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Market and political/regulatory perspectives on the recent accounting scandals

Market and political/regulatory perspectives on the recent accounting scandals
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2 page summary of page 290 – 300
2 page summary of page 300 – 317
DOI: 10.1111/j.1475-679X.2009.00325.x Journal of Accounting Research Vol. 47 No. 2 May 2009 Printed in
Market and Political/Regulatory Perspectives on the Recent Accounting Scandals
R AY B A L L *
Not surprisingly, the recent accounting scandals look different when viewed from the perspectives of
the political/regulatory process and of the market for corporate governance and ?nancial reporting. We
do not have the opportunity to observe a world in which either market or political/regulatory
processes operate independently, and the events are recent and not well researched, so untangling
their separate effects is somewhat conjectural. This paper offers conjectures on issues such as: What
caused the scandalous behavior? Why was there such a rash of accounting scandals at one time? Who
killed Arthur Andersen—the Securities and Exchange Commission, or the market? Did fraudulent
accounting kill Enron, or just keep it alive for too long? What is the social cost of ?nancial reporting
fraud? Does the United States in fact operate a “principles-based” or a “rules-based” accounting
system? Was there market failure? Or was there regulatory failure? Or both? Was the SarbanesOxley Act
a political and regulatory overreaction? Does the United States follow an ineffective regulatory model?
1. Introduction
The tsunami of accounting scandals at the beginning of the millennium is well known. A partial list of
companies involved includes AOL,
* The University of Chicago Booth School of Business. Helpful comments were gratefully received from
Sudipta Basu, John Coates, Ron Dye, Bob Jensen, Clive Lennox, Steve Orpurt, Sam Peltzman, Sarah
Zechman, participants at the 2008 Journal of Accounting Research Conference, and especially Christian
Leuz (the editor). Financial support from the University of Chicago, Graduate School of Business also is
gratefully acknowledged. 277
, University of Chicago on behalf of the Institute of Professional Accounting, 2009
Bristol-Myers Squibb, Cendant, Computer Associates (CA), Conseco, Dynegy, Enron, Federal Home Loan
Mortgage Corporation (“Freddie Mac”), HealthSouth, Peregrine Systems, Qwest, Rite Aid, Sunbeam, Tyco,
Waste Management, WorldCom, and Xerox, with Enron and WorldCom being the most familiar due to the
scope and audacity of their de?cient reporting. 1 In Europe, ComROAD AG (Germany), Lernout & Hauspie
Speech Products (Belgium), Parmalat (Italy), and Royal Ahold (Netherlands) achieved similar notoriety
during the period, and the United Kingdom earlier had been rocked by scandals in the 1960s and again in
the late 1980s and early 1990s (notably, Polly Peck). Nevertheless, the clear epicenter of the 2001 to
2002 scandals was in the United States. The scandal waves spread widely and quickly. Resulting damage
included: a decline in the worldwide reputation of a wide variety of U.S. institutions, including U.S.
generally accepted accounting principles (GAAP), auditors, security analysts, regulators, and ?nancial
markets generally; the conviction of over 1,000 executives; extensive private litigation and damages
awards against companies, managers, auditors, and complicit banks; the most substantial increase in
the regulation of U.S. public ?nancial reporting in 75 years, under the Sarbanes-Oxley Act of 2002;
creation of a Public Company Accounting Oversight Board (PCAOB) with almost unfettered powers to
adopt and enforce rules governing the audit industry and to discipline audit ?rms and employees; 2 the
demise of a once-proud accounting ?rm; and a forest of largely unhelpful literature. A variety of press
and academic commentators have tried to make sense of the scandals and the events that ensued. What
caused them? Why did they occur then? What were the consequences? Was more regulation the optimal
response? Will they happen again? Not surprisingly, these questions have been addressed from many
different perspectives. For example, there has been discussion of the roles of social norms, morals,
ethics, corporate culture, corporate governance, incentive-based compensation, emphasis on short-
term pro?ts, audit committees, audit standards, audit ?rm con?icts of interest due to non-audit
revenues, reporting rules, securities laws, and regulatory oversight. Differences in perspective can
enrich a debate but—if not made clear—they also can add confusion to it. The objective of this essay
therefore is to consider the scandals and several of the important ensuing events from two important
and contrasting perspectives: the perspective of the political/regulatory process and the perspective
of the market for corporate governance and ?nancial reporting. The general intent is to clarify our
understanding of the events and their consequences.
1 The precise extent of accounting fraud over the period is unclear. Lists tend to include nonaccounting
illegalities (such as insider trading, obstruction of justice, and money laundering), bankruptcies, and
unproven allegations. See http://www.trinity.edu/rjensen/Fraud.htm and
http://en.wikipedia.org/wiki/Accounting scandals. 2 Sarbanes-Oxley Act of 2002, Pub.L. 107-204, 116
Stat. 745, also referred to as the Public Company Accounting Reform and Investor Protection Act of
The difference between the market and political/regulatory perspectives on the scandals has more than
historical signi?cance: It substantially affects how one interprets not just the scandals, but also the
substantial regulation of U.S. corporate governance and ?nancial reporting that ensued. A speci?c
objective of this essay therefore is to assist in the debate on whether the Sarbanes-Oxley Act’s
historical increase in regulation was a good idea, in terms of both its scope and its form. We do not have
the opportunity to observe a world in which either market or political/regulatory processes operate
independently, so untangling their separate effects is dif?cult at best. Further, the events still are
recent and not well understood. Insuf?cient time has passed to allow a distanced perspective or to
conduct de?nitive research, the implication being that opinions tend to be based on only anecdotal or
small-sample evidence. Thus, while the following analysis is based where possible on the evidence and on
hopefully valid reasoning, much of it is conjectural. A further caveat is in order. When comparing the
political/regulatory and market views of the accounting scandals, I am much in?uenced by the Stigler
[1964, 1971]–Peltzman [1976] skepticism for regulation. 3 From this perspective, the political process
that creates and monitors regulation tends to be captured by the regulated industry and organized
special-interest groups, so it typically does not promote general social welfare. Further, even if it
attempts to, regulation does not always succeed in promoting social welfare, in part because it is
enforced by poorly informed and incented government employees. Hopefully, this skeptical perspective
will provide some counterpoint to the post-scandal rush to regulate governance and reporting. The
following section describes and interprets the scandalous events of 2001 to 2002. Section 3 and section
4 analyze the political/regulatory and market responses to the events, in an attempt to assess their
relative roles. Section 5 argues that regulation encourages a rules-based approach to U.S. ?nancial
reporting, and the concurrent belief that technical compliance with codi?ed GAAP is suf?cient, whereas
markets demand compliance with the wider concept of the accounting principles that are generally
accepted. Section 6 examines the principal political/regulatory response to the scandals—the
Sarbanes-Oxley Act of 2002—from a market perspective, and section 7 speculates on the long-run
consequences of the Act. Section 8 offers some conclusions.
2. The 2001 to 2002 Accounting Scandals
The analysis of market and political/regulatory perspectives that follows is unavoidably in?uenced by
my interpretation of these scandalous events, including my views on what the scandals were, why they
were scandalous, what
3 See also Benston [1969, 1973], Posner [1974], Coffee [1984], Coates [2001], Romano [2002], and the
public choice theory of Buchanan and Tullock [1962].
caused them, and why they occurred when they did. This section attempts to make those views more
The term “earnings management” is used to describe managers intervening in the reporting of their own
?nancial performance. It encompasses a range of practices, including:
r Practices that are legal, violate no accounting rules or principles, and
are generally viewed as ethical—such as structuring transactions with regard to their effect on the ?
nancial statements (leasing being a prominent example); Practices that are legal, violate no accounting
rules or principles, and are viewed by many as ethical—such as timing asset sales to book gains in years
with lower pro?ts, and to book losses in years with higher pro?ts (Bartov [1993]); Practices that are
legal, violate no accounting rules or principles, but might violate accepted standards of disclosure—
such as giving yearend quantity discounts to major customers, generating sales “pull forwards,” but
failing to disclose that they in?ate current earnings and borrow against future earnings; Negligent or
grossly negligent ?nancial reporting—such as unwittingly failing to comply with GAAP; Fraudulent ?
nancial reporting—such as knowingly failing to comply with GAAP.
