Can we stop another Enron? S.P. Kothari says new laws won't

More regulation is not the best way to prevent future Enron-like meltdowns, says S. P. Kothari, Gordon Y Billard Professor of Accounting at MIT Sloan.

“The activities that allegedly occurred at Enron are already no-no's under existing accounting rules or security laws,” he says. “Better enforcement is the answer, not more laws.”

Kothari, whose current research focuses on the link between financial reporting and stock prices, says Enron appears to have provided misleading or even fraudulent information to the capital markets. Corporate executives are tempted to engage in such activities, he says, because they think they can get away with it.

“For me, the crux of the issue is how well existing laws are enforced,” he says. “If Enron executives pay a stiff price for their activities, that would serve as a strong deterrent to other executives who contemplate engaging in similar activities.”

The same goes for the auditors in this case, adds Kothari.

“It appears that the Houston office of Arthur Andersen was willing to do things that risked the reputation and capital of their entire firm because they stood to gain from the Enron engagement,” he says.

“It's surprising,” says Kothari, “that the several thousand partners at Arthur Andersen in particular or at other audit firms in general do not monitor more carefully and thus let some rogue partners to risk their capital. A welcome change that might come out of this disaster would be better self-monitoring on the part of accounting firms. Again, that would not require more government regulation.”

Stronger board governance

Kothari says corporate monitoring and control also appears to have been lax at Enron. He suggests the case is likely to prompt boards of directors to assert greater control.

“I think directors will be more watchful as to what is going on because clearly this board wasn't sufficiently independent and appears to have been negligent in its activities,” he says. “I think boards will take their duties more seriously if Enron board members are held accountable for what happened in this case. Again, this is something that does not require new legislation.”

Kothari compares the Enron debacle to the 1995 collapse of Barings Bank, where one rogue trader was able to bring down a 232-year-old institution.

“Barings Bank was also a clear-cut case where sufficient internal control was not exercised over someone who was risking the financial reputation and capital of the bank,” says Kothari.

That case landed several accounting firms in hot water, with multiple lawsuits alleging that they failed to report accurately on the bank's activities.

The expectations gap

Kothari says public outcry over Arthur Andersen's role in the Enron case is in part the result of an expectations gap. The public assumes that accountants are supposed to uncover illegal activity; accountants say that isn't their job.

“It's important to realize that we don't have many cases where accountants have prevented companies from going bankrupt,” he points out. “I often think people have an unreasonable expectation of what auditors or accountants can tell you. Their job is not to set a value; they are, at most, providing input that is helpful in setting value. If auditors could tell you what the value of a company is, then we wouldn't need exchanges and markets, where billions of dollars are spent with regard to setting market values.”

Kothari says the actual role of accountants is to communicate whether financial statements summarize the results of activities corporations have already engaged in.

“In contrast,” he says, “stock prices are almost invariably forward-looking in the sense that prices go up and down based on market participants' expectations of the financial consequences of the future activities. Accountants have very limited things to say about that; that's not the role of an auditor.”

As an example, Kothari says, consider a company that says a building it built cost $30 million. The auditor confirms that the building actually did cost $30 million.

“They don't say that it is worth $30 million, however,” he explains. “Now, if there is clear evidence that the building has fallen in value, then they do try to communicate that.”

Accounting fraud a rare disease

Kothari says it's rare that accounting fraud causes the stock prices of large corporations to collapse.

“While it's true that Enron is the largest bankruptcy ever, if you take all the factors that can push a company into bankruptcy, accounting fraud is a fairly rare one,” he says. “Just look at the recent example of Kmart and the many new economy companies that came crashing down; there wasn't any accounting fraud involved in most of those cases.”

Among the proposals for new regulation that have appeared in the media is the notion of having the Securities and Exchange Commission contract directly with accounting firms to audit the books of public companies.

“This is a bad idea,” says Kothari. “The markets are sufficiently developed; we have a history of more than 100 years of capital markets with companies trading with audited reports. So we should let corporations decide if they want to present audited financial statements, and investors can decide if they should insist on corporations providing audited statements.

“Let the market decide,” he says. “Audited financial statements blessed by the SEC contracts is hardly the magic potion that will eliminate future bankruptcies or accounting fraud or incompetent audits.”

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