Accounting Reform After Enron: Issues in the 108th Congress

Accounting Reform After Enron: Issues in the 108th Congress

Order Code RS21530
Updated September 15, 2004
CRS Report for Congress
Received through the CRS Web
Accounting Reform After Enron:
Issues in the 108th Congress
Mark Jickling
Specialist in Public Finance
Government and Finance Division
Summary
The sudden collapse of Enron Corporation in late 2001, amid revelations that its
public accounting statements had been manipulated and falsified to conceal the
company’s true financial position, was the first in a series of major accounting scandals
involving American corporations. The response of the 107th Congress was to pass the
Sarbanes-Oxley Act (P.L. 107-204), sometimes described as the most sweeping
amendments to the securities laws since the 1930s. The law strengthened regulation of
auditors, required corporate management to certify the accuracy of their firms’ financial
statements, and increased penalties for a number of fraud-related offenses. (For a
summary of Sarbanes-Oxley, see CRS Report RL31879.)
The 108th Congress is unlikely to consider legislation as far-reaching as Sarbanes-
Oxley, but several issues related to accounting reform remain. These include questions
of accounting for stock options and financial derivatives contracts, the possibility of
replacing our current rules-based accounting system with a principles-based system, and
oversight of the implementation of the accounting reforms mandated by the Sarbanes-
Oxley Act. This report will be updated as events warrant.
Background
The wave of corporate accounting scandals that began in 2001 with Enron may have
no precedent in U.S. history; certainly there has been nothing comparable in the post-
World War II era. Dozens of large and well-respected firms have admitted to
manipulating their published financial statements. In the extreme cases, hundreds of
millions in reported profits were based on sham transactions with no economic substance.
The watchdogs meant to protect public investors — independent auditors, boards of
directors, Wall Street analysts, and regulators — were not an effective bar to corporate
management bent on artificial inflation of financial results.
The costs of the accounting scandals have been high. Firms have gone into
bankruptcy, thousands of workers have lost their jobs and retirement savings, and
investors in stocks, including pension funds and nonprofit organizations, have suffered
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major losses. The legislative response was swift: in July 2002, Congress passed the
Sarbanes-Oxley Act (P.L. 107-204), a sweeping reform of accounting regulation.
The 108th Congress is unlikely to consider legislation as far-reaching as Sarbanes-
Oxley, but several issues related to accounting reform remain. These include questions
of accounting for stock options and financial derivatives contracts, the possibility of
replacing our current rules-based accounting system with a principles-based system, and
oversight of the implementation of the accounting reforms mandated by the Sarbanes-
Oxley Act.
Sarbanes-Oxley Act Implementation
Congress’s intent in passing Sarbanes-Oxley was to restore confidence in financial
markets by increasing corporate accountability, enhancing public disclosures of financial
information, and strengthening corporate governance. More severe criminal penalties for
securities fraud were also enacted. The Securities and Exchange Commission (SEC) has
adopted more than a dozen final rules to implement the act’s provisions. These rules raise
standards of accountability for corporate executives, boards of directors, independent
auditors, and corporate attorneys.
The most difficult phase of implementation has been the launching of the Public
Company Accounting Oversight Board (PCAOB), created by Sarbanes-Oxley. The
PCAOB’s mission is to regulate the auditors of publicly traded companies and to ensure
that corporate financial statements are subject to tough, outside scrutiny and that the
auditor-client relationship is free from commercial conflicts of interest. The first nominee
for PCAOB chairman withdrew after it became known that he had served as a director of
a company under SEC investigation for securities fraud. This incident also led to the
resignation of SEC Chairman Harvey Pitt. The second choice to head the PCAOB,
William McDonough, was former president of the Federal Reserve Bank of New York,
and was widely respected in the markets. He took office on June 11, 2003, and under his
leadership the PCAOB has gotten up and running without further controversy or mishap.
It remains to be seen whether the PCAOB will become the effective regulator that
Congress intended.
Accounting for Stock Options
Accounting for stock options is a long-standing controversy. Under current
accounting rules, stock options granted to executives and employees are generally not
counted as a cost to the company, unlike other forms of compensation. (For more on
options accounting, see CRS Report RS21392, Stock Options: The Accounting Issue and
Its Consequences, by Bob Lyke and Gary Shorter.) Grants of options must be disclosed
in footnotes to financial statements, but do not affect the bottom line. Companies are thus
able to issue options without reducing their reported profits. Most accountants believe
that options should be “expensed,” or charged against earnings, as a matter of principle
and consistency. However, an argument in favor of the status quo is that options enable
cash-poor, startup companies to attract and retain skilled employees and managers they
could not afford otherwise. In this view, compensation via options fosters growth and
innovation, and if options were counted as a cost and reported profits reduced, high-tech
and other growing firms would have less appeal for investors and would face a higher cost

