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

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The collapse of the Enron Corporation and therevelation of accounting irregularities at Enron andother major corporations have led to a reexaminationof the adequacy of accounting, auditing, and disclosurerules in the United States. Many policymakersand commentators have viewed corporate malfeasanceas a widespread problem, but the accountingproblems that beset Enron and other failed corporationsdo not appear to be systemic in this country.Thus, the main risk facing equity markets post-Enronhas been one of too much political intervention in amarket that was already working to right itself.

Enron's senior management engaged in a systematicattempt to use various accounting andreporting techniques to mislead investors. Thatattempt was facilitated by the rules-based systemthat guides U.S. generally accepted accountingprinciples (GAAP), which have conditioned peopleto look at whether financial statements complywith the rules. But compliance with the rules,important as it is, cannot and does not by itselfguarantee bona fide economic results.

Accounting statements may at best give anaccurate representation of how a company hasperformed in the past, but they tell little abouthow a company will perform in the future andthus about how valuable a company is. For that,economists mostly use discounted cash flowanalysis--that is, they estimate the value of a businessby obtaining the present value of expectedcash flows discounted at an appropriate rate.

The difference between the backward-lookingaccounting mindset and the forward-lookinginvestment or financial mindset helps explain why,while Enron executives were announcing increasedearnings in 2001, Enron's stock price was fallingsharply. Indeed, movements in Enron's stock pricestrongly suggest that investors saw throughEnron's accounting machinations months beforeregulators initiated a formal inquiry into Enron'sillegal operating and accounting practices.

Unfortunately, the political focus has remainedsquarely on the measures and bodies that failed todo what they should have in the recent corporatescandals rather than on reinforcing the measuresand groups that "processed" the available informationin the most timely fashion--that is, thedebt and equity markets.

As a result, the Sarbanes-Oxley Act, and otherpolitical measures designed to restore confidence inU.S. corporations, will likely have the effect of harminginvestors by penalizing risk taking on the part ofcorporate management and increasing the quantitybut not necessarily the quality of financial reports.

Richard Bassett and Mark Storrie

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.