Policy Analysis No. 469

Accounting at Energy Firms after Enron: Is the “Cure” Worse Than the “Disease”?

By Richard Bassett and Mark Storrie
February 12, 2003

Executive Summary

The collapse of the Enron Corporation and the revelation of accounting irregularities at Enron and other major corporations have led to a reexamination of the adequacy of accounting, auditing, and disclosure rules in the United States. Many policymakers and commentators have viewed corporate malfeasance as a widespread problem, but the accounting problems that beset Enron and other failed corporations do not appear to be systemic in this country. Thus, the main risk facing equity markets post-Enron has been one of too much political intervention in a market that was already working to right itself.

Enron’s senior management engaged in a systematic attempt to use various accounting and reporting techniques to mislead investors. That attempt was facilitated by the rules-based system that guides U.S. generally accepted accounting principles (GAAP), which have conditioned people to look at whether financial statements comply with the rules. But compliance with the rules, important as it is, cannot and does not by itself guarantee bona fide economic results.

Accounting statements may at best give an accurate representation of how a company has performed in the past, but they tell little about how a company will perform in the future and thus about how valuable a company is. For that, economists mostly use discounted cash flow analysis—that is, they estimate the value of a business by obtaining the present value of expected cash flows discounted at an appropriate rate.

The difference between the backward-looking accounting mindset and the forward-looking investment or financial mindset helps explain why, while Enron executives were announcing increased earnings in 2001, Enron’s stock price was falling sharply. Indeed, movements in Enron’s stock price strongly suggest that investors saw through Enron’s accounting machinations months before regulators initiated a formal inquiry into Enron’s illegal operating and accounting practices.

Unfortunately, the political focus has remained squarely on the measures and bodies that failed to do what they should have in the recent corporate scandals rather than on reinforcing the measures and groups that “processed” the available information in the most timely fashion—that is, the debt and equity markets.

As a result, the Sarbanes-Oxley Act, and other political measures designed to restore confidence in U.S. corporations, will likely have the effect of harming investors by penalizing risk taking on the part of corporate management and increasing the quantity but not necessarily the quality of financial reports.

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Richard Bassett is the managing director and Mark Storrie is the chief technology officer at Risktoolz, a firm that provides corporate finance and credit analysis advisory services and software tools.