Why Enron Always Happens

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The rules governing accounting have also had to be developed, and new techniques and tools evaluated. As long as firms were small and family-owned there was little problem, but when very large corporations began to proliferate, new accounting and statistical tools were needed to manage them successfully. Still, the accounting interests of stockholders and management were not the same. Shareholders wanted honest, complete accounting; managers, naturally, wanted the affairs of their corporations to look as good as possible. Sometimes managers lurched over the line into outright fraud, as those at WorldCom and Enron appear to have done.

Wall Street too has had an interest in getting timely and truthful numbers from the corporations whose shares trade there, but until the late nineteenth century most publicly held corporations did not even issue regular reports, let alone conform to specified accounting standards. When the New York Stock Exchange asked the Delaware, Lackawanna & Western Railroad for information about its finances, the road curtly replied, “Railroad makes no report [and] publishes no statements.…”

Then, in the 1890s, Henry Clews, a major broker on the Street, began campaigning for periodic reports prepared by independent accountants. The number of these self-employed accountants climbed. In 1884 there were only 81 accountants listed in the directories for the three largest cities in the United States (not counting Brooklyn, which was still enjoying its independence from what would soon be Greater New York). Five years later, there were 322. In 1896 New York became the first state to recognize accounting as one of the professions, establishing criteria that a person must meet to be licensed as a certified public accountant, a term coined in that law. By the start of World War I companies that wanted their securities to be listed on the New York Stock Exchange or sought profitable relationships with banks had no choice but to issue quarterly and annual reports that were certified by independent accountants as accurate and in conformity with generally accepted principles.

That is not to say, of course, that crooked accounting has vanished. Accounting is not a static science, and it always involves many judgment calls. As the profession has developed, new concepts have come into being. Cash flow, for instance, is now considered one of the most important measures of a company’s financial condition. But the very phrase cash flow entered the English language only in 1954. These new ideas have provided new opportunities to skate near the edge of what is allowed. And always some have skated over the edge.

In recent decades accountants seeking to expand the reach of their profession moved heavily into business consulting. This often proved more remunerative than accounting itself. Unfortunately it caused a conflict of interest. Accountants, though hired by management and paid by the companies whose books they audit, have a fiduciary duty to stockholders and the public at large to ensure that the books are honest and give a true picture of a firm’s financial condition. Fear of losing the highly profitable consulting jobs that now often accompanied auditing created a pressure in close calls to see things the company way. This, in some cases, caused a slippery slope into increasing deceit, such as at Enron, where Arthur Andersen was earning millions in consulting fees.

 

The solution, once the problem became apparent, was obvious and is already now law: Accounting firms must not serve as consultants to firms they audit. Again, scandal has led to effective reform.

In a friendly, neighborhood touch-football game, peer pressure keeps the players honest. With bragging rights the only tangible reward of victory, there is little to be gained and much reputation to be lost by cheating. But when the stakes of the game get higher, the temptation to cheat increases proportionally. With millions at stake in the Super Bowl every winter, for instance, if there were no referees on the field, the game would quickly come to resemble the famous football scene in the movie M.A.S.H.

The same is equally true of the game of the free market. As Adam Smith explains in The Wealth of Nations , “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” In other words, if the problem with socialism is socialism itself, the problem with capitalism is always capitalists. That’s why free markets are not self-regulating and never can be as long as human beings are human.

There is no better example of what happens in a free market when there are no referees on the playing field than the so-called Erie Wars that broke out on Wall Street in the 186Os when Cornelius Vanderbilt tried to buy control of the Erie Railway, then under the control of a board that included Daniel Drew, Jay Gould, and Jim Fisk.