August 2002

IN GAAP WE TRUST

By D. Christopher Ohly

Part 1 of 2

The motto “In God We Trust” on every piece of U.S. currency invokes confidence that the medium may be exchanged in perpetuity, with a certainty of value. The Constitution endows Congress with the power “to coin money” and “regulate the value thereof,” while prohibiting the states from “coining money, emitting bills of credit and making anything but gold and silver coin a tender in payment of debts.” Our national currency, and eventually our national banking system, enabled our citizens to deal with one another across great cultural and geographic distance with assurance that the stored fruits of labor, converted into coin and paper, would be valued as greatly elsewhere as at home.

The illusion that the value of our currency is extrinsically underwritten has been systematically shattered by changes in our economic structure and periodic economic failures. The value of our currency has been transformed as recently as 1971, when then President Nixon allowed our currency to float freely, untethered from the price of an ounce of gold. As it has always been in reality, it is now clear in public understanding that our currency is backed by faith—not in God, not even in the “full faith and credit” of the United States—in the common trust and belief that a dollar can be exchanged for a good or service produced by another. Any currency is a unit of trust in the ability of one individual to exchange the representation of his saved labors and energies for the actual product of another individual’s energies, knowledge, skills, or genius, at a rate of exchange that each considers fair and proportionate.

Of course, currency values still fluctuate. As our national productivity increases faster than our international trading partners’, the value of the U.S. dollar rises as the euro or yen declines. Correspondingly, we are able to buy more foreign goods and services at a lower cost, while our trading partners find our goods and services relatively more expensive. Inflation is an obvious variant; deflation is equally feared but less frequent. Both reflect distortions not only in monetary policy and interest rates, but also in the relative scarcity of goods and services in light of extant demand.

The value of currency is also affected by unethical behavior, although perhaps less severely than in past years. “Fraud is as old as mankind,” a learned jurist once wrote, “and as versable as human ingenuity.” When an undetected rogue currency trader makes increasingly bad bets on the rise of the yen, the financial security of bank depositors appears threatened, however well insured by the FDIC. The risk-averse run for their bank deposits, stressing the banking system, making currency less available at low interest, creating inflationary pressures, and, perhaps, leaving behind them the litter of failed savings institutions.

Since at least 1934, when the Securities and Exchange Act was enacted, stocks, bonds, and their financial offspring have become another form of currency. Dynegy’s aborted bid to buy Enron relied on an exchange of Dynegy’s stock for Enron’s; the more successful combination of Time Warner and America Online involved a similar exchange; Hewlett Packard’s bid for Compaq used shares rather than cash. The more common transaction, whether initiated by a day-trader or a future retiree, involves the exchange of cash for the prospect of future appreciation or dividends. Stocks serve as a form of currency, albeit with a greater risk that the unit of productivity, represented by the cash investment, may ultimately be lost or depreciated, or may be significantly enriched, by the productive endeavors of the issuing corporation.

Much like cash, American investors have come to expect that their saved earnings, converted to stock, will be ultimately convertible to cash. No longer do we save our hard-earned wealth in seemingly well regulated and insured depository institutions; we have taken the risk that greater fortunes may be produced through investment in our national corporate economy. That trend, unlikely to reverse, is beneficial: It provides new aggregations of capital for inventive and productive activities. We assume productivity will increase and that the corresponding worth of our stocks will also grow.

Even more visibly than cash, the value of our stocks fluctuates with our society’s economic uncertainties. In theory, the apparent productivity of Intel, compared with that of AMD or Hitachi, determines the propensity of investors, small and large, to risk their cash fortunes on the probability that one will produce a greater return, protected from inflation, and, above all, protected from obsolescence and decline. All economic activity in stock markets depends upon their “efficiency.” At least in theory, our stock markets have achieved their success through the almost instantaneous dispersion of new information, both good and bad, which enables all investors to trade and assess risk equally.

The enactment of securities laws and the promulgation of detailed securities regulations were designed to ensure the fair and accurate presentation of information, in a form comprehensible by securities analysts, mutual fund managers, and other stock market opinion makers. Enforcement mechanisms, including those that impose civil liability for fraud or inaccuracy, were designed to provide ample incentive to those who report economic activity to disclose all information, and to disclose it consistently and truthfully. Those enforcement mechanisms have been an effective deterrent to fraud and even to negligence. They have endowed the stock markets with an aura of reliability, even if accompanied by a risk that can be fairly and accurately appraised.

