The Quality of Corporate Financial Statements and Their Auditors before and after Enron

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In recent years the financial statements of severallarge well-known corporations, mostnotably Enron Corporation and WorldCom,have had to be massively restated. Is this indicativeof inadequate accounting and auditing rulesor evidence of corporate misgovernance andauditor incompetence? Why did these problemsoccur, and are they widespread? Answers to thoseand other questions are provided in this paper,which examines historical and current evidenceof problems with corporate financial statementsauditing before Enron. To provide a better perspective,I discuss in detail the traditional historicalcost model of accounting and the FinancialAccounting Standards Board's move away fromthat model and toward a system of fair valueaccounting. A better understanding of accountingprinciples will help explain what Enron didwrong and the type and extent of recent mis-statementsby other corporations. In case aftercase, it appears that fair value accounting that isnot based on reliable market prices was abusedby managers to create misleading financialreports. Given the influence of the Enron scandalin shaping public policy and public opinionabout financial reporting, this paper analyzes allthe links in the audit chain that failed to performtheir duties, from the members of the board ofdirectors to the independent auditors to the regulatorsat the state and federal levels. Finally,three changes to generally accepted accountingprinciples (GAAP)--allowing restatements ofassets and liabilities only to the extent that thoseare based on trustworthy numbers, replacing theU.S. rules-based with a principles-based traditional"matching concept" system, and allowingpublicly traded corporations to use internationalaccounting standards as an alternative to U.S.GAAP--are proposed to restore value to corporateaccounting reports.

George J. Benston

George J. Benston is the John H. Harland Professor of Finance, Accounting, and Economics at the Goizueta Business School, Emory University.