July 12, 2002

July 12, 2002 | Commentary on Regulation

Accounting Scandals: The Bottom Line

For most people, the story of Enron, WorldCom and other companies enmeshed in accounting scandals starts and ends with the players themselves. The accountants, the CEOs and others built an elaborate house of financial cards, and it finally came crashing down.

Others see darker forces at work. They trace the scandals to the deregulation campaign the Reagan administration waged in the 1980s and a Republican congress pursued in the 1990s. Unmoored from the steadying hand of government, we're told, these companies started playing fast and loose with the books.

Wrong. The accounting industry never was deregulated -- for the simple reason that the federal government never directly regulated it in the first place.

That hasn't stopped some, such as Robert Borosage of the Campaign for America's Future, from rewriting history. In a Washington Post op-ed, he pins blame on a bill Congress passed in 1995 that "shielded outside accountants from liability for false corporate reporting and made it more difficult for shareholders to bring suit against fraudulent reporting."

A WorldCom account couldn't have made a bigger misstatement. In fact, the bill attempted to toughen reporting standards by requiring auditors to inform the Securities and Exchanges Commission of any illegal acts they uncover. And the "suits" it targeted were the infamous "greenmail" ones, in which an individual would buy a large number of shares in a company, then threaten to lodge costly nuisance litigation unless the company agreed to repurchase his shares at an exorbitant price.

In fact, these scandals were spawned by two larger societal trends. One is an overall laxness in ethical standards that crept into the corporate culture. People in positions of authority were unwilling to look rule-benders in the eye and say: "That's wrong."

The second is the bottom-line mentality that flowered in the boom '90s. People who focused only on quarterly earnings made money easily in an up market but found the sledding tough in a down market. When things started cooling off -- and they were being pressured to show the kind of gains registered earlier -- they found "creative" ways to make their quarterly reports look as impressive as clamoring stock-holders expected. And they kept doing it quarter after quarter.

Since the culprit here is values, new regulations won't do the trick. Indeed, the quasi-government agency some federal lawmakers are trying to create to police the accounting industry would do little to prevent wrongdoing -- and could encourage companies to indulge in even more questionable bookkeeping.

Sure, it's a tough-sounding proposal, and it would satisfy the understandably high level of outrage these scandals have generated. But it would take industry lawyers about 10 minutes to discover loopholes in the strict laws and explicit requirements the agency spent months writing.

Consider how Enron first got into trouble. To reduce its liabilities, it created "limited partnerships" so that the company could shift assets and boost profits, at least on paper. Such an action may skate the edge of legality, but it didn't violate the letter of the law -- and it's the kind of behavior that's bound to increase if a new agency is handing down detailed rules that can be flouted with ease.

The Senate Banking Committee recently approved legislation proposing a new government agency that would police the accounting industry. A better solution can be found in a bill the House passed in April. It would set up privately organized entities that would review audits and auditors and take disciplinary actions when necessary -- actions that would be reported to the SEC, which could have corporate crooks thrown in jail.

These private groups would be able to respond quickly to changes in the accounting industry and would be far more flexible than a government agency. Since they don't have to follow a cumbersome federal process, they can revise their standards faster and make it less tempting for companies to play games with their books and hoodwink investors.

The goal shouldn't be so much to chastise the industry -- however justifiable that be -- but to provide the public with accurate financial information.

That's where the Senate bill falls short. It would lock future audits into a straitjacket of government regulations that may well increase the likelihood of future problems. The flexible approach the House has proposed, along with criminal prosecution of willful violations, would do a better job of encouraging companies to keep reliable books and restoring public confidence in the market.

###

David John, a former vice president with New York's Chase Manhattan bank, is a research fellow at The Heritage Foundation (www.heritage.org).

For most people, the story of Enron, WorldCom and other companies enmeshed in accounting scandals starts and ends with the players themselves. The accountants, the CEOs and others built an elaborate house of financial cards, and it finally came crashing down.

Others see darker forces at work. They trace the scandals to the deregulation campaign the Reagan administration waged in the 1980s and a Republican congress pursued in the 1990s. Unmoored from the steadying hand of government, we're told, these companies started playing fast and loose with the books.

Wrong. The accounting industry never was deregulated -- for the simple reason that the federal government never directly regulated it in the first place.

That hasn't stopped some, such as Robert Borosage of the Campaign for America's Future, from rewriting history. In a Washington Post op-ed, he pins blame on a bill Congress passed in 1995 that "shielded outside accountants from liability for false corporate reporting and made it more difficult for shareholders to bring suit against fraudulent reporting."

A WorldCom account couldn't have made a bigger misstatement. In fact, the bill attempted to toughen reporting standards by requiring auditors to inform the Securities and Exchanges Commission of any illegal acts they uncover. And the "suits" it targeted were the infamous "greenmail" ones, in which an individual would buy a large number of shares in a company, then threaten to lodge costly nuisance litigation unless the company agreed to repurchase his shares at an exorbitant price.

In fact, these scandals were spawned by two larger societal trends. One is an overall laxness in ethical standards that crept into the corporate culture. People in positions of authority were unwilling to look rule-benders in the eye and say: "That's wrong."

The second is the bottom-line mentality that flowered in the boom '90s. People who focused only on quarterly earnings made money easily in an up market but found the sledding tough in a down market. When things started cooling off -- and they were being pressured to show the kind of gains registered earlier -- they found "creative" ways to make their quarterly reports look as impressive as clamoring stock-holders expected. And they kept doing it quarter after quarter.

Since the culprit here is values, new regulations won't do the trick. Indeed, the quasi-government agency some federal lawmakers are trying to create to police the accounting industry would do little to prevent wrongdoing -- and could encourage companies to indulge in even more questionable bookkeeping.

Sure, it's a tough-sounding proposal, and it would satisfy the understandably high level of outrage these scandals have generated. But it would take industry lawyers about 10 minutes to discover loopholes in the strict laws and explicit requirements the agency spent months writing.

Consider how Enron first got into trouble. To reduce its liabilities, it created "limited partnerships" so that the company could shift assets and boost profits, at least on paper. Such an action may skate the edge of legality, but it didn't violate the letter of the law -- and it's the kind of behavior that's bound to increase if a new agency is handing down detailed rules that can be flouted with ease.

The Senate Banking Committee recently approved legislation proposing a new government agency that would police the accounting industry. A better solution can be found in a bill the House passed in April. It would set up privately organized entities that would review audits and auditors and take disciplinary actions when necessary -- actions that would be reported to the SEC, which could have corporate crooks thrown in jail.

These private groups would be able to respond quickly to changes in the accounting industry and would be far more flexible than a government agency. Since they don't have to follow a cumbersome federal process, they can revise their standards faster and make it less tempting for companies to play games with their books and hoodwink investors.

The goal shouldn't be so much to chastise the industry -- however justifiable that be -- but to provide the public with accurate financial information.

That's where the Senate bill falls short. It would lock future audits into a straitjacket of government regulations that may well increase the likelihood of future problems. The flexible approach the House has proposed, along with criminal prosecution of willful violations, would do a better job of encouraging companies to keep reliable books and restoring public confidence in the market.

###

David John, a former vice president with New York's Chase Manhattan bank, is a research fellow at The Heritage Foundation (www.heritage.org).

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

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