A philosophical investigation into Enron
Page 3
Here we enter a murky world that almost no economists, and
only a limited number of other social scientists, have sought to
enter. Let's call it the world of "ethnoaccountancy". The term is
analogous to "ethnobotany", which is the study of how cultures
classify plants, and which sets aside the issue of whether these
classifications are correct according to our modern botany.
An ethnoaccountant, similarly, would study how people produce
numbers, how they actually do their financial reckoning.
An ethnoaccountant couldn't just read the rule book, even
though it exists in the form of GAAP, the Generally Accepted
Accounting Principles of the Financial Accounting Standards
Board. The ethnoaccountant has to be a Wittgensteinian. In the
Philosophical Investigations, Wittgenstein pointed to the hidden
complexity of the apparently simple notion of "following a rule". If
we think of a rule as a set of words - written, for example, on the
pages of GAAP - then following it seems to involve an act of
interpretation of what the words "mean".
Interpretations, however, are contestable - especially if you have
expensive lawyers and sophisticated accountants bent on
finding an interpretation that will permit a valued client to do what
he or she wishes. Of course, one can write rules for
interpretation, but these rules themselves need to be interpreted:
we are at the start of a potentially endless regress. If rules are
simply verbal formulae, then, as Wittgenstein put it, "no course
of action could be determined by a rule, because every course of
action can be made out to accord with the rule."
All philosophers know Wittgenstein's discussion of following a
rule. It seems as if the US Financial Accounting Standards
Board does not, for it has progressed a long way into the
interpretive regress: Fox reports that GAAP now comprises
100,000 pages of rules. At every stage of the regress, however,
the Wittgensteinian analysis holds: even when expanded to
100,000 pages, what the rules of accounting "mean" can be
contested.
Hence the need for ethnoaccountancy, for discovering how
accountancy is actually done. Because there has been only a
little of it, one can merely speculate as to what exactly would be
found by an ethnoaccountant of the modern American
corporation. It's certain that she would find a myriad of special
purpose entities. Often their purpose is precisely to manage
debt: to match it with a defined and predictable income stream
in a way that will attract for the entities a higher rating from
Moody's or Standard & Poor's. More generally, she would also
find that the different ways in which rules can be applied can
have major financial consequences. As Louis Lowenstein, a
scholar straddling finance and law, put it in the Columbia Law
Review in 1996:
Accounting is not precise or scientific. It is an art, and a
highly developed one... GAAP requires industry to use
accrual basis accounting. Income is thus recognised
when it is earned rather than when cash is received. The
essence of the accrual basis is the matching of
expenses with revenues, so as to produce a truer picture
of a company's profitability. The rub is that accrual-basis
accounting affords a great deal of flexibility and judgment
in the timing of income and expense recognition. Will
American Airlines' new aeroplanes be serviceable for
thirty years or should they be depreciated over just
twenty? Should research and development expenses be
charged to earnings as they are incurred, or should some
portion be capitalised and charged only over time? And
so on. There is no single, correct answer to such
questions.
The ethnoaccountant might well find that timing is the key issue.
It is, for example, greatly in managers' interests for share prices
to be kept high at least until their share options can be
exercised profitably - what happens in the more distant future
may be of less concern.
More subtly, flexibility about when income and expenses are
recognised on balance sheets permits what is known as
"income smoothing": managing balance sheets in such a way
that a corporation's profits rise smoothly and predictably (just
beating the "forecasts" which investor relations departments
have fed to Wall Street analysts), rather than fluctuating
erratically.
One way of smoothing income is to have a "cookie jar", or a
reserve of earnings that have not yet been declared on the
balance sheet. A good moment to create or replenish a cookie
jar is when a corporation takes a "big bath" or reports a large
loss. The markets can be perfectly tolerant of an occasional
large loss, so long as it seems to be one-off and can be
explained satisfactorily, for example as the costs associated
with doing things of which the market approves, like reducing
employee numbers dramatically.
What better time to be very pessimistic in the way one values
assets or provides for future liabilities? Such pessimistic
reporting refills the cookie jar, because rising asset values or
lower than expected liabilities then form the foundation for future
reporting of profits.
It's easy to overstate the practical implications of Wittgenstein's
"rule-scepticism". He was saying that words alone can't
constrain us, not that nothing constrains us. Sometimes we just
know (in ways we may not be able entirely to explain in words
and can't really construe as acts of interpretation) that an action
is right or wrong.
Intriguingly, while most of us would say that we can just see
these things, Wittgenstein reversed the visual metaphor. He said
we must ultimately follow a rule blindly. But however we choose
to express the point, juries often have little difficulty convicting
murderers, even though precisely how to distinguish between
murder and legitimate or less culpable forms of killing is a
matter of continuous legal and ethical debate.
There was certainly quite some unease among those who had
an insider view of Enron's accounting practices. Had there not
been, staff at its auditors, Arthur Andersen (one of the "big five"
global accountancy firms before its spectacular Enron-induced
collapse), would not have taken the fatal decision to shred
Enron-related records when they learned that the corporation
was being investigated by the Securities and Exchange
Commission.
But unease is not the same as assertion of blatant illegality,
especially when those with the most negative views were
sidelined, as apparently happened to the most sceptical
Andersen partner, Carl Bass. In February 1999, David Duncan,
the partner in charge of its dealings with Enron, told the latter's
audit committee that "Obviously, we are on board with all of
these" - Enron's accountancy practices - "but many push limits
and have a high 'others could have a different view' risk profile."
He was warning the corporation that what it was doing had the
potential to create a damaging dispute - not telling them they
would end up in jail if they kept doing it.
If Enron's CFO, Andrew Fastow, had thought that special
purpose entities like LJM1 and LJM2 would be the subject of
criminal proceedings, he would scarcely have named them, as
he did, after the initials of his wife and two children. Enron was
sailing close to the wind, but that's the way to sail fast, and in
the late 1990s the stock market was rewarding those who did
so.
To read on
26.05.2003: A philosophical investigation into Enron (part 2) |