r r
Earnings management is a generic term for all of these practices. 4 While they differ in economic, legal,
and ethical severity, they all undermine the quality of ?nancial reporting to some degree. Earnings
management therefore is analogous to a suite of ?nancial system viruses: Some are more severe than
others, but all weaken the ef?ciency of the system. This paper addresses ?nancial reporting that is
negligent or fraudulent. Negligence involves managers or auditors making unintentional errors due to
factors such as inadequate experience, training, knowledge, supervision, or effort. Negligent behavior
involves failing to do what is considered reasonable and prudent for a person in their position under the
circumstances: in the context of ?nancial reporting, failing to meet accepted accounting, disclosure, or
auditing standards. Gross negligence involves reckless disregard for accepted standards. Negligence
that can be proven to harm others, such as investors, gives rise in law to an actionable tort. Fraud is a
4 The term “earnings management” appears to be popular because most ?nancial statement
manipulation involves earnings. Nevertheless, some manipulation affects balance sheets or operating
cash ?ow, without affecting earnings.
serious transgression, because proving fraud requires establishing scienter , de?ned loosely as
intentional wrongdoing. 5 In contrast, much academic research on earnings management establishes
such a weak burden of proof that earnings management appears almost universal, perhaps re?ecting the
Hobbesian outlook that has overtaken accounting academe, its limited knowledge of accrual
accounting, and the ease with which correlated omitted variables can produce the result one is looking
for. 6 The advantages of focusing on negligent and fraudulent reporting include: a proven case of
negligent or fraudulent ?nancial reporting is an institutional “fact,” as distinct from an error-prone
academic estimate; reporting negligence and fraud have been shown to have substantial adverse effects
on ?rm values (Palmrose, Richardson, and Scholz [2004]); and the sight of executives being led away in
handcuffs under indictment for reporting fraud created more scandal than a whole literature of Jones-
model discretionary accrual estimates. 7
James Q. Wilson opens The Moral Sense with the insightful observation that two conditions must hold for
a public scandal to occur: the events must be unusual (i.e., relatively infrequent in occurrence) and they
must be shocking (i.e., counter to our norms) (Wilson [1993, p. 2]). The public pays little attention to
frequent events and there is no scandal arising from infrequent but morally acceptable events. The
events of 2001 to 2002 certainly were unusual. The relative frequency of negligent or fraudulent
reporting in the United States is dif?cult to estimate precisely, mainly because it is unclear how to de?
ne the exact population of reports from which it is drawn, in terms of both the total number of ?rms in
existence and the length of the time period used for reference. Nevertheless, the reference population
undoubtedly is large relative to the number of convictions for malfeasance, and the relative frequency is
correspondingly low, despite the extraordinarily large number that came to light
5 The legal standard of proof is subjective. For securities cases, the Private Securities Litigation Reform
Act of 1995 set the standard as “strong inference” of scienter . In Tellabs, Inc. v. Makor Issues & Rights,
LTD (21 June 2007), the Supreme Court interpreted this as a requirement to prove “cogent and
compelling evidence” of scienter . 6 “Discretionary” accruals are estimated as the residual component
of accruals that cannot be explained by accruals models. These models typically are mechanical,
perfect-certainty descriptions of “nondiscretionary” accruals, and are not built on credible economic
models of why ?rms hold working capital (e.g., to absorb shocks in production, demand, and cash
receipts). They thus are so poorly speci?ed that they explain only a minor proportion of accruals. They
seem likely to substantially overestimate the amount of even the mildest (and presumably most
frequent) type of earnings management: Practices that are legal, violate no accounting rules or
principles, and are viewed as ethical. 7 On the other hand, an unobserved quantity of negligence and
fraud goes undetected or unproven, even though it is argued below that material ?nancial misreporting
is dif?cult to conceal for an extended period.
over two years. For example, if 4,000 public companies on average ?le quarterly reports over 50 years,
the population is 8 million total ?lings. 8 As noted above, an unknown amount of negligence and fraud
goes undetected, so the true incidence undoubtedly exceeds the observed. Nevertheless, even a
generous allowance for undetected malfeasance in past years seems unlikely to alter the conclusion
that the events of 2001 to 2002 were scandalous in large part because they occurred with such a low
relative frequency. 9 The events of 2001 to 2002 also were scandalous because they clashed so strongly
with the norm. Common law countries, chief among them the United States, have built large debt and
equity markets, and correspondingly large public corporate sectors, by following a model founded on
high-quality ?nancial reporting and disclosure. This allows lenders, shareholders, suppliers, and
customers to transact at arm’s length with corporations, across a public market, without private
(insider) access to information about them. Consequently, high-quality ?nancial reporting has long been
viewed as a foundation of the U.S. ?nancial system. 10 In contrast, public ?nancial reporting has not
played such an important economic role in code law countries, including most of continental Europe.
Under the code law model, access to information has been more on a relationship basis, public ?nancial
reporting has been lower in quality by observable measures, large corporations have been more likely to
be private, and public capital markets have been a comparatively smaller part of the economy (Ball,
Kothari, and Robin [2000]). The reporting transgressions that came to light in 2001 to 2002 therefore
were scandalous both because negligent or fraudulent reporting is infrequent and because it so strongly
violates expected standards of behavior.
How can the notion that scandals are infrequent be reconciled with such a large number of cases coming
to light in such a short period? There is limited evidence on what was different about this period, so the
8 In the United States, a public company is de?ned for regulatory purposes as one that is required to
register its securities (including stocks and bonds) for sale to the public on a major stock exchange such
as the New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated
Quotations (NASDAQ), or “over the counter” through quotation services such as the OTC Bulletin Board
and Pink Sheets. In addition, small companies are publicly traded without being required to register. 9 A
similar point was made in a speech by Thomas J. Donohue, the President of the U.S. Chamber of
Commerce (U.S. Chamber of Commerce [2003]): “There are more than 17,000 publicly traded companies in
the U.S., and only a couple (of) dozen of them have been accused of wrongdoing.”
http://www.uschamber.com/press/speeches/2003/030714tjd hitachi.htm. 10 In one of several untimely
remarks, then Deputy Secretary of the Treasury Lawrence Summers wrote in the Financial Times, London,
on 11 March, 1998 (cited by Beresford [1998, p. 151]): “If one were writing a history of the American
capital market, it is a fair bet that the single most important innovation shaping that market was the
idea of generally accepted accounting principles.”
is uncomfortably conjectural. The closest supporting theory and evidence is in Harris and Bromiley
[2006] and Kedia and Philippon [2007], and is consistent with the following hypothesis that the economic
cycle was a major factor. 11 The longest boom in U.S. history ended in March 2001. Bearing this in mind,
the following sequence of cycle-related events seems plausible. First, in an extended boom, high growth
becomes built into performance expectations: into earnings and revenue forecasts, budgets, share
prices, option values, investment decisions, and debt commitments. Managers therefore come under
peer and ?nancial pressures to deliver strong earnings growth and share market performance. Second,
lax practices likely develop in a long boom: Corporate monitors (boards, internal and external auditors,
analysts, rating agencies, the press, and regulators) come to accept high growth as normal, and there is
a risk of “falling asleep at the switch.” Third, the boom “busts,” growth suddenly falters, and around the
same time many managers are unable to meet expectations. Fourth, some managers resort to either
faking transactions or adopting unaccepted accounting methods to disguise their faltering
performance. Fifth, with some probability, the reporting malfeasance is detected. 12 Sixth, after a series
of malpractices are uncovered, they reach widespread public attention, and become scandalous. 13
Other factors surely were at play. A “rule-checking” mentality appears to have crept over the
accounting profession, including the Financial Accounting Standards Board (FASB, a ?ttingly named
successor to the Accounting Principles Board), audit ?rms, researchers, and educators. Under this narrow
world view, ?nancial reporting requirements are embodied in rules, not principles, and compliance with
rules-based GAAP is suf?cient. In several of the scandalous cases (Enron in particular), investors were
alleged to have been mislead by ?nancial statements that were in technical compliance with GAAP but
that did not re?ect the economic substance of the transactions they were reporting. Regulation
downplays the basic common law principle
See also Alexander and Cohen [1996], Strobl [2008], and Davidson [2008]. The likelihood of detection
decreases with postmalfeasance performance. Many schemes to overstate revenues (e.g., “channel
stuf?ng” and “sales creep”) involve borrowing revenue from future periods, thereby increasing present
earnings and correspondingly reducing future earnings. They are less likely to be detected if future
revenues recover. Further, companies such as Enron and WorldCom, whose false reporting temporarily
disguised ?nancial insolvency, are forced into bankruptcy if real performance does not improve, at which
point managers acting on behalf of creditors can examine the books. 13 The above is uncomfortably
close to Galbraith’s [1961, p. 153] account of the embezzlement scandals that came to light after the
1929 market crash, and contributed to the creation of the Securities and Exchange Commission (SEC): “In
good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful,
there are always many people who need more. Under these circumstances the rate of embezzlement
grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed.
Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest
until he proves himself otherwise. Audits are penetrating and meticulous.”
12 11
that market participants are expected to behave according to the standards that are generally
accepted and practiced by informed, competent market participants (here including ?nancial statement
users as well as preparers). In contrast, regulators prefer to administer rules. 14 I conjecture that
regulation played a substantial role in fostering this rules-based perspective, and hence played an
important role in setting the stage for the accounting scandals. This conjecture lies in contrast with the
more orthodox view that the scandals occurred in spite of regulation—a view that is dif?cult to
reconcile with the fact that the U.S. ?nancial reporting market is highly regulated by international
standards (Coffee [2007]). A widely viewed culprit in the scandals was con?icts of interest arising from
audit ?rms performing non-audit work for clients. To many observers, auditors had incentives to appease
their clients by giving them favorable audit treatment, in order to retain lucrative consulting
engagements. I return to this issue in section 4.3, and conclude that con?icts of interest most likely are
not a major factor in the scandals. Nevertheless, user trust in ?nancial reporting requires perceived as
well as actual audit independence, so the issue is unlikely to go away. A less obvious but possibly more
important culprit in the scandals was a subtle drift in the auditor–client relationship over time. The
relationship always has been unusual in a legal sense. Auditors supply a certi?cation that is used by
investors and the public at large, and it is to them that they owe a standard of care. However, they are
engaged and compensated by client ?rm managers, who are interested parties (i.e., prefer a clean audit
certi?cate). The argument here is not that non-audit revenues create a potential con?ict of interest, but
that audit fees themselves do. Perhaps related to this issue, anecdotal evidence suggests that over time
auditors have drifted from a skeptical, adversarial interaction with clients toward a cooperative
approach. The drift possibly accelerated as a consequence of the lax practices that developed in the
prolonged economic expansion of the 1990s. It needs emphasizing that this argument is based only on
anecdotal evidence; salient elements of the auditor–client relationship are not readily observable, and
research on the issue tends to use proxies, such as length of auditor tenure, that are correlated with
important omitted variables. Further, the argument ignores reputational and other mechanisms that
constrain such con?icts of interest, as discussed in section 4.3 below. Coffee [2005] argues that
dispersed share ownership makes the United States more prone to ?nancial reporting problems than the
concentrated ownership systems of continental Europe, where scandals are more likely to involve
appropriating private bene?ts of control. 15 While this argument has some legitimacy, it is not
consistent with much evidence. First, the argument implies that, if anything, ?nancial reporting should
be of higher quality in private companies than public companies, because they have more
14 15
This point is developed further in section 5.7 below. A similar argument is made by Zingales [2009].
concentrated ownership. The evidence supports the opposite view (Ball and Shivakumar [2005],
Burgstahler, Hail, and Leuz [2006]). Second, the dispersed ownership argument makes no allowance for
the evidence that common law countries such as the United States generally set a higher standard for ?
nancial reporting. Many of the scandalous U.S. cases involved practices that historically have fallen
within legitimate managerial discretion in many code law countries, such as drawing on “cookie jar”
reserves to in?ate pro?ts in bad years. In that regard, attributing the scandals to dispersed ownership
also seems inconsistent with the evidence on international differences in reporting quality (Ball, Kothari,
and Robin [2000], Leuz, Nanda, and Wysocki [2003]). Increased use of stock options in executive
compensation in the United States was blamed by several commentators, including Coffee [2005] and,
notably, Alan Greenspan [2002]. While the argument has merit, in that performance-based compensation
provides an additional motive to misrepresent performance and was found to be a factor in at least one
case (Computer Associates), there is evidence that stock options were not a major factor. 16 While the
number of cases that came to light over 2001 to 2002 is astonishing, and while additional cases
presumably went undetected, there are reasons to suspect that the press exaggerated the scandal. The
press generally overreports risks. Bailis and MacCoun [1996] document that the press overrepresents
the frequency of tort litigation generally, the frequency of disputes going to court without prior
settlement, the frequency of trials won by plaintiffs, and the average size of jury awards. During the
scandal period, accounting-related issues were unusually newsworthy, and the press reported even
minor issues that previously would not have made the news. 17 This bias was fed by panicking companies
that, in a post-Enron “witch hunt,” combed their books for the slightest hint of an accounting issue,
which the press duly reported as scandalous. 18 The press thereby exaggerated the extent of an already
substantial scandal.
Managers face a variety of well-known ?nancial incentives to meet performance expectations. These
include: gaining earnings-based bonuses;
16 Compare Erickson, Hanlon, Maydew [2006] with Burns and Kedia [2006] and Efendi, Srivastava, and
Swanson [2007]. Option backdating became a separate scandal several years later. 17 Similar reporting
behavior occurs for small earthquakes and plane crashes, which are more likely to be covered
immediately after a large earthquake or crash brings the issue to public and press attention. 18 For
example, the Wall Street Journal Online ran the exaggerated and misleading headline “Tyco’s Internal
Report Finds Extensive Accounting Tricks” over a story that actually reported “the problems weren’t
large enough to be ‘material’ to the company’s overall pro?ts” and “many of the maneuvers fell within
accounting rules and didn’t require any correction” and also “the report said these were relatively
minor and didn’t amount to a ‘systemic fraud.’”
increasing their promotion prospects; avoiding termination; avoiding a decline in the value of their
stocks, stock appreciation rights, and options; avoiding a downgrade of the company’s debt, which
could result in higher borrowing costs and further reductions in earnings; avoiding debt covenant
violations that could lead to restrictions on dividend payments, new investment, and further borrowing,
or accelerated debt repayment; avoiding corporate bankruptcy; and hiding some other fraud (e.g.,
stolen assets, including cash). My view, based on mainly anecdotal experience, is that non?nancial
motives are more powerful than is commonly believed, and sometimes are the dominant reason for
committing accounting fraud. An important motivator seems to be maintaining the esteem of one’s
peers, ranging from coworkers to the public at large. Enron executives reportedly were celebrities in
Houston, and in important places like the White House. 19 Much of this celebrity derived from the ?rm’s
reputation as an extremely successful innovator in the postderegulation energy market. Much
apparently was purchased using shareholders’ seemingly abundant money to support a wide range of
charitable causes. Either way, the celebrity would have evaporated if the company’s poor pro?tability
and weak ?nancial condition had been truthfully revealed. 20 In general, there appear to be substantial
private nonmonetary bene?ts of controlling a company for managers committing fraud, even though
they presumably are more dif?cult to prove in court than monetary bene?ts from bonuses, options, etc.
Financial frauds appear to share three properties: 1) Inability to meet performance expectations, 2)
Personal costs—pecuniary or nonpecuniary—of failing to meet expectations, and 3) Being able to
convince oneself that real performance will improve soon. The last property arises for several reasons.
First, if real performance does not subsequently improve, the deception must be repeated to disguise
the continuing performance shortfall. Second, fraud is very dif?cult to conceal for an extended period.
