 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
 |
Developments Relating to Enron Corp
Full Committee on Energy and Commerce
Mr. Baruch Lev
This witness submitted graphics information along
with his testimony that are best viewed in the Adobe PDF
version of this testimony. E
L A B O R A T I O N S
21st
century business enterprises are fast changing; involved in a complex network of
alliances, joint ventures, partnerships and other related entities; and derive
their value and growth primarily from intangible assets (patents, brands,
knowhow, unique organizational designs). The
traditional accounting system, and its major product-the publicly-released
financial reports-essentially reflect past transactions (sales,
purchases, borrowing, etc.) only, and recognize physical and financial
assets (plant and equipment, securities), to the exclusion of most
intangible assets. Such
narrowly-based, backward-looking corporate reports are ill-suited to provide the
information needed by investors, creditors, and policymakers (e.g., for national
accounting measurements). Primarily
missing from current financial reports are: 1.
Networking activities A
hallmark of the modern corporation is its involvement in a wide range of
corporate activities conducted through alliances, joint-ventures, partnerships,
and special purpose entities. For
example, pharmaceutical, biotech, and chemical companies are conducting much of
their R&D and marketing activities through alliances and joint ventures, as
do software developers, and special purpose entities are often used to shift and
optimize ownership and risk. There
are solid economic reasons for most of these networking activities, although
occasionally they are abused. Most
of these wide ranging activities are either ignored or improperly reflected in
corporate financial reports, adversely affecting the information available to
investors and creditors, and creating incentives for misrepresentation and
fraud. 2.
Unexecuted Obligations The
current, transaction-based accounting system practically ignores most unexecuted
obligations and contractual arrangements, despite the fact that they can create
major liabilities in the future.[1]
Thus, for example, Enron's alleged obligations to cover SPE's losses
were not reflected in its financial reports. More
broadly, firms' myriad unexecuted obligations to and contractual arrangements
with alliance partners, suppliers, and financial institutions (e.g., debt
securitzation) are deficiently reported, if at all.
This creates significant incentives to misrepresent the true obligations
profile of the company, and distorts the true economic situation of the
enterprise. 3.
Intangible Assets In
today's economy, physical and financial assets are largely commodities (i.e.,
competitors have equal access to them, such as Merck and Pfizer's access to
the best lab equipment and information technology).
Value and growth, of both corporations and nations, is primarily derived
by unique intangible assets, such as patents, brands, and trademarks, as well as
unique organizational designs (e.g., supply chains) and knowledge management
systems. The
current, industrial era-based accounting system regards most intangibles as
expenses, as if they were devoid of future benefits, thereby introducing serious
biases to corporate balance sheets and income statements.[2]
It has been empirically shown that these reporting deficiencies cause
serious social harms, such as excessive cost of capital, large insider gains,
and manipulation of financial reports.[3] 4.
Risk Exposure The
traditional accounting system, focusing on assets/liabilities and the outcomes
of operations (income, cash flows) essentially ignores the risk exposure of
business enterprises. The
fast growth of financial innovations in the last 20 years (derivative
instruments for hedging and speculation, debt and other assets' securitization,
employee stock options, etc.) expose companies and their shareholders to
considerable and difficult to quantify risks.
In the early 1990s, the SEC instituted various requirements for risk
disclosure in prospectuses and financial statements.
These, however, resulted in extensive yet largely meaningless boilerplate
statements enumerating every possible risk "under the sun," and insufficient
specific risk disclosures. Particularly
missing are results of comprehensive risk-related stress-tests, informing
investors of the earnings and asset/liabilities consequences of expected changes
in interest rates, foreign exchange rates, commodity (e.g., oil) prices, or
changes in the economic conditions of countries where the company has major
operations. The Solution: Current financial reports should be expanded to comprehensive disclosures, portraying in addition to the consequences of past transactions (the current system), a fair representation of the networking activities of the company, the obligations undertaken (executed as well as unexecuted), and its risk profile. Assets should include both tangible and intangibles. This is, of course a major endeavor, but a possible one, if such a comprehensive disclosure will be placed on the top of standard-setters (FASB, SEC) agendas. It
is important to emphasize, particularly in the current Enron-intensive climate,
that the major benefit of the proposed comprehensive disclosure system is to
improve resource allocation in the economy and enhance the integrity of capital
markets. The rooting of occasional
misrepresentation and fraud is an important, yet secondary objective.
II.
Auditing
The
auditing of public companies by external auditors is in many cases an "all in
the family" affair. Auditors are
in too many companies effectively appointed and reappointed by managers,
who also have a significant say in the audit fees.[4]
Auditors' rotation is very low; quite frequently auditors serve the
same company 10-20 years, or more (much of the auditors' rotation, as is, is
due to frequent mergers and acquisitions by companies rather than to inadequate
service.) Cases in which auditing
personnel switch without a cooling off period to work for clients proliferate,
as are cases in which auditors engage in lucrative consulting with audit
clients. Such close arrangements
and relationships between auditors and auditees are manifestly inconsistent with
independent, effective and high quality auditing services. Yet
another dimension of the "all in the family" is the fact that the
auditors' trade association-the American Institute of Certified Public
Accountants (AICPA)-is in charge of promulgating auditing standards (GAAS), on
which in turn, the audit report relies. This
uniform report is long on hedging (e.g., "the financial statements are the
responsibility of the Company's management") and short on information
relevant to investors and creditors. To
top it all, the industry oversight is performed by "peer reviews" conducted
by other auditing firms. It was
widely reported in the media that in the last two decades this peer review did
not publicly sanction a single "big five" accounting firm. The
Solution:
A substantive revamp of the auditing industry along the following lines.
III.
Enforcement
Two
important elements are currently missing, in my opinion, from the
auditing-accounting enforcement systems: a quick-reaction investigatory body and
transparency.
IV.
Postscript
The analysis, proposals and suggestions outlined in this document are not just aimed at preventing future Enrons and its audits. More broadly and importantly, they are aimed at enhancing corporate disclosure and the effectiveness of audits, which are necessary conditions for a fast growing economy, well-functioning capital markets, and ethical and equitable corporate behavior. The pursue of these high level social goals, is the major purpose of the proposed corporate reporting and auditing reforms. [1] An obligation is recognized in GAAP (generally accepted accounting principles) as a liability, only when a transaction (e.g., a purchase or a borrowing), or an event (a legally-binding fine) has already occurred. [2] Particularly revealing in this respect is the fact that the current average market-to-book ratio (ratio of market value of companies to their net assets on the balance sheet) for the S&P 500 companies is over 5.0, implying that of every $5 of market value, only $1 appears on the balance sheet. [3] For elaboration on intangible assets, their sources and impact, as well as the reporting deficiencies and social consequences, see Baruch Lev, Intangibles: Management, Measurement and Reporting (Brookings Institution Press, 2001). [4] Formally, the board's audit committee is primarily involved in auditors' appointment, and their reappointment is approved in the annual shareholders' meeting. In many corporations, however, these are just formalities. [5] For example, the FASB has recently added to its agenda the "intangibles disclosure" item. Surely, questions concerning the disclosure of intangibles (e.g., the value of a patent portfolio), depend in part on the auditability of the disclosed items.
|
|||||||||||
|
