According to classical economic theory, here is how a corporation is supposed to work in the capitalist system. Owned by its shareholders, a corporation is run by a board of directors, who are voted into office by the shareholders. The board, in turn, appoints managers, led by a chief executive officer, to run the company’s day-to-day operations. At certain set times, usually annually, the financial operations of the business are audited by a public (that is, independent) accounting firm. This accounting firm, hired by the board, reviews the company’s financial records to ensure that they are prepared according to generally accepted accounting principles. Typically, the accounting firm is also asked to advise management on various business concerns that arise during the course of the year.
At the close of the financial year, the company issues its annual report, including a statement of income and a balance sheet that shows how much the company owes and is owed. At the end of the annual report, the accounting firm signs its corporate name to a statement attesting that the report fairly represents the current financial position of the corporation. Using information like the annual report, the financial markets as a whole are able to determine a fair price for the company’s stock. Frequently, much of this research is accomplished by security analysts working for investment banks, who analyze the performance of the company, based, once again, on public records.
If the company has done well that year (or is expected to do well in the future), the price that the marketwhich includes private investors, company employees who hold stock and larger corporate investorsis willing to pay for a share in that company’s ownership will increase. If it does poorly, the price will decline. Salaries of the management team also hinge on how well the company has performed. With such checks and balancesthe oversight of the board, the efficiency of the managers, the diligence of the auditors and the expertise of security analyststhe market is assured of accurate information that enables it to be, as economists say, efficient.
That, in theory, is the way it is supposed to happen.
In the case of Enron, however, very little of this happened. Arthur Andersen, the accounting firm, looked the other way while Enron management created special-purpose entities (that is, complicated financial arrangements) that kept hundreds of millions of dollars of losses and debt off the balance sheet, and thus away from the scrutiny of investors. This led to an overstatement of profits of almost $600 million and an understatement of debt of $630 million between 1997 and 2000. Arthur Andersen was also hardly independent, as more than half of its income from its Enron account came not from auditing but from lucrative consulting work. Further, repeated public statements by some of Enron’s most senior managers misled investors into thinking the company was doing much better than it was.
All the while, some senior managers were cashing in their own Enron stock. (Mr. Kenneth Lay, the chief executive officer, sold $37 million of his shares between May 2000 and August 2001.) Security analysts, too, whose firms had profited over the years from Enron’s spurious success, were reluctant to let go of a good thing; many continued to recommend the stock to investors until the bitter end. And in that bitter end, after the market finally digested the company’s true financial situation, the share price of Enron collapsed. Thousands of investorsmost poignantly Enron employees holding the stock in their 401(k) retirement planslost millions of dollars.
There are some obvious remedies. First, the accounting profession should be regulated by organizations that are not appointed by the accounting firms themselves, as they are now. Second, the conflict of interest inherent when accounting firms serve as both auditors and consultants needs to be eliminated. Third, what are known as generally accepted accounting principles should be brought in line with the requirement for fair representation of financial results. Finally, even if the law does not require it, equity demands that managers who profited unfairly be severely penalized, and that funds from such penalties be used to compensate employees whose retirement savings were eradicated.
More importantly, the Enron scandal shows the absolute requirement for boards of directors, executives and everyone else in the business world to accept the moral responsibility for honesty. While maximizing return for shareholders is the foundation of our economic system and provides for generally efficient capitalism, the system can be easily corrupted by the immorality and greed of a few. And with Enron, we see the wages of immorality: the suffering of many hardworking people who have lost their life’s savings.
Is there any clearer example of the value of morality in business?