Fraud typically requires cooperation among several employees, or involvement by parties on the other
side of a fraudulent transaction. Financial reporting fraud usually leaves a document trail that is subject
to internal and external audit. Third, if real performance does not increase and the deception must
continue, its effects cumulate in the accounts
19 In addition to providing substantial employment and stock gains to Houston residents, Enron’s name
was on Enron Field and it generously supported the Alley Theater, the Houston Ballet, the Houston
Symphony, and the Museum of Fine Arts, among others. See Kinzer [2001] and Yardley [2002]. 20 Painter
[2002] and Brudney and Ferrell [2002] discuss legal issues. After heavy lobbying by charities, the ?nal
version of Sarbanes-Oxley dropped requirements in early drafts that corporations disclose their charity
and the probability of being detected rises. 21 Fourth, many schemes that overstate current earnings
involve accelerating revenue recognition (incorporating revenues in earnings too early), and hence only
“borrow” revenue and earnings from future periods. This increases reported performance in the current
period, but reduces it in future periods, apparently in the hope or belief that future real performance
will increase and will allow the deception to be covered up. Convincing oneself that real performance will
improve before the fraud is discovered would be assisted by an excessively strong belief in oneself and
in one’s company. 22 Thus, committing accounting fraud frequently involves a “gambler’s mentality.” 23
This is an important point in assessing whether the increased penalties under the Sarbanes-Oxley Act are
likely to deter future ?nancial reporting fraud, discussed below.
3. Political/Regulatory Reaction to the Scandals
The political and regulatory response to the scandals has two branches: criminal proceedings against
companies and individuals accused of acting negligently or fraudulently in the past and legislative
proceedings aimed at reducing the incidence of future negligence and fraud.
Criminal law is created, administered, and prosecuted by governments. In criminal law, defendants found
guilty in securities cases can be punished with prison sentences, ?nes, asset seizures, or disbarment
from practice. Additional costs borne by defendants include legal fees, loss of reputation, loss of
employment prospects, time, and stress on themselves and their families. Criminal proceedings were
initiated by the United States against a range of individuals and corporations involved in the accounting
scandals. The audit ?rm Arthur Andersen was indicted and convicted with astonishing speed. The SEC
opened its investigation of Andersen on November 29, 2001. On January 9, 2002, the Department of
Justice upgraded it to a criminal investigation. Andersen ?rst attracted widespread public attention the
following day, January 10, 2002, when it announced it had destroyed certain Enron audit documents the
previous year, some after learning of the
21 Parmalat reported fake sales for decades, the cumulative effect being that by 2002 it reported €3
billion in fake bank accounts. The alternative—faking uncollected accounts receivable—would more
likely have been detected by auditors (verifying individual receivables) or analysts (noticing an unusually
high receivables/sales ratio). 22 Kenneth Lay and Jeffrey Skilling (Enron), Richard Scrushy (HealthSouth),
and Bernard Ebbers (WorldCom) claimed in their trial defense that their companies were fundamentally
sound, despite compelling evidence to the contrary. The link between ?nancial fraud and excessive self-
belief is explored by Schrand and Zechman [2008]. 23 The diagnostic criteria for pathological gambling
of the American Psychiatric Association (APA [2000]) include: “after losing money gambling, often returns
another day to get even (‘chasing losses’).”
SEC investigation. On May 6, 2002, in the U.S. District Court for the Southern District of Texas, the
United States charged Andersen with obstruction of justice by failing to retain audit documents. After a
widely covered trial, Andersen was convicted by a jury on June 15, barely ?ve months after the
allegation of destroying documents initially surfaced. Andersen then lost an appeal against the
conviction, in the U.S. Court of Appeals for the Fifth Circuit, and because federal regulations disbar
convicted felons from auditing public companies, it surrendered its license to practice on August 31.
Three years later, on May 31, 2005, the conviction was unanimously overturned by the U.S. Supreme
Court—a Pyrrhic victory for Andersen, which had long since closed its doors. 24 I hold no brief for Arthur
Andersen. In fact, I argue below that, in the absence of government involvement, the market most likely
would have closed Andersen by itself, because its reputation for independent professional auditing was
in tatters due to a series of poor audits, and its ?nancial viability was threatened by pending damage
claims. It also is possible that Andersen would have been convicted in the criminal case even if the
District Court had shown greater objectivity. But the fact that Andersen’s conviction was unanimously
overturned by the U.S. Supreme Court, in an opinion written in such strong language by the Chief Justice,
does raise substantial concerns about federal prosecution in high-pro?le cases. The District Court judge
in Andersen’s Houston trial was placed under substantial pressure by a press baying for conviction, by
politicians denouncing Andersen, by a local Houston public deeply affected by the Enron bankruptcy,
and by aggressive federal prosecutors. Prosecutors enjoy considerable power in such cases, because a
high-pro?le prosecution played out in the world press—however unwarranted it may be—is a crippling
penalty per se for the company and its managers. Compared with the Andersen case, the criminal
prosecution of individuals involved in the scandals has taken longer and been more successful. Acting
under intense political pressure to “?x the problem,” President Bush created the President’s Corporate
Fraud Task Force on July 9, 2002, “to restore public and investor con?dence in America’s corporations
following a wave of major corporate scandals.” Department of Justice statistics for prosecutions
between July 2002 and June 2007 record 1,236 convictions attributed to the Task Force, including 214
CEOs and presidents, 129 vice presidents, 53 CFOs, and 23 corporate counsels. Penalties included over $2
billion in
24 The court ruled that Andersen’s original conviction was marred by the judge instructing the jury to
the effect that criminal intent need not be proven (Andersen claimed it had followed normal policy of
retaining important audit documents but discarding volumes of unimportant documents, and was
unaware it was taking any illegal action). Chief Justice Rehnquist wrote the opinion, which included (Oyez
Project [2005]): “Indeed, it is striking how little culpability [on the part of Andersen] the instructions [to
the jury] required.”
restitution and ?nes. 25 These ?gures include convictions for securities fraud, insider trading, market
manipulation, wire fraud, obstruction of justice, false statements, money laundering, Foreign Corrupt
Practices Act violations, stock option backdating, and conspiracy, and are not limited to ?nancial
reporting, but they give an indication of the aggressive and effective criminal prosecution by the U.S.
Government in response to the scandals.
The legislative response to the accounting scandals was straight out of the Stigler [1964, 1971]–
Peltzman [1976] playbook. Applying Peltzman’s [1976] theory, Watts and Zimmerman [1986, p. 229–31]
argue that the political process has an incentive to avoid perceived responsibility for investor losses,
and that legislative action is a political attempt to escape blame. Spurred on by the White House and
the press, by declining U.S. prestige, by a declining dollar, by declining share prices, by the events of
September 11, and by an economic downturn, Congress rushed to pass the Sarbanes-Oxley Act. The
House vote was 423 to 3 and the Senate vote was 99 to 0. President George W. Bush immediately signed
it into law, on July 30, 2002. The extensive provisions of the Sarbanes-Oxley Act include:
r CEOs and CFOs must certify their ?nancial statements and internal r r r r r r r r
controls, with substantial criminal penalties (notably, 20-year prison terms) for reckless certi?cation; An
independent audit committee of the board must be responsible for hiring and overseeing auditors;
Fraudulently in?uencing or misleading auditors is prohibited; Non-audit work by the company’s auditor
that would compromise its independence is prohibited (such as bookkeeping, internal audit, and legal
work); Rotation of audit engagement partners is mandated; Increased disclosure of a variety of matters
is required, including companies’ internal controls, codes of ethics, and off-balance-sheet transactions;
Security analysts are prohibited from publishing reports on companies where con?icts of interest exist
(notably, due to investment banking work); Corporate loans to of?cers are prohibited; and The PCAOB is
created to oversee the audit industry.
The PCAOB is a regulator with daunting powers. It is empowered to promulgate rules that affect almost
all aspects of the audit industry, including auditing standards and procedures, audit ?rm practices, and
Figures are from U.S. Government [2007].
?rms’ internal controls. It monitors compliance with its own rules. Further, it enforces its own rules: It is
empowered to take disciplinary action against audit ?rms and their employees. In many ways, the PCAOB
is legislator, policeman, judge, and jury. It is given wide-ranging discretion and is subject only to
supervision by the SEC. In the long run, it has the capacity to regulate the audit industry with an iron ?
st. Overall, the Sarbanes-Oxley Act provides the most extensive regulation of the securities markets
since the Securities Act of 1933 and the Securities Exchange Act of 1934, which among other things
created the SEC. That legislation also was a response to a political crisis: the Great Crash of 1929 and
the Great Depression. The Sarbanes-Oxley Act substantially expands government and regulatory
involvement in the securities markets, and ?nancial reporting in particular. It represents a major move
toward a continental European securities market model and a substantial abandonment of a model that
served the United States well for a century. Yet the SarbanesOxley Act was drafted, debated, voted
upon, and signed into law within seven months of the SEC opening its investigation into Arthur Andersen.
