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Don't overreact to the fall of Enron

For a while, as the story of the Enron Corporation's collapse and the role of accountants at Arthur Andersen broke onto the front pages, I was spending 10 hours a week on the phone, talking about little else. At the other end of the line were lawyers, reporters, and congressional aides, all looking with new urgency for information and insight about the American public accounting system. Many were as unfamiliar with the hows and whys of the system as we in the accounting profession are with our newfound notoriety. Most brought up the demands, heard often these days, for extensive regulation. I believe that would be a mistake.

The challenge of accounting measurement is to condense into three or four pages of financial statements (and 10 to 20 pages of footnotes) information about millions of current and future events affecting a business, each carrying risk: How many current debts are going to end up unpaid? What is the value of a recently acquired brand name? Unlike the price at closing of 1,000 shares of Intel on June 15, the numbers that represent the answers to these questions are usually uncertain. Reasonable men and women may differ about them, and they may all be proved wrong.

What accountants call GAAP, short for "generally accepted accounting principles," is a mixture of norms, laws, and premises developed to guide the evaluation of uncertainty. But if these principles are applied too formally or become too restrictive (say, in response to a publicized crisis like the collapse of Enron), they will only ensure that the public gets mediocre, and not very useful, information.

Take bad debts, for example. Using an accepted accounting principle, accountants can fix the range of loans that go sour during a time of generally low credit risk at between 2 and 4 percent. Unfortunately, even this range can penalize the best managers--those who are the most adept at selecting customers likely to pay their bills and at keeping a watchful eye on their receivables. Investors can't recognize the good performers or even avoid the bad ones if all businesses are reported within the "generally accepted" range. Overly strict adherence to the form of accounting principles at the expense of good accounting judgment and evaluation is, to my mind, what lies at the heart of the Enron debacle.

Of course, lodged within accepted ranges of honest error are opportunities for manipulation and dishonesty. And in the past five years, the range of honest measurement error became wider. During the "irrational exuberance," to use Federal Reserve Chairman Alan Greenspan's description of the recent stock market run-up that peaked in March 2000, the accounting system was tested more intensely than at any time since the 1929 Crash. We saw an increased emphasis on derivatives, special-purpose entities, and other risk-management vehicles. New business models were created for which there were limited measurement benchmarks. And the incentives to misrepresent information increased significantly with emphasis on stock options and the growth of opportunities at companies whose stock was on the way up.

To be sure, there is a need for reform. Deceit must be punished. And we need to examine closely the structure of incentives that make dishonest behavior tempting. Yet it's worth pointing out that with the evaporation of trillions of dollars from the stock market in the last two years, among the thousands of publicly traded companies that file with the Securities and Exchange Commission, remarkably few audit failures have surfaced. Andersen appears to have relaxed its internal vigilance at a time when others of accounting's Big Five did not.

Accountants know that in order to serve the public interest--and indeed to continue to work--they need to demonstrate a healthy skepticism about the quality of information reported by companies. But it would be a serious mistake to respond to the fall of Enron and the moral and professional errors of individuals at Arthur Andersen by prescribing overly stringent restrictions on accountants' judgment, whether in the form of internal professional codes or outside law and regulation. That would be sacrificing skepticism for cynicism.

G. Peter Wilson

G. Peter Wilson is the Joseph E. Sweeney Professor of Accounting in BC's Carroll School of Management. A more detailed analysis by Professor Wilson of accounting reform issues can be found at The Full Story, on the BCM Web site: www.bc.edu/bcm

Photo: AP Photo/Kenneth Lambert

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