Why the Emphasis on Rules, Not Principles, Contributed to Accounting Abuses

Published: June 18, 2003 in Knowledge@Emory

The fact that Arthur Andersen, among the most respected of the Big Five accounting firms, was involved in massive financial irregularities on behalf of its client Enron is still a puzzle to many. Why did Arthur Andersen take such risks? How could there have been such a breathtaking failure of accounting and auditing ethics? And was Andersen the unfortunate victim of a systemic failure in our public accounting industry?

George Benston, a chaired professor of accounting and finance and economics at Emory University and its Goizueta Business School, has spent a lot of time reviewing the evidence and examining the role accounting firms played in high-profile scandals involving Enron, WorldCom, Tyco and others. Benston shared his observations in a lecture entitled "The Regulation of Accountants and Public Accounting Before and After Enron," as part of the Emory Law Journal’s 2003 Randolph W. Thrower Symposium. Benston’s written paper on this subject will be published in an upcoming edition of the Emory Law Journal.

The prevailing attitude is that it was Andersen’s desire to protect its high margin consulting fees that prompted the company to collude with Enron executives. But Benston, who is also a CPA, doesn’t agree with that assessment. Instead, he lays blame at the feet of the SEC and the prevalence of rules-based GAAP (Generally Accepted Accounting Principles). "GAAP has increasingly become rules-based rather than principles-based. In large part, this may be due to the auditing profession’s belief that IPAs [Independent Public Accountants] can avoid being sued successfully if they can show that their clients, and they, followed the rules."

With that provocative introduction, Benston backed up to give a big-picture overview of the accounting profession, an exercise he feels is necessary for understanding why the industry finds itself in such trouble today. The use of IPAs began long before they were required by the SEC in the 1930s, Benston said, because companies wanted to assure lending institutions and investors that they indeed had the assets they said they did, and that they were generating genuine profits. In other words, "until the establishment of the SEC, the principles of accounting were determined by the marketplace."

Benston noted, "After the SEC, things changed -- it had the authority to determine accounting procedures in detail. There was a move, in fact, to have the SEC create [an entire system] of accounting, and to have federal agents go into corporations and actually do the auditing.

"That idea didn’t last very long. The accounting profession obviously opposed it, but it was also a bureaucracy that just wouldn’t have worked, [especially] with more than 10,000 firms reporting to the SEC today." So the SEC turned over the formalizing of accounting principles to "various committees of the American Institute of Certified Public Accountants [AICPA]. The committees were composed of practitioners who were in tune with how things worked, they were part time, and they didn’t have any staff." As a result, while accounting procedures remained somewhat generalized, they still reflected real-world practices.

Then in 1973 the Financial Accounting Standards Board [FASB] was established, and that, declared Benston, "was the beginning of the end, because with the FASB there’s a big budget, a professional staff, and a big board with high salaries. Basically they have proliferated accounting standards considerably, and there are hundreds of various interpretations ... GAAP has developed into a set of specific rules, not unlike the tax code, which must be followed to the letter -- but not necessarily, or at all -- according to its intent."

Also, because of the SEC, corporate financial statements are statements generated by the company, attested to by the accountants. This means the IPA firms have less control over the statements, while facing pressure from their clients to approve them.

Having given that overview, Benston got to the heart of his presentation: "What went wrong at Enron? I have to be very careful about some of the things I say, because I’m an advisor to the Examiner in Bankruptcy [on the Enron case], so everything I’m saying I discovered prior to taking that position. What Enron did basically was stretch GAAP to the breaking point, and in some cases they made out and out mistakes -- some of which, like the $1.2 billion [mis-statement of profits] were Accounting 101 errors -- I don’t know why they did it.

"Such misrepresentations weren’t common before the 1990s," Benston asserted. "You have some cases of very bad audits, but very few actual misrepresentations." In the late ’90s there was a significant increase, but Benston pointed out that it’s still a tiny percentage of the thousands of SEC-regulated firms. Nonetheless, he asked, "What are the reasons for the increase? One may have been an unintended consequence of the 1993 tax act, which said you couldn’t pay executive salaries over $1 million and deduct the expense -- unless they were performance-based. That paved the way for a great movement toward options that corporate boards gave their executives, which made firms try to boost their accounting statements and their earnings, in order to produce a positive effect on their stock prices.