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of capital. The change in accounting methods, in this view, even though it would not
require one dollar of additional cash expenditure by companies that issue options, would
have real (and undesirable) economic consequences.
The post-Enron scandals have sharpened the dispute. Critics of current accounting
rules now argue that some companies have been too generous with options, and that
executives with huge personal stakes in the company’s share price have strong incentives
to practice deceptive accounting to conceal bad news from the market. Alan Greenspan,
in 2002 congressional testimony, noted that grants of options, designed to align
management’s interests with those of the shareholders, “perversely created incentives to
artificially inflate reported earnings in order to keep stock prices high and rising.... The
incentives they created overcame the good judgment of too many corporate managers.”1
In April, 2003, the Financial Accounting Standards Board (FASB2), proposed
requiring the expensing of options and began its normal process of public comment and
deliberation. FASB appeared to be on course to adopt a final standard by the end of 2004,
but Congressional action may result in a delay.
H.R. 3574, which passed the House on July 20, 2004, by a vote of 312-111, would
prevent FASB from adopting an options accounting standard in 2004. The major
provisions of the bill include the following:
! Section 2 requires companies that report to the SEC to record as an
expense the fair value of options issued to the CEO and the four other
most highly-paid individuals in the company. (Under current SEC rules,
total compensation, including stock and options, for these five
individuals must be disclosed in the annual proxy statement.) Options
granted to other executives and employees could continue to be treated
under current accounting rules, that is, disclosed in the footnotes with no
effect on the bottom line.
! Section 2 also provides that in determining the fair value of an option to
be expensed, the company shall assume that the volatility of the
underlying stock is zero. This provision would result in many options
having a value of zero, and thus the bottom line impact of many expensed
options would also be zero.3
1 Federal Reserve Board’s Second Monetary Policy Report for 2002. Senate Committee on
Banking, Housing, and Urban Affairs, July 16, 2002. (S. Hrg. 107- 835)
2 FASB is a private sector body that formulates accounting standards for companies that are
regulated by the SEC. The SEC has statutory authority to set accounting standards, but generally
defers to FASB. FASB standards are recognized as official by the SEC, and are therefore
mandatory for companies that sell stock or bonds to the public and must file periodic financial
reports with the SEC.
3 Many stock options can be exercised only at a stock price above the current market price at the
time the option is issued. The point is to create an incentive: executives’ options become
valuable only if the market price of the stock rises to the option’s exercise price, which is good
for all shareholders. But, if the assumption is zero volatility — that the share price will never
(continued...)

