Shred or dead? The fall of Enron has shaken public faith in the accountancy profession. David Allen considers what accountants can learn from the affair and asks how far they are responsible for share prices

Financial Management (UK), April, 2002 by David Allen

Over recent weeks the accountancy profession has attracted much unwelcome publicity following the spectacular collapse of Enron. Some myths have been shattered and weaknesses have been exposed, but what lessons are there for management accountants?

The first concern to hit the headlines was the potential conflict of interest between the two parts of public practice. If a firm of accountants is paid to advise a company on how far it can hide from public view the level of its borrowings (using off-balance-sheet partnerships) without contravening accounting standards, can the same people be trusted to report impartially to the public on the stewardship of that company's directors?

Revelations about document-shredding at Enron shook the foundation of public practice: the assertion that it is devoted to the public interest. For the sake of the future of joint stock enterprise, auditors must be seen to be independent of the directors of the companies being audited.

Some auditors have pointed out that responsibility for the accounts lies with the directors; we should not blame auditors if these are misleading. There is some justification for this argument. Non-executive directors certainly have a clear responsibility, but the argument could backfire. People will start asking what auditors are for and the "expectations gap" that occurred a decade ago will open up again.

Other auditors have tried to pass blame on to the standards-setters. They argue that they can only check that the accounts comply with the standards; the question of whether or not they are misleading is outside their remit. This is not true, but it draws attention to the perverse effect of standardisation. It has deskilled the jobs of preparing and auditing accounts so much that the pre-standardisation professionalism has been diminished.

This brings us to an important myth. For years finance theorists have argued that a company's share price, being a function of the value of the company and therefore forward looking, is not affected by backward-looking accounting reports. This theory should be abandoned now there is evidence that the most powerful influence on share prices is the accounting numbers disclosed or forecast by directors. That is why so many directors (whose incomes largely depend on the share price) comply with the letter of corporate governance requirements, but not the spirit, to cast the results in a favourable light.

Unfortunately for the theorists, an admission that share prices are affected by accounting disclosure would need to be followed by an admission that share prices are unreliable indicators of corporate value. One of the clearest lessons of recent years is that there is no correlation between the value of a company and its share price, creating the possibility for individuals to make massive gains or losses. All too often the directors make the gains and the public sustains the losses.

Any claim to incorporate concepts of value in accounting reports is bound to fail. Many people assume that the balance sheet is designed to show the value of the business. They must be disabused. The days when value was a function of investment in tangible assets are long gone. Today there is no correlation between the so-called net worth of a business as shown in its accounts and its value in terms of cash-generating potential.

It is therefore possible for misleading accounts and inadequate auditing to promote an inappropriate share price so that people gain or lose wealth. That is not to say that they cause a company's insolvency. The financial health and value of a company are a function of financial management--the forward-and outward-looking sector of the profession.

Insolvency is not caused by earnings per share falling below analysts' expectations. It arises when spending exceeds income. This happens either because uneconomic projects are knowingly undertaken (where forecast income is less than forecast expenditure) or because actual results are not as good as forecast (income being lower, or expenditure higher, than expected).

Sound financial management would stop the former from happening, and would counteract the latter with appropriate hedging or contingency planning. By the time a company's accounts show that it's insolvent, it is too late to do anything about it. The lessons being learnt from Enron are shaking the foundations of the profession. Things will never be the same again.

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David Allen CBE is a past president of CIMA and a director of a number of private companies