"Options and derivatives were used to a great extent by many firms, not just Enron, to get around rules-based GAAP. There were accounting firms and banks that were peddling various procedures to get around the intent of GAAP rules."

Benston also speculated as to why Arthur Andersen went along with Enron’s increasingly bold misrepresentations. "Why did they do it if they were going to be destroyed when they were found out? One reason is that the rules-based GAAP fostered by the FASB and the SEC made it very difficult for independent public accounting firms to object to what their clients wanted to do, because the clients could say: ’We are following GAAP. The fact that it’s misleading [doesn’t matter] because that’s the rule, and we’re presenting this statement fairly in accordance with GAAP. All we have to do is follow the precise rules, even if [our statement] might be misleading.’ And that’s what a lot of these firms did."

According to Benston, the other reason for Andersen’s actions is "the lack of punishment by the SEC, or anyone else, of individual accountants. You look at some of the major problems found at Waste Management, Enron and others, and it’s hard to believe a professional accountant would condone them. But the individual CPAs don’t get punished, because their firm has to back them -- if the firm doesn’t, then it as a whole will suffer, because it will be sued, and that’s what happened at Andersen."

Benston referred directly to David Duncan, "the particular accountant at Enron who caused the problem. I wouldn’t be surprised if he got off scot-free -- but he destroyed the entire firm. Andersen’s mistake was that they threw him to the wolves; they should have done what most accounting firms have done: insist that he did absolutely nothing wrong, and ride it out -- that might have been a better strategy."

Benston continued, "The AICPA, the professional association, can remove them from membership – if they are a member. Only the state that issued their CPA certificate can revoke it, but they almost never do. People get kicked out because they didn’t keep their professional education credits up, they didn’t return a client’s money, or they went to jail for some reason. But it’s almost never because of bad accounting."

From a regulatory point of view, the major fallout from the huge scandals at Enron, WorldCom and others was the passage of the Sarbanes-Oxley Act of 2002. The Act, as summarized by Benston, "substantially increases the role and power of audit committees of the boards of directors of publicly traded corporations, although the New York Stock Exchange was headed in that direction anyway. The consulting services of IPA firms are severely limited, [in terms of] what they can offer their audit clients. It also provides for the examination of audits and the disciplining of both individual IPAs and their firms by a [new] government agency, the Public Company Accounting Oversight Board [PCAOB]. And there will be significant additional fees imposed on reporting companies, on top of those already imposed by the SEC."

Overall, Benston is clearly no big supporter of Sarbanes-Oxley. "First, it has no effect on GAAP. There’s been no change in ’fair value’ accounting, which permits firms to use management-estimated values when actual market prices are not available. For example, the SEC and the FASB have permitted firms to take energy contracts that are as long as 10 years into the future, discount the expected cash flow, and report that as the asset’s value and increase in value as income. “

"But the main thing to keep in mind is that the number of firms that had to produce restated financial statements is really very small." Benston admits there have certainly been losses, but he contends that the extra scrutiny called for by Sarbanes-Oxley will end up costing investors. "My guess is that if you take all those new, extra fees, you’ll get a number that’s considerably larger than the benefits that might be found from improved audits.

"So what would I do? I think it’s a good thing to have the audit committee have additional powers. I think it’s a good thing that individual accountants should be punished when they violate the rules -- which they already can be under the previous regulations." And there’s no doubt Benston would favor the return to a much more principles-based GAAP rather than the rules-based system now in use.

Benston is especially critical of the new PCAOB, which he believes "will just create another layer of bureaucracy and another layer of cost on the whole process, and I doubt it will be beneficial." In a historical context, Benston said, "There have been very few charges of outright fraud by auditors. There may have been sloppy auditing, there may have been bad practices, but the actual participation of accountants in fraud has been very, very rare."

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