The Enron Failure and the State of Corporate Disclosure George Benston, Michael Bromwich, Robert E

Following the Moneythe The Enron Failure and the State of Corporate Disclosure George Benston, Michael Bromwich, Robert E. Litan, and Alfred Wagenhofer AEI-Brookings Joint Center for Regulatory Studies 00-0890-FM 1/30/03 9:33 AM Page i Following the Money 00-0890-FM 1/30/03 9:33 AM Page iii Following the Money The Enron Failure and the State of Corporate Disclosure George Benston Michael Bromwich Robert E. Litan Alfred Wagenhofer - Washington, D.C. 00-0890-FM 1/30/03 9:33 AM Page iv Copyright © 2003 by AEI-Brookings Joint Center for Regulatory Studies, the American Enterprise Institute for Public Policy Research, Washington, D.C., and the Brookings Institution, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without per- mission in writing from the AEI-Brookings Joint Center, except in the case of brief quotations embodied in news articles, critical articles, or reviews. Following the Money may be ordered from: Brookings Institution Press 1775 Massachusetts Avenue, N.W. Washington, D.C. 20036 Tel.: (800) 275-1447 or (202) 797-6258 Fax: (202) 797-6004 www.brookings.edu Library of Congress Cataloging-in-Publication data Following the money : the Enron failure and the state of corporate disclosure / George Benston . [et al.]. p. cm. Includes bibliographical references and index. ISBN 0-8157-0890-4 (cloth : alk. paper) 1. Disclosure in accounting—United States. 2. Corporations—United States—Accounting. 3. Corporations—United States—Auditing. 4. Accounting—Standards—United States. 5. Financial statements—United States. 6. Capital market—United States. 7. Enron Corp.—Corrupt practices. I. Benston, George J. II. AEI-Brookings Joint Center for Regulatory Studies. HF5658.F65 2003 657'.95'0973—dc21 2003000068 9 8 7 6 5 4 3 2 1 The paper used in this publication meets minimum requirements of the American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials: ANSI Z39.48-1984. Typeset in Adobe Garamond Composition by R. Lynn Rivenbark Macon, Georgia Printed by R. R. Donnelley Harrisonburg, Virginia 00-0890-FM 1/30/03 9:33 AM Page v Foreword nly a few short years ago, after the Asian financial crisis Oof 1997–98, Americans held out their systems of corporate governance and financial disclosure as models to be emulated by the rest of the world. Thomas Friedman, in his best-selling book The Lexus and the Olive Tree, cited these features of the U.S. economic system with approval. It was with some embarrassment then, and no little dismay, that begin- ning in late 2001 American policymakers and corporate leaders found themselves facing the largest corporate accounting scandals in American history. Although accounting irregularities had shown up in several large corporations in preceding years, they paled in comparison to the abuses uncovered at Enron, WorldCom, and a handful of other American corporate giants. Both Enron and WorldCom went bankrupt. Criminal and civil investigations and lawsuits were pending in those and several other cases as 2002 drew to a close. The scandals led the Bush administration to call for far-reaching reforms in both the corporate governance and financial v 00-0890-FM 1/30/03 9:33 AM Page vi vi disclosure regimes. Congress quickly followed by enacting most of them, and others, in the Corporate Responsibility Act of 2002. Policymakers were not the only ones to take quick action in the wake of the scandals. The major stock exchanges—the New York Stock Exchange and the NASDAQ—made fundamental changes to their listing requirements. The private sector acted as well. Corporate boards of directors and managers now give disclosure issues far more attention and scrutiny than before. Accounting firms—watching in horror as one of their largest, Arthur Andersen, collapsed after a criminal conviction for document shredding—have tightened their auditing procedures. Stock analysts and ratings agencies, hit hard by a series of disclosures about their failings, have changed their practices as well. As embarrassed and shocked as Americans may have been about these events, they also can be proud that the U.S. political and economic system had enough strength to address the problems almost as soon as they were uncovered. But will these reforms be enough? Are some counterproductive? And are other shortcomings in the disclosure system, both in the United States and elsewhere, still in need of correction or at least serious attention by policymakers? These are among the questions that George Benston, Michael Brom- wich, Robert E. Litan, and Alfred Wagenhofer address in this book. The authors had begun the project that has culminated in this book even before the Enron scandal broke. As they explain, even setting the scandals aside, the corporate disclosure system needs to be updated to reflect changes in the underlying economy and to make full use of new communications and