Underlying our faith in stock as a currency is not a trust in God, but a rational belief that an invisible hand will guide our dollars to the most productive economic engines, and our trust that we can select the best of those engines in careful and justifiable reliance upon consistent, truthful, and accurate financial reporting.

Generally Accepted Accounting Principles (GAAP), applied consistently and assessed through competent and independent audits under Generally Accepted Auditing Standards (GAAS), are supposed to be the guarantors of transparency. Ultimately, as with any other forms of saved wealth, stocks remain subject to manipulation and fraud. Whatever the system, some people will always find ways to abuse it and to find ways to profit from the less well informed. But for decades GAAP and GAAS have been viewed as the bulwarks that protect investors against abuse by corporate insiders.

In some respects, the Enron failure may be seen as a simple case of manipulation by corporate insiders, whether well or ill motivated. No new or old litigation can completely deter people determined to magnify income, conceal losses, and thus to distort the “efficient” market. Even if the Private Securities Litigation Reform Act of 1995 had not been enacted, Enron’s failure—and other companies’ as well—would still have been inevitable once the bubble burst and public confidence in its future was destroyed. Indeed, from all accounts Enron’s future was sealed by the hubris of its corporate managers, who apparently believed that Enron’s stock price would never decline below fixed values, that triggered calls upon the resources of Enron instead of its now infamous special purpose entities (SPE)—the Raptors, EDI, Chewco, LJM, and LJM2.

We can also view Enron’s collapse as a simple failure of accounting integrity or as evidence of the lack of sufficient structural restraint in the accounting profession’s interaction with corporate clients. Calls for reform of auditor independence standards have grown beyond those discussed during the tenure of Arthur Levitt. Even auditors have succumbed to pressure to change these behaviors. In a statement issued in December 2001, shortly after Enron filed for protection under the bankruptcy laws, the AICPA announced that, early in 2002, it would issue new draft audit standards, including improved audit process standards for assessment of risks of material misstatement caused by fraud or error, and new draft standards for detecting material misstatements due to fraud. Clearly, as AICPA president Barry C. Melancon later told the media, the AICPA wants to “put this issue behind us.” The managing partner of one of the major accounting firms, in a New York Times op-ed the same day, acknowledged that “accounting rules and literature have grown in volume and complexity as we have attempted to turn an art into a science;” that the accounting profession has “fostered a technical, legalistic mindset that is sometimes more concerned with the form rather than the substance of what is reported;” and that it is “time to rethink the rules.”

But the obviously necessary reforms are only palliative: It is difficult to imagine that an accounting firm would have been deterred from conduct that contributed to an Enron-type demise by a simple prohibition of joint consulting and auditing engagements. Even if such prohibitions had existed, an accounting firm would still risk the loss of large audit fees if it vigorously challenged the fancy SPEs that a business like Enron may have established.

Calls for auditor independence reform, together with others for enactment of “self-regulation with teeth,” mandatory rotation of auditors, imposition of a larger number of forensic audits, limitations as to when an auditor can become an employee of a client, and corporate audit committee reform (see “Accounting in Crisis,” Business Week, January 28, 2002) are now plentiful. Recent legislative proposals, particularly H.R. 3763, the proposed Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, would enact some of these reforms. For example, the SEC would adopt rules to require that an accountant not be considered independent if it provides internal audit services to the client or designs or implements the client’s financial information systems. Such legislation would also require SEC rules mandating “adequate and appropriate disclosure” of an issuer’s “off-balance sheet transactions and relationships with unconsolidated entities or other persons,” at least to the extent they are “reasonably likely to materially affect liquidity or the availability of, or requirements for, capital resources.” These calls for reform and these legislative proposals may not, by themselves, be enough.

One need not agree with the commentary of some European accountants, who have suggested that International Accounting Standards (IAS) would have revealed Enron’s difficulties sooner. Nevertheless, the suggestion from some commentators that accounting standards have become so complicated that they are now like the tax code—that the complexity of accounting principles masks basic aspects of a company, and that clarification, if not simplification, of basic GAAP and AAS rules is now critically needed—deserves far greater attention.

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