And this by a Congress that takes decades to address Social Security reform.
4. Market Reaction to the Scandals
We do not have the opportunity to observe a world in which either market or political/regulatory
processes operate independently, so it is only possible to conjecture what the response of a completely
unregulated marketplace would have been. Even if we could observe market forces separately, Hayek
[1945, 1988] continually reminds us that they are complex, dispersed, dif?cult to fully identify, and easy
to underestimate. Nevertheless, it is possible to identify some market mechanisms that operated, and
to attempt an assessment of their effectiveness. In parallel to the political and regulatory response to
the scandals, the market response had two branches: penalties assessed against those accused of past
negligence or fraud and adaptive changes in institutional arrangements aimed at reducing its future
While the criminal prosecution cases attracted most worldwide public attention, a blizzard of private
litigation was launched against ?rms, managers, board members, audit ?rms, insurance companies, and
any parties alleged to have been complicit in ?nancial reporting malpractices. Civil litigation is
prosecuted by private litigants who allege they were harmed by the actions of others. Litigants
included stockholders, creditors, bondholders, employees, labor unions, and pension plans. Defendants
found guilty in securities cases are punished by the courts awarding monetary compensation to the
litigants for the damages they have incurred as a consequence of the harmful actions. Unlike criminal
proceedings, civil litigation is a private, market
process of enforcing explicit and implicit contracts among ?rms, managers, auditors, creditors,
shareholders, and other contracting parties. 26 The press attention given to the criminal trials makes it
easy to overlook the scale of the market-based penalties that have been meted out. Total damages
settlements in securities litigation over 2000 to 2007 exceeded $50 billion (Simmons and Ryan [2008]). In
the Enron case alone, extensive private litigation against banks alleged to have been complicit in just
some aspects of Enron’s ?nancial misreporting has been settled for a total of approximately $9 billion
(for comparison, Enron’s total assets peaked at approximately $70 billion). WorldCom settlements
exceeded $6 billion, and Cendant settlements exceeded $3 billion. Some litigation arising from the 2001
to 2002 scandals is still ongoing.
Reputation effects have long been viewed as a powerful market mechanism, imposing penalties on
parties found to have acted inappropriately (for example, Telser [1980] and Kreps and Wilson [1982]).
Karpoff and Lott [1993] document substantial reputational costs to ?rms committing fraud generally. In
the audit industry, the audit ?rm’s reputation for independent, professional work is central to
performing its economic role of verifying ?nancial statements for use by uninformed outsiders (see
Jensen and Meckling [1976], Watts [1977], and Watts and Zimmerman [1983, 1986]). DeAngelo [1981]
argues that large audit ?rms, like Arthur Andersen before its demise, earn substantial quasi-rents, which
they stand to lose if they perform poor-quality work. Research has shown that audit ?rm reputation is
associated with audit fee premiums (Simunic [1980], Francis [1984], Francis and Simon [1987], Palmrose
[1986], Craswell, Francis, and Taylor [1995]) and with the market valuation of their clients (Kellogg [1984],
Beatty [1989]). Palmrose [1986, 1987] links litigation risk to audit quality. Events that could reduce
auditors’ reputations, such as regulatory action or private litigation against them, are associated with
stock price reductions for clients (Loebbecke, Eining, and Willingham [1989], Firth [1990], Moreland
[1995], Franz, Crawford, and Johnson [1998]), with loss of clients (Firth [1990], Wilson and Grimlund [1990]),
and with reductions in audit fees (Davis and Simon [1992]). By the time it ceased business as an auditor,
Andersen’s reputation for quality, independent auditing was in tatters due to a series of de?cient audits.
These included its audits of Enron, Sunbeam, Waste Management, and WorldCom, which garnered
international attention. But there were lower-pro?le transgressions, including its audit of the Baptist
Foundation of Arizona, which became the largest bankruptcy of a religious nonpro?t in
26 While it is a fundamentally private (market) process, civil litigation is subject to regulation (notably,
via the Private Securities Litigation Reform Act of 1995) and is affected by the existence of securities
laws (notably, private lawsuits citing the violation of Section 10(b) and Rule 10b-5 of the Securities
Exchange Act of 1934).
U.S. history. Further, there was evidence (discussed below) that Andersen’s responsibility for de?cient
audits was not due to isolated rogue engagement partners, but was systemic and reached the top of
the company. Based on prior research on the economic role of auditor reputation, one could expect that
by the time Andersen’s clients digested the implications of its de?cient audits and had been able to
negotiate a replacement auditor, reputation effects alone would have caused it to shed much of its
client base. A related market mechanism for enforcing discipline on audit ?rms is bonding. Audit ?rm
partners are jointly and severally liable for partnership debts, and hence in principle the entire pool of
capital in the audit ?rm is available to satisfy damages arising from the actions of individual partners. 27
This acts as a bonding mechanism, giving the audit ?rm incentives to create high standards of behavior
for individual partners, monitor their performance, and enforce compliance. Andersen’s capacity to bond
itself to provide high audit quality was impaired by another market mechanism, civil litigation. As
discussed in the previous subsection, civil litigation is a market process for recovering damages from
parties who do not follow accepted standards of behavior. Investors and lenders are owed a duty of
care by audit ?rms which, if not performed, can trigger lawsuits to recover damages. Because litigation
is on behalf of damaged parties, it usually occurs in relation to client ?rms whose stock prices have
fallen substantially (Lys and Watts [1994]) and whose capacity to pay therefore is limited. Audit ?rms
then are named as defendants. Andersen was deluged with lawsuits. Its settlements included: Sunbeam
for $110 million, the Baptist Foundation of Arizona for $217 million, Waste Management for $27 million
including ?nes, WorldCom for $65 million, and Enron for $40 million. These amounts do not include legal
expenses. Andersen currently is named as a defendant in more than 100 suits still pending in the courts
(Wikipedia Contributors [2008]). Settlements and legal expenses depleted Andersen’s resources, to the
point where its ability to credibly bond itself to investors and lenders against future ?nancial reporting
negligence and fraud would have been severely impaired. A market mechanism closely related to
bonding is a form of insurance provided by auditors. Kellogg [1984], Wallace [1987], Chow, Kramer, and
Wallace [1988], and Kothari et al. [1988] develop the hypothesis that, because audit ?rms are named as
codefendants in corporate ?nancial reporting cases, their resources provide insurance to investors and
lenders against ?nancial reporting negligence and fraud. Whether they self-insure against this potential
liability or can purchase insurance, a competitive audit market should allow audit ?rms to pass this
insurance cost on to their client ?rms as a component of their audit fees (Dye [1993]). The depletion of
Andersen’s resources from litigating and settling past cases would have impaired
27 The Private Securities Litigation Reform Act of 1995 restricted audit ?rm joint and several liability. In
addition, audit ?rms are organized with limited liability, so individual partners’ liabilities are limited to
their invested capital.
its ability to insure investors and lenders against future ?nancial reporting negligence and fraud. Given
its loss of both reputational and monetary capital, it is not surprising that Andersen started shedding
clients. It lost a net 21 clients in 2000 and 73 clients in the ?rst three quarters of 2001, while during the
same intervals the other Big 4 audit ?rms had net gains of 44 and 14 clients. 28 These defections
preceded the Enron and WorldCom scandals, suggesting that the losses were due primarily to the Waste
Management case. Barton [2005] studies Andersen’s subsequent post-Enron client losses. He reports
that the earliest defections were by clients that were more visible in the capital markets, in the sense
that they attracted more analysts and more press coverage, had larger institutional ownership, had
larger turnover, and issued more securities. By the time Andersen surrendered its license, it had lost its
client base. 29 Barton [2005, p. 549] concludes: “Overall, my study suggests that ?rms more visible in the
capital markets tend to be more concerned about engaging highly reputable auditors, consistent with
such ?rms trying to build and preserve their own reputations for credible ?nancial reporting.” There is
some debate about the relative contributions of reputation, insurance, and bonding effects in the
demise of audit ?rms. Menon and Williams [1994] study the fraud-induced 1990 bankruptcy of Laventhol
and Horwath, then the seventh-largest U.S. audit ?rm. They conclude that the insurance hypothesis
explains the negative stock price reaction of its clients to its bankruptcy. However, Baber, Kumar, and
Verghese [1995] conclude that the Laventhol and Horwath clients’ price movements are consistent with
both insurance and reputation effects. Sinason and Pacini [2000] and Khurana and Raman [2004] reach a
similar conclusion from wider samples. Chaney and Philipich [2002] attribute the stock price behavior of
Arthur Andersen clients around the time of the Enron scandal to reputation effects, but Nelson, Price,
and Rountree [2008] document confounding effects. Weber, Willenborg, and Zhang [2008] study the
interesting German accounting scandal involving ComROAD AG, which is informative because damages
awards are both rare and minor in Germany, so bonding and insurance effects are not substantial. They
report that clients of KPMG, ComROAD’s audit ?rm, experienced negative abnormal returns and tended
to change auditors. They conclude that reputation effects are important. The most likely explanation is
that reputation, insurance, and bonding effects cannot be separated, either logically (because the
concepts overlap)
Numbers supplied in private communication by Clive Lennox. As Barton [2005, p. 566] observes, we know
only the dates when a change in auditor was announced, which would have substantially lagged the
decision to change. Most clients had December 31 ?scal year-ends, and the earliest they could have
terminated their Andersen engagements would have been after the Annual Report and 10-K were
completed and ?led, several months after the year-end. In addition, it takes time for managers to locate
alternative auditors (e.g., to explore potential con?icts of interest is a detailed, complex task), and to
request and review the audit programs proposed by replacement candidates, and for the audit
committee to meet and vote on the replacement.
