Although the fall of Enron has generated a burst of reform proposals, policy makers in Washington and abroad are still at work on many of these measures, and it’s unclear which will be enacted and in what form, according to Robert E. Litan, senior vice president for economic research at the Brookings Institution.
In a speech titled “The Agenda for Reform,” Litan noted that as soon as the scandals broke, reforms began to proliferate. “What happened was a market-induced correction with boards and accountants scared out of their minds.” Then financial gatekeepers began to get involved, Litan added, pointing to the New York Stock Exchange and NASDAQ which tightened up listing requirements, particularly provisions that auditors be hired and fired by an audit committee of the board.
Congress stepped in too, with the Public Company Accounting Reform and Investor Protection Act of 2002, also known as the Sarbanes-Oxley Act, which passed in July. According to Litan, this is significant because it requires a new oversight board for the audit profession, limits auditors from being involved in other businesses such as consulting, and sets jail terms for violations of the new law.
“Is all of this going to be worth it?” he asked.
Using Federal Reserve models of the U.S. economy, Litan was able to calculate that the overall effect of the scandals on stock market valuations and gross domestic product was about $40 billion. By comparison, that is close to estimates of what the nation needs to spend for additional homeland security.
When the problems at Enron and other companies began to surface, he said, the U.S. system of Generally Accepted Accounting Principles (GAAP) drew criticism, mostly in the context of Enron’s misuse of accounting for special-purpose entities. But Litan said that for the most part, GAAP was not at fault for the scandals. The problems that surfaced at many of the companies, including Tyco, Xerox, and WorldCom, lay in simple misstatements of revenue or expenses.
“WorldCom was the most brazen,” he said because it booked lease payments as capital. “This is like flunking the first four or five weeks of Accounting 101. If you exclude Enron, this is not that complicated. It is hard to say the accounting standards are at fault. It was really management having an unbelievable amount of chutzpah and the accountants saying okay.”
Accounting for stock options is the only area in which Litan said he would fault GAAP. He blamed the ability of management to leave stock options off the books on the political influence that business lobbyists have on the Financial Accounting Standards Board (FASB), which oversees U.S. accounting practice. FASB is now reviewing how to treat stock options.
Undue Influence over FASB
“If I blame FASB for anything it’s the fact that narrow business interests have an undue influence over it and more influence than investors,” he said. Litan also criticized institutional investors, who could have provided a balance against business interests, for not paying enough attention to FASB.
When it comes to the ability to enforce new reform measures, Litan is “cautiously optimistic,” although he is concerned about the highly politicized process in which the chairman of the new oversight board required under Sarbanes-Oxley was handled by the SEC. Several weeks ago it seemed there would be a smooth appointment of John Biggs, former chairman of the TIAA-CREF pension fund, to head the board. But by a bitter 3-2 vote, the Republican majority on the SEC elected William Webster, a former director of the FBI and the CIA. Democratic members of the commission charge Webster was appointed after accounting firms complained about Biggs to the Bush Administration. “The appointment of the new chairman was not handled in the best way possible, suffice it to say,” Litan commented.
Ironically, on October 31, the SEC itself announced an investigation into the appointment after it was reported that SEC chairman Harvey Pitt had failed to inform other commissioners that Webster was head of the audit committee of a company, U.S. Technologies, now facing fraud charges. The resulting uproar led Pitt to submit his resignation to the White House on Tuesday, Nov. 5. His resignation letter suggested that the move was “in everyone’s best interest.”
Litan is also concerned that the SEC has not received $300 million budgeted for enforcement. The Bush administration had proposed $100 million. “The whole thing is stuck in the House,” he said, adding that he would be “more confident about real reform if the SEC had these resources.”
Depending on the fallout from yesterday’s (Nov. 6) elections, there could be substantial revisions in the Private Securities Litigation Reform Act of 1995, which lessened the extent to which auditors could be held liable in securities litigation. Research, he added, indicates this law did not really reduce the number of securities lawsuits: There were roughly 940 such suits filed before the litigation and approximately the same amount five years after it was enacted. “I do not blame the ’95 Act for all these misadventures,” he said.
Regardless of which party wins, Litan predicted Congress will also revisit conflict-of-interest rules for banks and securities companies but will not go so far as to separate them.
He is also dubious about the ability of FASB and the International Accounting Standards Board, which oversees European accounting, to agree on one set of international standards by 2005. In September both boards said they would work toward harmonization of accounting regulations by then. Litan is skeptical about this happening quickly because the U.S. system is based on detailed rules while the European standards are rooted in principles. “FASB and IASB are completely different,” he said. “It’s going to be hard writing one set of rules with one philosophy.”
Back in the Tower of Babel
Even if there is an agreement by 2005, he questioned whether it would be a success. There is already a long lag in adjusting accounting to changes in the business and financial world. If FASB and IASB have to make new rules in tandem, that could take even longer. And if these standards-setters fall behind, FASB, IASB or individual European nations may start to issue interim interpretations. “Over time you’re back in the Tower of Babel,” he said. “It won’t take long for one set of rules to crumble.”
Litan supports a proposal in which the different exchanges in the United States and Europe could adopt any set of accounting rules they wanted as part of their listing requirements. He said this competition among exchanges would diminish the problem of political influence over national accounting standards.
One objection to this idea is that it does not solve the problem of reconciling different financial statements so investors can compare firms, Litan acknowledged. However, he said the world is not likely to settle on one set of standards anyway. Furthermore, he predicted that companies seeking capital will have an incentive to release information in a way that can be reconciled by third-party analysts. “There will be an analyst industry built on reconciliation between IASB and GAAP and they will charge for it.”
Litan favors experimenting with different ways to standardize new financial measures that would give investors a better forward-looking picture of a firm, rather than the current model that merely reports past results. However, he would oppose the idea of formally booking intangibles because “it can be too loosey-goosey.”
He suggested the SEC might simply encourage disclosure of non-financial measures, such as customer and employee satisfaction rates, on an industry-wide basis. The relevant information could be standardized with input from companies and trade groups. Companies would be encouraged to disclose more information if they thought it would please investors.
Finally, Litan said, the ability of the Internet to compile financial information on a daily basis could make the obsession with quarterly earnings passé. Financial institutions, he noted, are already required to balance their books every night. “Information will be so rapid,” Litan concluded, “that no one will be able to manage the weekly or daily earnings. So we’ll give up.”