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! Section 2 would, however, permit companies to treat options as an
expense voluntarily, as many have begun to do since the Enron scandal.
! Section 3 prohibits the SEC from recognizing any FASB standard
relating to the expensing of options until an economic impact study had
been completed by the Departments of Commerce and Labor. The study
would be due one year from enactment of the bill.
! Section 4 requires the SEC to adopt rules mandating that companies’
financial statements include more extensive and transparent discussions
of the extent and economic impact of their option plans.
Other legislation before the 108th Congress would affect the tax treatment of certain
stock options. Section 342 of H.R. 2, as amended and passed by the Senate on May 15,
2003, would have imposed an excise tax on stock-based compensation, including stock
options, received by executives involved in certain corporate “inversion” transactions
(where companies move their corporate domicile to a foreign tax haven, such as Bermuda,
to reduce their U.S. taxes). This provision was not included in the bill as enacted, but
similar tax provisions appear in H.R 4520 (passed the House on June 17, 2004) and S.
1637 (passed the Senate on May 11, 2004).
Derivatives Accounting and Disclosure
Financial derivatives are instruments without an intrinsic claim on any corporate or
financial asset. Instead, their value is linked to the price of some other asset or financial
indicator — an interest rate, stock index, or commodity price. Some derivatives markets
(such as the futures exchanges) are regulated, others (the “over-the-counter” market) are
not. Enron was a major dealer in unregulated derivatives, and, although that company’s
worst problems lay elsewhere, some now believe that unregulated derivatives should be
subject to disclosure and reporting requirements, in order to give regulators new tools to
prevent or respond to episodes of financial instability or attempts to manipulate market
prices.
Derivatives affect accounting statements because they must be assigned a “fair
value” at the end of each accounting period, and changes in fair value reported as income.
Many over-the-counter derivatives are complex contracts for which no trading market
exists: fair values are calculated according to firms’ own valuation models, which critics
believe are susceptible to manipulation by traders (whose pay is often linked to portfolio
gains or losses) and by companies seeking to “manage” their reported earnings.
Since the Enron failure, several energy derivatives dealers have admitted to making
“wash trades,” which lack economic substance but give the appearance of greater market
volume than actually exists and facilitate deceptive accounting (if the fictitious trades are
reported as real revenue). In 2002, energy derivatives trading diminished to a fraction of
3 (...continued)
move — those options will never come “into the money” and their accounting value will always
be zero.

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pre-Enron levels, as major traders (and their customers and shareholders) re-evaluated the
risks and utility of unregulated energy trading. Several major dealers have withdrawn
from the market entirely.
Internal Enron memoranda released in May 2002 suggest that Enron (and other
market participants) engaged in a variety of manipulative trading practices during the
California electricity crisis. For example, Enron was able to buy electricity at a fixed
price in California and sell it elsewhere at the higher market price, exacerbating electricity
shortages within California. The evidence to date does not indicate that energy
derivatives, as opposed to physical, spot-market trades, played a major role in these
manipulative strategies. Numerous firms and individuals have been charged with civil
and criminal violations related to the manipulation of energy prices in California and
elsewhere.
Even if derivatives trading was not a major cause, Enron’s failure raises the issue of
supervision of unregulated derivatives markets. Would it be useful if regulators had more
information about the portfolios and risk exposures of major dealers in derivatives?
Although Enron’s bankruptcy appears to have had little impact on energy supplies and
prices, a similar dealer failure in the future might damage the dealer’s trading partners and
its lenders and could conceivably set off widespread disruptions in financial and/or real
commodity markets.
Legislation considered during the 108th Congress would have given (among other
things) the Commodity Futures Trading Commission (CFTC) more authority to pursue
fraud (including wash transactions) in the OTC market and to require disclosure of certain
trade data by dealers in energy derivatives. In 2003, the Senate twice rejected legislation
(S.Amdt. 876 and S.Amdt. 2083) that would have increased regulatory oversight of
energy derivatives markets by the CFTC and FERC.
Principles-Based Accounting
The recent corporate scandals revealed two kinds of problems with our accounting
system. One was that companies (and sometimes their auditors) ignored the rules. The
other was that the rules themselves are so complex that even when they are followed to
the letter, investors may not get a clear picture of a firm’s financial condition. Enron
created numerous off-the-books affiliates and partnerships, and entered into complex
transactions with them. These transactions were not in all cases violations of generally-
accepted accounting practices (GAAP), but they did make Enron’s financial reports
impenetrable to outsiders.
The Sarbanes-Oxley Act called for more stringent enforcement of current rules, but
also called for an SEC study of an alternative accounting system, called principles-based
accounting. The basic idea is that a system based on a few basic principles requiring
accountants to produce a true and fair picture of the economic reality of a company’s
finances could be more effective than detailed sets of rules, which invite a search for
loopholes. FASB’s chairman Robert Herz has endorsed the concept of principles-based
accounting, noting that under the current rule-based system, “People see the trees and not
the forest.” Some fear that reduction of complex rules to a few principles could lead to
confusion over what is legal and result in selective enforcement, but at this point we can

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only guess what a principles-based accounting system in the United States would look
like.
The SEC staff study appeared in July 2003. Its general tenor was that principles-
based accounting held promise in the long term, but the SEC has not made a fundamental
transformation of accounting into a short-term priority.