29 28
or empirically (because their effects are correlated). This seems particularly likely in common law
countries, where loss of reputation is associated with litigation and consequential loss of monetary
capital. Nevertheless, all are market mechanisms. While it is impossible to completely untangle the
effects of market and political/regulatory processes in the demise of Arthur Andersen, there appears to
be ample evidence that the audit market would have closed Andersen on its own accord, because the ?
rm’s greatest asset (a reputation for quality, independent auditing) and its ?nancial viability (hence, its
capacity to bond the quality of the accounts it audited and to insure against harm to users) were in
ruins. In addition, even if it had won its criminal trial, the ?urry of private civil lawsuits ensuing from the
Enron collapse surely would have bankrupted it. It seems reasonable to conclude that market forces,
left to their own devices, would have closed Andersen. Finally, it is worth re?ecting on what the closure
of an audit ?rm implies, and why an audit ?rm is not closed whenever a single negligent or fraudulent
audit comes to light. It is important to distinguish between the actions of an individual partner, those of
a regional of?ce, and those of an audit ?rm as a whole. Individual partners acting alone in negligence or
fraud typically lose future employment prospects, lose personal assets in damages settlements, and can
be disbarred, ?ned, or jailed. Some ?nancial and reputational losses also are suffered by those who are
not directly implicated. Financially, under joint and several liability, the partnership as a whole is
responsible for ?nes and damages awards, which normally exceed individual partners’ wealths. Firm-wide
?nancial and reputational losses due to the actions of a rogue partner provide an incentive for partners
to monitor each other (though this mechanism apparently was not suf?cient in Andersen’s case). When a
scandal is due to poor oversight or a corrupt audit culture in an entire regional of?ce, but is clearly
contained within that of?ce, the penalties fall more heavily on partners in that of?ce, but here too they
typically do not threaten the entire ?rm. 30
30 In the May 2007 ChuoAoyama PricewaterhouseCoopers (PwC) scandal in Japan, the regional of?ce was
closed and many auditors were dismissed, but those not associated with the scandal were retained in a
newly created ?rm under the PwC global network, with new management and 30% fewer clients. Parmalat
S.p.A. is a similar case. In December 2003, it was revealed that an Italian audit ?rm associated with the
U.S. auditor Grant Thornton had accepted a fax—allegedly from the Bank of America, but faked by
Parmalat managers to conceal large losses—as con?rming the existence of accounts totaling
approximately €4 billion held on behalf of a Parmalat subsidiary. Dianthus S.p.A., an Italian audit ?rm
associated with the U.S. ?rm Deloitte & Touche, audited Parmalat’s accounts, and relied on the Grant
Thornton associate’s audit of the subsidiary. Web sites and other public statements made it clear that
both U.S. audit ?rms accepted no responsibility for their Italian associates’ work (possibly in recognition
of Italy’s reputation for lax enforcement of audit procedures). Nevertheless, there were spillover effects
on the U.S. ?rms. Deloitte & Touche paid $149 million to settle a €13.2 billion lawsuit by Parmalat, Grant
Thornton is still defending a similar suit for €10 billion, and Grant Thornton experienced U.S. client losses
almost immediately (Michaels [2004]).
So why was Andersen forced to close its doors when this normally does not happen? Presumably
because in Andersen’s case there was clear evidence that culpability did not simply lie with individual
audit engagement partners, or even with a single regional of?ce, but involved managers at the very top.
The ?rm itself was tainted. In the Waste Management scandal that preceded Enron, the following top-
level Andersen people were directly implicated in a blatant attempt to disguise improper accounting,
while at the same time Andersen was issuing clean audit opinions: Andersen’s managing partner, the
practice director for its central region, its director of global risk management, and the audit division
head of its Chicago head of?ce (SEC [2001]). When this ?rm-level culpability was discovered, Andersen was
?ned a thenrecord $7 million, and consented to a permanent injunction against further violations. The
Enron and WorldCom cases, which broke soon thereafter, ?ew in the face of this injunction. 31 It is
reasonable to conclude that Arthur Andersen’s ?rm-wide capacity to credibly perform independent
audits was severely damaged by its ?rm-level culpability in these events, and that this explains why the
?rm—and not just individual rogue partners or branch of?ces—went out of business. 32
Part of the adverse public and political reaction to the accounting scandals was the revelation that
audit ?rms conduct substantial non-audit work for their clients, thereby creating at least the
appearance of con?icts of interest. Con?icts of interest were given at least partial blame for the
scandals by the press (e.g., Herrick and Barrionuevo [2002]) and by some researchers (e.g., Coffee [2002]).
In response to the adverse reaction, the Sarbanes-Oxley Act prohibits the type of non-audit work by the
company’s auditor that would compromise its independence in performing the audit. Examples include
the provision of bookkeeping and internal audit services, where as an external auditor it would in effect
be auditing its own work. The SarbanesOxley Act sensibly does not prohibit other services, such as tax
advice. There are several reasons to doubt whether this statutory prohibition was advisable or
31 Two Andersen partners banned from auditing public companies for three years were not ?red, but
reassigned to non-audit jobs. Robert V. Kutsenda, the Director of Global Risk Management, was banned
for a year but reassigned to revising Andersen’s document retention policy. Ironically, this revised
policy received widespread adverse publicity when the Enron scandal broke. Asked why they had not
been ?red, Andersen’s managing partner Joseph F. Berardino said: “You need to be fair to people who are
trying to do a good job” (Norris [2002]). 32 Eisenberg and Macey [2004] show that the frequency of ?
nancial restatements by Andersen clients—a measure of ?nancial reporting quality—was not signi?cantly
different from that of clients of other large audit ?rms, controlling for important variables such as size.
This is consistent with the hypothesis that Andersen closed its doors because its culpability in several
important cases reached the top of the company, not because of audit failures per se.
First, the hypothesis that audit ?rms allow their audit judgment to be compromised by non-audit
revenues does not make as much sense as one might initially believe. Why would audit ?rms attach such
a low value to their reputations as independent auditors? Why would they willingly place the entire
capital of the partnership at risk by cutting audit quality? The hypothesis might seem to make sense if
one accepted the premise that they were earning quasi-rents on non-audit business, but none on audits.
They then might seem to have little to lose by reducing audit quality to attract lucrative non-audit
engagements. But even if one accepted that premise, the argument still would make no sense. Why
would they willingly risk losing quasi-rents on their non-audit work by gaining a reputation for poor
audit quality? Would not the existence of quasi-rents earned from non-audit business imply that ?rms
with substantial non-audit revenues put up a larger bond to guarantee their audit quality and hence are
less likely to compromise it? All things considered, the motives of audit ?rms are not as clear-cut as
many commentators portray them. Second, if client ?rms view their reputations as valuable assets, one
would expect them to voluntarily avoid contracting for the audit ?rm to provide any non-audit services
that could compromise audit independence. Kinney, Palmrose, and Scholz [2004] test this hypothesis,
using the need to subsequently restate previously issued ?nancial statements as an indicator of low-
quality ?nancial reporting and auditing. They do not ?nd a pervasive relation between non-audit services
fees and restatements. Third, one should not lose sight of the bene?ts non-audit work brings to clients.
