congress should consider requiring
companies to switch auditors every few years so firms do
not grow too cozy with their clients. Corporate executives
should disclose more quickly when they buy and sell their
company's stock. Boards should be strengthened, perhaps
by including directors who are accounting professionals
and do not own the company's stock, said Robert Tucker,
an accounting professor at Fordham University.
"We need to protect the person out there who is not
necessarily reading Footnote 16," Mr. Tucker said. "The
weighting of the balance between investors' interests and
clients' interests has been lost."
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