It is 15 years this week since Enron proved the limits of a rules-based approach to regulation. By playing at the boundaries of accounting standards, the US energy trader was able to hide its losses off balance sheet and continue to operate when it was in effect already bust. We still need to ask whether we have learned the right lessons from the debacle.
When the company was forced to reveal the truth – when its accounting games fell apart – it fell into the largest bankruptcy in US history, destroying billions in notional investor value. The aftermath of that bankruptcy included the shredding of evidence at a single office of a global accountancy firm, which led to the disintegration of Arthur Andersen. In all, thousands of individuals lost their jobs and pensions.
As Enron demonstrated, detailed rules can encourage gaming of the system. It’s ironic therefore that the main response to the collapse was a new set of detailed rules: the Sarbanes-Oxley Act (SOx) of 2002. SOx has become a byword for detailed auditor analysis of internal controls and management systems for all companies subject to US SEC jurisdiction.
Sarbanes-Oxley did foster a number of broader changes for companies and auditors, some positive. The Public Company Accounting Oversight Board (PCAOB) was created, to call the audit firms to account, while auditors were faced with higher barriers to provide non-audit services. Management and audit committees had to take greater responsibility for the accuracy of published accounts and there were stricter disclosure rules for director share dealings and transactions with subsidiaries.
We take many of these protections for granted now, as bare minimum expectations of what is necessary to provide some foundation of confidence regarding the quality of financial reporting and of the auditor’s role in maintaining both that quality and that confidence.
Unfortunately, the mindset did not change. Confronted by the evidence that a rules-based approach had led to misleading reporting and misinformation, the US responded with more rules. This was typified by the mechanical approach to SOx internal controls compliance, a very expensive approach that may help prevent some problems (though not those typified by Enron) but which might have been delivered with much less detailed and costly regulation.
US accounting standards remain highly rule-based, with sometimes thousands of pages of detail, compared to the dozens of pages of the principle-based IFRS standards, adopted by much of the rest of the world. The result is that US accounting becomes divorced from the reality of running the business and is a compliance exercise in itself. IFRS accounts sometimes fall into this trap too, but there is a greater chance of there being a focus on communication, not just obedience to the rules.
The switch to principles-based standards hasn’t been entirely smooth. For example, investors in Japan are currently troubled to find that companies have significantly reduced the dis-aggregation of their balance sheet numbers following a switch from Japanese GAAP standards to IFRS. Companies have cut back their disclosures to what is actually specified in the standards. We are confident that this disclosure will improve over time as companies realise that investors need a better dynamic for communication of information than a compliance-led approach.
IFRS is not perfect – Aberdeen is directly involved in working with the IASB to help enhance it. But it does seem to us that the principles mindset is a surer foundation, because it encourages less gaming around the edges of standards. It means that similar transactions are reported similarly rather than appearing completely different because they fall one side or other of a bright line test.
This method has benefitted the UK - and we expect the outcomes of the government's latest corporate governance review will again avoid prescriptive rules. The UK has led the world in developing a new form of annual auditor report, one that actually discloses some of the substance of the work of the auditor. We are now enjoying the third year of these reports and the greater insight - and confidence - that these bring.
The global standard setter has followed suit and we should see similar reporting from much of the world shortly. But the US still struggles to take this positive step forward: after years of trying, a proposal will be debated later this month DEC, and we hope it will pass.
Perhaps the biggest lesson of Enron for investors is the behavioural one. In effect it is the reflection of the principles-based approach - rather than focusing just on the numbers, investors need to step back and apply common sense. They must consider whether they can trust the individuals at the top of organisations, and the numbers that they produce.
It is just possible that investment stories that seem too good to be true may be exactly that and managements that squeeze out analysts who ask difficult questions, or doubt the company’s story, may just have something to hide. Investors must apply intelligent judgement. Sadly, since Enron, the evidence is that fewer are willing to do so, as the investment markets have become more mechanised and dominated by passive and algorithmic investing. This is akin to another form of rules over principles.