The accounting ?rms have built substantial businesses in areas such as consulting, systems, taxation,
and litigation support. They have done so in a competitive market. Their comparative advantage
appears to lie in a combination of training, cost, and speci?c client and industry knowledge. Excessive
restrictions on using their comparative advantage can impair economic ef?ciency. Fourth, there is
substantial evidence that non-audit business in fact does not lead to audit ?rms compromising their
audit judgments (Craswell, Francis, and Taylor [1995], DeFond, Raghunandan, and Subramanyam [2002],
Frankel, Johnson, and Nelson [2002], and Larcker and Richardson [2004]). If anything, the evidence in
these studies points to non-audit revenues being associated with less favorable audit treatment, most
likely because ?nancially weaker ?rms exhibit greater use of consultants and also receive harsher audit
opinions. 33 Fifth, before the passage of the Sarbanes-Oxley Act and in response to the scandal-induced
perception that con?icts of interest in?uence audit
33 Coffee [2006, p. 147–8, 322–5] counters that non-audit revenues create industry-wide, not ?rm-speci?c,
incentives and hence audit ?rms cater to all clients, independent of clientspeci?c non-audit fees. While
this argument has some validity, it does not seem plausible that industry-wide catering would coexist
with audit ?rms catering equally to clients, independent of the amount of their non-audit revenues.
judgment, all but one of the major accounting ?rms decided to cease providing internal audit and audit-
related technology consulting services to clients where they are the external auditor. This decision was
made by Arthur Andersen (it was still operating at the time), Ernst & Young, KPMG, and
PricewaterhouseCoopers. Deloitte & Touche alone among the then Big 5 audit ?rms resisted the change,
arguing with some justi?cation that the issue was one of perception arising from “the level of hyperbole
in the debate” (Glater [2002]). Nevertheless, perceptions do matter, and it is not clear that Deloitte
would have been able to hold out on this position for long. In any event, the Sarbanes-Oxley Act codi?ed
the standard that the market had largely moved to in response to the scandals. The Sarbanes-Oxley Act
also restricts public companies from hiring directly from their audit ?rms. More speci?cally, Section 206
prohibits a company from employing a former auditor of its accounts in a senior accounting or ?nancial
position until at least a year has elapsed since that person left the audit ?rm. The principal concern with
“revolving door” appointments is that they induce various con?icts of interest, including those that
could occur when audit ?rm employees have to audit a former colleague or supervisor. This Sarbanes-
Oxley prohibition was fueled by public outcry upon news that former Andersen auditors had been
employed by Enron, Waste Management, and other companies with de?cient ?nancial reporting. But here
too, the need for such prohibition is far from clear. Lost in the argument is the potential bene?t a former
auditor can bring to a company, stemming from specialist skills and speci?c knowledge of the company.
Consistent with such bene?ts, Geiger, Lennox, and North [2008] report a positive share market reaction
to pre–Sarbanes-Oxley revolving door appointments, in excess of the price reaction to other
appointments. They also report that revolving door appointments are not associated with lower scores
on measures of ?nancial reporting quality. In sum, there is reason to believe, and some supporting
evidence, that market forces can resolve potential auditor con?icts, in the absence of regulatory
prohibitions. This does not imply that there should be no regulation, but it does help place in
perspective the Sarbanes-Oxley rush to heavily regulate the industry.
Was Enron forced into bankruptcy—and did employees lose their jobs— due to the accounting scandals?
Or due to bad business decisions? Here too, the political and market perspectives seem to differ. The
notion that accounting transgressions led to the Enron bankruptcy, and the associated job losses, is
correct in a sequential sense: Revelation of the company’s ?nancial misrepresentations was swiftly
followed by its demise. That does not mean that accounting transgressions caused the Enron
bankruptcy or the job losses, because revelation of the ?nancial misrepresentations was accompanied
by revelation of the motive behind them, which was to conceal the company’s true ?nancial position. I
will argue
that, if anything, the accounting transgressions actually deferred bankruptcy and job losses for a short
period. The immediate press coverage of Enron dwelt extensively on job losses. 34 This focus returned at
the sentencing of Skilling and Lay. For example, the BBC News stated on October 23, 2006: “The scandal
at the one-time energy giant left 21,000 people out of work” (BBC). When signing the SarbanesOxley Act
into law on July 30, 2002, President Bush stated: 35 “This law says to workers: We will not tolerate
reckless practices that arti?cially drive up stock prices and eventually destroy the companies, and the
pensions, and your jobs.” At the sentencing hearing for Skilling and Lay, U.S. District Judge Sim Lake
admitted testimony from several former Enron employees, including Charles Prestwood (who testi?ed he
and the other former employees were the real victims in this case) and Diana Peters (who testi?ed her
husband was diagnosed with cancer shortly before the company went bankrupt, leaving her without
health insurance, and to pay for his treatment she had taken different jobs and sold her furniture, home,
and assets). The prosecution team attributed Enron job losses to the ?nancial misreporting under
Skilling and Lay. After their sentences were handed down, Alice Fisher, an assistant U.S. attorney general,
stated: 36 “Today’s sentence is a measure of justice for the thousands of people who lost their jobs and
millions of dollars in investments when Enron collapsed under the weight of the fraud perpetrated by the
company’s top executives.” It is not a crime per se to have bad business judgment, or make bad
business decisions, even if they lead to bankruptcy or unemployment. However, deliberate ?nancial
misreporting is a crime, and as Judge Sim Lake indicated, the extent of job losses is a relevant
consideration in sentencing under federal guidelines. But one would have thought job losses would be
relevant only if the misreporting caused them. I also hold no brief for Skilling or Lay, and the following
observation has no implications for their guilt or otherwise, which is a separate issue from sentencing.
But I am unaware of any reliable evidence that the accounting scandals caused (as distinct from
deferred) job losses. The most plausible hypothesis is provided by Kedia and Philippon [2007], who
conclude that overstating earnings initially causes overinvestment and overemployment, distorting the
allocation of real resources. When the overstatement is discovered, the ?rm sheds labor and capital. 37
34 In a retrospective review of media coverage, Myatt [2004] concluded “the TV networks and
mainstream dailies focused on business, the job losses and human interest.” 35
http://www.whitehouse.gov/news/releases/2002/07/20020730.html. 36 “Enron’s Skilling Sentenced to 24
Years for Fraud,” Bloomberg, 23 October 2006, http://www.bloomberg.com/apps/news?
pid=20601087&refer=home&sid=a Jbjnng.4u4. 37 Sadka [2007] similarly analyzes the product market
effects of ?nancial misrepresentation.
Some indication can be gleaned from Enron’s ?nancials. Between 1995 and 2000, reported revenues grew
from $9.2 billion to $100.8 billion: a tenfold increase in ?ve years. However, reported pro?ts did not even
double over the period, and consequently the net pro?t margin on sales fell by 2000 (using reported
numbers) to less than 1%. We now know that even that slim margin actually was not earned, because
reported pro?ts that year were overstated. Based on the Bankruptcy Examiner’s estimate, Enron’s true
2000 pro?t was $42.3 million. 38 The restated numbers imply a paltry 0.04% margin on sales (and a mere
0.06% of restated total assets of $69.6 billion). This estimate might be biased downward because it was
made by an interested litigant, but it suggests that Enron was an unpro?table company the year before
it entered bankruptcy, and that its accounting transgressions were designed to hide that fact. It is dif?
