Enron, Sarbanes-Oxley and Accounting: Rules Versus Principles Versus Rents

Abstract

In our self-regulatory system of corporate law, the job of insisting on trustworthy numbers devolves in the first instance on the gatekeepers. It follows that the auditors take the brunt of the blame and that the Sarbanes-Oxley Act (the Act), the legislation intended to address the scandals and restore confidence in the securities markets, responds by regulating the profession. More accurately, Sarbanes-Oxley triggers the start of a political process intended over time to produce a new regulatory regime. The statute follows the standard regulatory strategy of delegating most of the task of devising the new regime's terms to an administrative agency, a new Public Oversight Board (POB). The regulatory outcome remains open accordingly. High financial stakes imply an ongoing political contest over the POB's political and institutional gestalt and the terms of any new regulation. The resulting uncertainty, although regrettable, probably could not have been avoided. Unfortunately, Sarbanes-Oxley does not stop with an open-ended delegation of authority respecting the audit function to a new agency. The Act goes on to address the substance of Generally Accepted Accounting (GAAP). It does this first in section 108(d), which requires the SEC to study the system to ascertain the extent to which it is principles-based, as opposed to rules-based, and to tell us how long it will take for us to achieve a system; and second, in section 108(a), which requires the Financial Accounting Standards Board (FASB) and any other approved standards-setting body to adopt procedures ensuring prompt consideration of new rules reflecting international convergence on high quality standards. Given an ongoing political contest respecting the shape of the POB and its regulatory program, critical questions need to be asked about these substantive initiatives. More particularly, this Article asks whether substantive intervention into the articulation of GAAP could trigger just the sort of regulatory error that the agency delegation model, followed in respect of the POB, was intended to avoid. Principles-based accounting and international however desirable in the abstract, have to be considered in light of the institutional contexts in which they would operate and effect consequences. Principles and convergence, by themselves do little to constrain rent-seeking behavior on the part of managers and auditors. Absent antecedent institutional reform that ensures auditor independence and lessens the negative impact of rent-seeking and influence activity on audit quality, perverse effects could follow in the event that sections 108(d) and 108(a) influence GAAP's future shape. Unfortunately, Sarbanes-Oxley does not ensure the requisite institutional reform; it merely holds out the possibility of reform. Part I describes Sarbanes-Oxley's delegation to the POB, surveying the issues the Act leaves open and the ongoing political contest respecting their resolution. Part II situates the principles-based that the Act commends in the context of the Enron disaster. This discussion begins with a story currently in circulation - that Enron exemplifies the abuses of rules-based under GAAP and demonstrates the need to move to principles-based accounting. The discussion then falsifies the story, showing that Enron violated both rules and standards under GAAP. Full responsibility for the disaster goes to the enforcement of GAAP's rules and standards by Enron's auditor rather than to the rules and standards themselves. The discussion then broadens, explaining why the relative merits of rules and principles are being debated in respect of GAAP at this time, and how the principles-based argument rests on a false premise, holding out risks for audit quality.