Despite the scandals that have surrounded Enron, Arthur Andersen, and several other companies, Joshua Ronen believes the venerable accounting profession can reform and redeem itself. In the past year, accounting has emerged as a prominent force in the investment and regulatory world. The saga of Arthur Andersen’s involvement in the Enron scandal and a series of alleged accounting improprieties have undermined investor confidence and led to calls for reform. The issues surrounding auditor independence, earnings management, and accounting standards are famously complex. But Professor Joshua Ronen, who has taught accounting at NYU Stern since 1973, is an experienced and lucid observer of the accounting scene. A former editor-in-chief of the Journal of Auditing, Accounting, and Finance, and a former director of the Vincent C. Ross Institute of Accounting Research at Stern, Ronen has proposed reshaping the relationship between auditors and public companies. In an interview with Sternbusiness, he helped shed light on how accounting has come to capture headlines, and how the profession could be reformed.

 

Sternbusiness: Why don’t we start with the Enron story? Was it a question of the accountants abetting corrupt behavior by the executives? Or the other way around?

Joshua Ronen: It’s difficult to tell. My guess is that this was a mutually enforcing creative approach, because essentially Arthur Andersen received millions of dollars in helping Enron structure the limited partnerships and special-purpose entities through which all these transactions occurred. So did the outside lawyers. It’s conceivable that Arthur Andersen had explained to the Enron people the possibility of such entities and some very smart and creative people at Enron caught on to the idea.

SB: One of the issues that surfaced was so-called “earnings management,” the way companies either manipulate or selectively interpret results to reach a desired goal. Why do we have this phenomenon and how should the public view it?

JR: Financial engineering by corporate executives in order to produce earnings, or manage earnings, has been going on for a very long time, but I think recently it’s been happening with far greater intensity simply because of the increasing availability of earnings forecasts by analysts. With the prevalence of these forecasts, there has arisen the need to beat the forecasts, or, rather, a great aversion to falling short of the forecasts. And this has produced a very strong incentive for corporate executives to manage earnings. On the average, I would say that if you fall short of a forecast, at least in recent years, the company suffered a penalty in the marketplace of about 20 to 40 percent. The fear of litigation and the fear of the penalty in the market induce companies to manage earnings. Now, this, of course, is a self-destructive mechanism because you cannot manage earnings forever. Ultimately, the truth will come out. A possible rational explanation of this seemingly ruinous behavior is that the earnings-management executives expect not to stay with the company long enough to face the “deluge.” At the same time, they do not fear loss of reputation: they would continue to be favored by shareholders and investors striving for short-term speculative profits.

SB: When it comes to these instances of accounting problems, is it a case of individual bad actors, or is it a function of a system that has inherent problems built into it?

"If accountants are paid by the company to whose financial statements they attest, they would have a great deal of temptation not to resist a client who would like to present a positive picture of the financial statements."

JR: Well, there is an inherent conflict of interest. If accountants are paid by the company to whose financial statements they attest, they would have a great deal of temptation not to resist a client who would like to present a positive picture of the financial statements. In the case of Enron, for example, when Andersen received an annual audit fee of $25 million, with promise of an annual stream of fees of such magnitude into the foreseeable future, that’s a very large sum even for a firm like Arthur Andersen.

SB: We like to think our accounting and disclosure systems here in the United States by and large are the most elaborate in the world. Is that still the case, or are there some basic flaws that have cropped up?

JR: The United States capital markets and disclosure rules and accounting standards are the most sophisticated and elaborate in the world. But, even so, the standards are sufficiently flexible to allow a lot of leeway for earnings management. And one of the problems with the standards is that the Financial Accounting Standards Board (FASB), in order to try to reflect more of economic reality and the proliferation of financial instruments and derivatives, has allowed more intangibles to creep into the financial statements. Once you do that, you provide a larger, or more flexible, set of opportunities to manage earnings. And since valuations of intangibles are not verifiable, auditors cannot audit them effectively. One of the solutions, as radical as it may seem, is to separate the presentation of non-verifiable assets and results – intangible future projections that cannot be verified mostly because they consist of private information – and the verifiable, which are past transactions that can be audited and verified.

SB: Is there an alternate model, whereby the accountant would be paid by the state or by a third-party?

JR: Yes. And this what I’ve advocated. One possibility is to have financial statements insured by insurance companies. The insurance companies would hire the auditors and pay the auditors. The auditors would provide reports on the basis of which the insurance carrier can decide whether or not to provide the coverage to the companies requesting the coverage. The coverage amount, which directly covers investors for losses as a result of omissions or misrepresentations, and the premiums paid by the clients, would be disclosed in the financial statements. Obviously, higher coverage and a small premium would be a signal of better quality financial statements. The companies would want this coverage because that would signal credibility and quality and in turn, decrease the cost of their equity capital.

SB: The accountants would still be doing the same sort of things but their check would be coming from someone else?

JR: They essentially would be hired by the insurance carriers.

SB: And they can continue to do consulting work?

JR: Yes, because the consulting work wouldn’t pose a conflict of interest anymore. Simply because if they allow that connection to contaminate their audit, then they would risk losing multiple audit assignments from their own client, which is the insurance carrier.

SB: What about the debate over the continued self-regulation of the accounting industry?

JR: If you self-regulate, but if the profession as a whole does not have the incentive to self-regulate effectively, then we have a problem. And since the auditors themselves are regulating themselves, the conflict of interest is still there. We cannot allow regulators, or a supervisory board, to be paid by the profession which consists of the same auditors who have the conflict of interest. So I think we need something other than self-regulation.

SB: In light of recent events, are your students asking different types of questions, or expressing doubts, about what it means to become an accountant?

JR: On the one hand, accounting all of a sudden becomes more important. Witnessing the drastic effect that accounting issues have on the marketplace, as reported in the press, makes accounting seem much more important. It’s no longer that boring subject that they thought it was. On the other hand, there is this issue of ethics, and what are accountants doing, and the issue of independence and conflict of interest. Overall, I find much greater interest by students in the accounting issues. They are curious about it.

SB: Where are we in the arc of these accounting-related scandals? Is Enron the high point?

JR: I think we will see many more such instances. It’s likely that the additional cases we find will not be the same size, but there are probably a larger number of companies where we will find similar revelations. That’s because the techniques used by Enron – primarily the use of the special purpose entities whose results were not consolidated – can be used by others. In fact, Enron was selling some of these schemes to other companies. And even without buying the ideas from Enron, the ideas are there. As long as a loophole exists it will be exploited.

Joshua Ronen is a professor of accounting at NYU Stern.