Enron Will Spur Reform but More Is Needed

Some reforms of accounting and business practices will actually be enacted, after all the shouting and congressional hearings about Enron Corp. and its auditor, Andersen. But problems will persist because the issues are far bigger and more complex than Enron.

There will be a board set up by the government to oversee accounting firms, said Arthur Levitt, former chairman of the Securities and Exchange Commission.

Also, there will be a reform requiring companies to disclose more information about their subsidiaries, a move aimed at preventing companies from hiding debts and losses in secret partnerships.

But no amount of accounting reform will prevent another Enron, Levitt said. Enron is not an isolated case. “It is the result of a cultural change in U.S. business, an erosion of business ethics,” Levitt said after testifying before Congress last week.

He was referring to the widespread corporate practice of stating profits in the most favorable way to boost stock prices. That problem has reached such extremes that it is undermining investor trust in the stocks of U.S. companies and therefore hurting the whole economy.

It happens in the best of companies. IBM Corp., for example, reduced expenses and thereby increased reported profit two years ago by recording a gain on a sale of property in its operating income instead of as a one-time event, as accounting rules normally dictate.

During the 1990s boom, the Internet-telecommunications pioneers, Cisco Systems Inc., Nortel Networks Corp. and Lucent Technologies Inc., shipped equipment to start-up telecom companies on essentially free credit terms, but recorded current sales and profits from the shipments. The big firms had to make massive write-offs and restatements of previous year’s results in 2000 and 2001 when the boom ended.

“Let’s put things in perspective,” says a businessman-investor, who requests anonymity because he’s involved with Silicon Valley companies. “Enron lost almost $70 billion in market capitalization [total value of its shares], Cisco has fallen $400 billion in market cap. Enron is not the biggest problem.”

But Enron is different. It collapsed amid mounting evidence of fabrication of earnings and subterfuge to hide the true state of its finances from shareholders and investors.

That has “seriously shaken” the investment managers of pension and mutual funds, the $10-trillion mountain of capital that undergirds a good portion of the U.S. and world economies, says Patricia McConnell, senior managing director of Bear Stearns investment banking firm.

Investment managers are shaken because they missed the signals that Enron was in trouble, and also because they fear that prices of common stocks may be based partly on air.

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Stock Options Are Controversial Subject

Indeed, the Jerome Levy Economics Institute of Bard College issued a report in the fall, before Enron fell, stating that profits of the companies in the Standard & Poor’s 500 index have been overstated by 10% to 20% for two decades.

The report focused in part on the accounting treatment of stock options--a controversial subject in accounting and industry circles. Companies grant options to employees as a form of compensation. But they do not record the options’ value as a cost, as they do with salary and benefits.

And companies do not add the optioned shares to total shares outstanding on which earnings per share are calculated--although they do report the added shares in footnotes in their annual reports. The effect, critics say, is to artificially lower costs and boost earnings per share.

For example, Microsoft Corp., a firm that makes stock options a key part of employee compensation, last year reported official earnings per share of $1.45. But a footnote explains that if optioned stock had been included, the earnings would have been $1.38 a share, 5% less.

The difference is in accord with a Bear Stearns’ finding that earnings at the largest U.S. companies would have been 6% lower on average if the value of options had been charged to earnings.

Yet high-tech firms, in Seattle and Silicon Valley and elsewhere, argue that paying in stock options helps conserve cash for young companies that can’t afford big salaries and do not wish to reduce reported earnings on which stock prices are based. Employees, especially many who grew rich at Microsoft, tend to agree.

So there are rational arguments for options. “Stock options are fine, but reporting their cost in earnings would not hurt the concept and would make the accounts clearer and more trustworthy for investors,” says Michael Clowes, editor of Pensions and Investments, a publication for the institutional investment community.

The point is moot, however, because “no reform of stock options accounting will be made. Congress would never pass such a measure,” Levitt says.

When he headed the SEC in the 1990s, Levitt tried to strengthen accounting regulations, including a prohibition of the conflict of interest inherent in the practice of accounting firms auditing corporations’ books while soliciting consulting contracts from them. Congress not only refused Levitt’s reforms but threatened to cut the SEC’s budget if he persisted--which says a lot about Congress’ professed zeal for reform today.

But reforms will be made at this time. The investment community is worried.

“Standards have slipped,” says Patricia J. Hughes, accounting professor at the Anderson School at UCLA.

“Companies today restate earnings from past years. They never used to do that. It’s a problem because it puts in doubt the basis for investments made years before.”

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Demand to Separate Auditing and Consulting

Problems are coming to a head. With global companies moving money around at unprecedented speed, “financial engineering is outrunning the accounting laws’ ability to keep up,” says Clowes, author of “The Money Flood,” a history of pension funds’ rise to investment importance.

“Investment professionals don’t trust the corporate accounts so they are adding a risk premium to all their investments,” says economist Albert M. Wojnilower of Clipper Asset Management, a New York investment firm.

But Enron has delivered a wake-up call. Major investors may force reform by insisting on rigorous accounting from auditing firms and corporate boards. The nation’s largest pension fund, the California Public Employees’ Retirement System, is “demanding that the SEC draw a bright line for accounting firms to separate their consulting and auditing functions,” a spokeswoman says.

It’s a profoundly serious matter. Many countries are poor because they do not have trustworthy investment markets capable of distributing capital to businesses and families. The lesson of Enron is that the trustworthiness of the vital U.S. market needs protection.

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James Flanigan can be reached at jim.flanigan@latimes.com