analytical technologies, the Internet in particular. The series of accounting scandals in 2001 and 2002, however, prompted the authors to shift direc- tion and to address specifically the nature of the problems those scandals revealed and the efficacy of the remedies that have since been adopted to address them. The broad message of this book is that while the various “fixes” should improve matters, some were unnecessary, and some problems remain unaddressed. The authors advance what are sure to be some controversial suggestions: that rather than attempt to craft a single set of accounting and reporting standards for all companies throughout the world, policymakers should allow a competition in standards, at least between the two major 00-0890-FM 1/30/03 9:33 AM Page vii vii sets (Generally Accepted Accounting Principles, or GAAP, in the United States, and International Financial Reporting Standards); that policymakers should encourage experimentation in disclosure of a variety of nonfi- nancial indicators to better enable investors and analysts to ascertain the source and nature of intangible assets; and that policymakers should exploit the advantages of the Internet by encouraging more frequent financial disclosures in a form that will make them more widely accessible and more easily used. This book could not come at a better time—when accounting and disclosure issues are now at the top of the public policy agenda and very much on investors’ minds. The authors hope that the book will help contribute to better understanding of these issues. The authors are grateful to a number of individuals who have helped make this project and the book possible: to Sandip Sukhtankar and Chris Lyddy for research assistance; to Dennis Berresford, Robert K. Elliott, Robert Hahn, and Katherine Schipper for comments and suggestions on earlier drafts; to Martha Gottron and Margaret Langston for editorial assistance; to Gloria Paniagua for verification of the manuscript; and to Alicia Jones for secretarial support. The authors remain responsible, however, for the manuscript and its contents, any errors, or omissions. This book was prepared under the auspices, and with the funding, of the AEI-Brookings Joint Center for Regulatory Studies. The Joint Center builds on the expertise of both sponsoring institutions on regulatory issues. The primary purpose of the Joint Center is to hold lawmakers and regula- tors accountable for their decisions by providing thoughtful, objective analysis of existing regulatory programs and new regulatory proposals. This book helps carry out this mission with its special focus on rules relating to corporate disclosure and governance. . Director . Codirector AEI-Brookings Joint Center on Regulatory Studies 00-0890-FM 1/30/03 9:33 AM Page ix Contents Foreword v 1 The Crisis in Corporate Disclosure 1 2 What’s Wrong—and Right—with Corporate Accounting and Auditing in the United States 18 3 Fixing Corporate Disclosure 49 4 Disclosure Challenges Ahead 80 appendix What Are the Major Differences between GAAP and IFRS, and Why Do They Matter? 95 Notes 105 Contributors 117 Index 119 ix 00-0890-FM 1/30/03 9:33 AM Page xi Following the Money 01-0890-CH 1 1/30/03 9:33 AM Page 1 The Crisis in 1 Corporate Disclosure nly a few short years ago, the American system of cor- Oporate disclosure—the combination of accounting and auditing standards, the professionalism of auditors, and the rules and practices of corporate governance that are designed to ensure the timely dis- semination of relevant and accurate corporate financial information—was championed as a model for the rest of the world. In the aftermath of the Asian financial crisis of 1997–98, which was marked by among other things a woeful lack of disclosure by companies, commercial banks, and even central banks, American commentators and experts were urging not only Asian countries, but others as well, to adopt the key features of the U.S. disclosure system. How much has changed since then! A corporate disclosure system that Americans thought was beyond reproach has turned out to be flawed in ways that few would have imagined or dared suggest only a few years earlier. The shift in attitude is reflected in various measures, among them earnings restatements. The number of American corporations whose earnings have been restated rose modestly throughout the 1990s, but then took 1 01-0890-CH 1 1/30/03 9:33 AM Page 2 a big jump in 1998 and hit a peak of more than 200 in 1999.1 All the while, concern has continued to mount about “earnings management” by many companies. Under this practice, strongly decried by Arthur Levitt, a recent past chairman of the Securities and Exchange Commission (SEC), firms exploit the discretion allowed under accounting rules to ensure that their earnings show continued growth or at least reach the quarterly earnings estimates put out by financial analysts.

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