Called to Account | Lessons from the Post-Enron Era

Say the word “accounting” these days, and a number of images immediately come to mind: fallen execs handcuffed just below the sleeves of their designer suits; their “What, me guilty?” testimonies in front of Congress; and fire sales for furniture once used by now-jobless employees.

Enron, Worldcom, Global Crossing, and other companies that played fast and loose with the truth left in their wake an incriminating trail of greed and duplicity. As outrage and disbelief slowly give way to analysis and reflection, accounting experts are beginning to assess the long-term implications of these financial statement fiascos. Professors, too, are asking themselves whether there is something they can do to keep today's ambitious spreadsheet whizzes from becoming tomorrow's Andrew Fastows. After all, keeping the books squeaky clean may be in right now – but integrity shouldn't be a mere fad.

Fine-toothed combing

One immediate consequence of the bookkeeping brouhaha is increased scrutiny of U.S. accounting standards and reporting requirements. Not surprisingly, everyone’s looking closely at the accounting of options, the use of special purpose entities, and aspects of improper revenue recognition that played such a key role in enabling public companies to distort the numbers they were reporting for so long.

While many in the industry hail such review as long overdue, there is considerable debate about whether it can last. As Patricia A. Williams, associate professor of accounting at Fordham Business, says, “It took the failure of several large corporations and the substantial financial losses incurred by stakeholders (shareholders, creditors, and employees) to force the SEC and the government to react.” Public memory is short; if the market starts climbing out of the slump, it is quite possible that boom-time permissiveness will return. Plus, media demonizing of U.S. accounting practices may just end up undermining oversight efforts. Why? Well, there's a tendency to throw the baby out with the bath water, experts say. “It seems that the financial press has become too focused on searching for the next Enron. Issues are being raised in the press that are basically non-issues," notes Williams. "Before March 2000, it seemed journalists could find nothing wrong with corporate behavior. Now they can find nothing right.”

Observers do believe, however, that the scandals will ultimately result in positive long-term changes. In addition to new laws such as the Sarbanes-Oxley Act and the initiatives adopted by the Bush administration to give the SEC more disciplinary power, the scandals have ignited political debates about other accounting issues, such as the proper treatment of stock options.

Perhaps even more effective in the long term may be the series of class-action lawsuits brought by aggrieved shareholders and government advocates like New York State Attorney General Eliot Spitzer, whose high-profile assaults on Wall Street’s investment banks have helped put securities reform on the public agenda.

Such progress may, in fact, be the best that can be achieved in the context of a dynamic accounting system. “Will this eliminate future Enrons and WorldComs? I doubt it,” says Williams. “But it will make accounting fraud more difficult. As long as greed exists, unethical managers, accountants and analysts will create new ways to defraud the public.”

Cash Flow in the Classroom

Though the public scandals include cases of both outright fraud and poor judgment calls, accounting students can only be taught to prepare for the latter. After all, fraud is deliberate -- and willful deception is, under any circumstances, wrong. But helping students develop a better understanding of the spirit behind and the mechanics of accounting can be tremendously useful in preventing the problems that arise from poor decision-making in ethically complex situations.

To illustrate this point, Williams explains how banks estimate the dollar amount of future loan losses: “This estimate appears on the bank’s income statement as an expense in the period in which the estimate is made. Many assumptions are involved in making the estimate. Thus, any estimate risks being too aggressive or too conservative. There is a very thin line between aggressive accounting and fraud. If the bank underestimates future loan losses, net income will be overstated (i.e., too high) for the period. Conversely, if the bank overestimates future loan losses, net income will be understated. Since management does not have a crystal ball, there is no way in advance to determine the exact amount of future loan losses. However, if management deliberately lowballs the number in order to artificially boost net income, or refuses to categorize a loan as doubtful that obviously is, we have moved from aggressive accounting into fraud.”

Certainly, many of the participants who found themselves embroiled in accounting scandals were under a great deal of external pressure. Wall Street was calling for quarterly results, colleagues and auditors adopted an attitude of permissiveness, and overconfidence in the future helped exacerbate poor estimates. That’s why it is important to couple the teaching of accounting practices and principles with an understanding of ethics, says Williams. “I try to make students aware of the importance of ethics in accounting judgment calls. Ethics is part of the corporate culture. If you have a CEO who is always pushing the limits or is too focused on the bottom line, it often follows that this aggressiveness permeates the entire organization,” she explains.

Putting It in Perspective

Are the recent shenanigans unique in the history of the industry? Not really, say experts. “I have been teaching accounting for approximately 17 years. During this time, it has never been difficult to find examples of accounting misbehavior," says Williams. "In the late 1980s and early 1990s, companies were playing games in accounting for inventory. During the 1990s, revenue recognition issues were prevalent long before Enron came on the scene. I’ve never had a problem finding a current example for any ‘accounting game’ I was discussing in class. The only difference between current and former accounting scandals is the sheer magnitude of recent corporate misstatements and of the losses incurred by stakeholders.”

So why are business students suddenly so anxious to learn more about accounting? Perhaps their interest stems from a genuine desire to make things better, to be more informed, or to avoid being duped by questionable accounting. Based on her own classroom experience, Williams believes it is probably self-interest that is driving most of the increased focus: “I have not taken any formal survey, but based on class discussions, students are concerned about the current accounting scandals to the extent that their jobs and investments are affected. Most students realize that as long as greed exists, there is always the possibility of another Enron. Evidently, students are becoming aware that a sound basis in accounting will better help them identify corporate financial games.”

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