cult to escape the conclusion that market forces caused Enron’s bankruptcy, for the simple reason that
by 2000 it was not generating pro?ts on an enormous amount of invested capital. Conditional on the
company having misallocated capital and labor resources to unprofitable projects such as its energy
trading and broadband businesses, its accounting transgressions most likely kept the company alive for
some period (perhaps one or two years) longer than would have occurred if it had reported the true
pro?tability. Absent misrepresentation, Enron would have been at least restructured and possibly
liquidated, and many Enron employees would have lost their jobs, at an earlier point in time. If Enron
managers anticipated the possibility of ?nancial misrepresentation before committing to these
businesses, they might even have been encouraged to overinvest and overemploy in them in the ?rst
instance. Whatever counterfactual is assumed, Enron’s levels of investment and employment would have
peaked earlier in the absence of ?nancial misrepresentation. The welfare loss arose from employing
excess capital and labor that were better used elsewhere. 39
As is the case with the political/regulatory system, markets have their own mechanisms for penalizing
and hence deterring harmful behavior that
38 U.S. Bankruptcy Court, Southern District of New York [2003]. Enron reported operating cash ?ow of +
$3.0 billion, which the bankruptcy examiner claimed should have been -$0.2 billion. 39 Tragically,
employees also lost approximately $1 billion on their 401(k) portfolios, which on average were 63%
invested in Enron stock (U.S. House of Representatives [2002]). A welfare loss would arise from any
overinvestment during the period in which the company’s poor ?nancial condition was not revealed, but
the entire loss is dif?cult to attribute to the scandal because it primarily postponed the date of
reckoning and hence the loss. Employees generally overinvest their 401(k) plans in their employer’s
stock, so it is dif?cult to attribute poor diversi?cation entirely to the misrepresentation. The aggregate
welfare loss from accounting scandals due to undiversi?ed 401(k) plans is unclear.
does not meet accepted standards. While the political/regulatory response to the scandals of 2001 to
2002 garnered considerably more press attention, the market response was substantial. It included
enormous damages awards under civil litigation, reputation effects, and bankruptcy. Furthermore,
markets are adaptive mechanisms, and learn from past events, even though many of the likely market
changes in response to the scandals were pre-empted by legislation. I return to this issue in section 6
5. GAAP versus “Accounting Principles That Are Generally Accepted”
Codi?ed standards arise naturally in a variety of market settings, as an ef?cient way of satisfying
demand. High-quality individual producers, acting atomistically, have incentives to incur costs of
signaling to uninformed buyers the standards met by their products (Spence [1973]). Minimum education
requirements are one such signaling mechanism. In many markets there also are ef?ciency gains from
developing, codifying and enforcing standards across multiple producers. These include networking
gains (e.g., Besen and Farrell [1994]) and gains from economies of scale (designing standards once
centrally, and applying them multiple times locally). Professional standards typically exist whenever
there is a profession, absent regulation. To be accepted and compensated by the marketplace as a
professional, one must meet accepted market standards of practice. Standards might simply take the
form of generally accepted best practice. Alternatively, a professional organization with voluntary
membership might formally codify a body of rules that it enforces through its own disciplinary
procedures. There might be competition among such organizations, with different standards. The
question then arises as to why countries generally have gravitated to a single professional accounting
body (in the United States, the American Institute of Certi?ed Public Accountants (AICPA)) and a single
set of codi?ed standards nationally (U.S. GAAP) and perhaps even worldwide (International Financial
reporting Standards (IFRS)). Is this an ef?cient solution in the ?nancial reporting market, or is it due to
regulation? A closely related question is the nature of the interplay between market and political forces
in determining reporting standards. What is the ultimate criterion against which ?nancial reporting in
the United States is evaluated? GAAP, de?ned as the codi?ed set of rules endorsed by the FASB? Or
“generally accepted accounting principles,” de?ned in the common law sense as the accounting
principles that are generally accepted by market participants as applying in the United States, a
criterion that encompasses all factors that determine appropriate ?nancial accounting? These are
important questions. The relative merits of “principles-based” and “rules-based” accounting have been
argued extensively in the international arena, due largely to the belief that these different approaches
underlie IFRS and U.S. GAAP, respectively. 40 The SEC in particular has been wary of the lack of speci?city
in some IFRS standards. The debate took on fresh impetus as a consequence of the recent accounting
scandals, which were attributed in part to companies following the letter, but not the spirit, of the
rules. A “rule-checking” mentality among accountants and managers is widely believed to have
contributed to the scandals that emerged in 2001 to 2002. Codi?ed GAAP certainly gives the impression
that U.S. ?nancial reporting is rules based. Accounting for leases is the paradigmatic example when
examined from the viewpoint of codi?ed rules alone. Shortridge and Myring [2004] note that there are
only seven relevant IFRS documents affecting leases, but the relevant U.S. GAAP is contained in at total
of 78 FASB Statements, Interpretations, Bulletins, and Emerging Issues Task Force (EITF) Abstracts.
Further, the primary IFRS lease standard (International Accounting Standard (IAS) 17) simply de?nes a
transaction as a capital lease “if it transfers substantially all of the risks and rewards incident to
ownership” to the lessee, making it dif?cult for ?rms to write contracts that barely avoid minimum
requirements and hence keep them off their balance sheets. The equivalent U.S. standard (Statement of
Financial Accounting Standard (SFAS) 13) speci?es four precise numerical criteria for capital leases, so
companies routinely structure their lease contracts to avoid triggering the criteria by the barest of
margins, thereby facilitating substantial off–balance-sheet ?nancing. The more “principles-based”
approach of IFRS, if implemented, therefore would lead to balance sheets that better re?ect the
economic substance of the lease transaction. Considering only speci?c GAAP standards, such as those
applying to leasing, U.S. accounting appears unequivocally rules based, and not principles based. In this
section, I propose that the standard against which ?nancial reporting ultimately is evaluated in the
United States has substantial elements of the common law version (i.e., the standard of reporting that is
generally accepted as applying in the United States). A corollary is that the United States de facto
operates a “principles-based” accounting system, contrary to popular belief. Further, I propose that
regulation is largely responsible for fostering the incorrect view that codi?ed GAAP alone determines
acceptable ?nancial reporting standards.
The FASB’s Statements of Financial Accounting Concepts (SFACs) are “intended to serve the public
interest by setting the objectives, qualitative characteristics, and other concepts that guide selection
of economic events to be recognized and measured for ?nancial reporting and their display in ?nancial
statements or related means of communicating
40 The distinction between rules-based and principles-based accounting is not totally clear because, as
Schipper [2003] points out, rules generally are based on principles.
information” (FASB [1987]). SFAC No. 2 states “The quality of reliability, and, in particular,
representational faithfulness leaves no room for accounting representations that subordinate substance
to form” (FASB [1980]). This statement reaf?rms a long-standing and fundamental principle. Earlier,
Accounting Principles Board (APB) 4 had stated “Financial accounting emphasizes the economic
substance of events even though the legal form may differ from the economic substance and suggest
different treatment.” 41 The standard unquali?ed U.S. audit report states that the ?rm’s ?nancial
statements “present fairly, in all material respects, the ?nancial position of the company at year end,
the results of operations, and its cash ?ows, in conformity with generally accepted accounting
principles.” A similar requirement has been in effect for three quarters of a century, its origins being in
the ?rst codi?cation of generally accepted standards by the then American Institute of Accountants.
The precise interaction between the “present fairly, in all material respects” and “in conformity with
generally accepted accounting principles” components of the audit certi?cate is debatable, but they
clearly are not intended to be equivalent statements. Statement of Accounting Standard (SAS) 69 clari?
es the interaction between the two components, by explicitly requiring auditors to judge whether the
company’s selection and use of formal GAAP pronouncements is such that transactions and events are
treated in accordance with their substance. “The auditor should consider whether the substance of
transactions or events differs materially from their form.” 42 The same section also cautions that it is
possible to follow the letter of a particular GAAP pronouncement but still fail to meet the objective of
providing relevant and reliable information about the true economic position of the ?rm. SAS 90 further
clari?es the interaction between “present fairly” and “in conformity with generally accepted accounting
principles” by requiring public company auditors to discuss with the company’s audit committee their
judgment of the quality of the accounting employed by the company, not simply its compliance with
GAAP. 43 The discussion should address matters such as the completeness and clarity of the ?nancial
statements, the neutrality, representational faithfulness, and veri?ability of the information they
contain, new accounting policies, changes in policies, estimates, judgments, uncertainties, and unusual
transactions. The standard notes that these assessments require exercising judgment in the particular
circumstances that cannot be subsumed by objective criteria.
41 APB 4, “Basic Concepts and Accounting Principles Underlying Financial Statements of Business
Enterprises,” ¶¶41, 64, and 66. 42 “The Meaning of Present Fairly in Conformity with Generally Accepted
Accounting Principles in the Independent Auditor’s Report,” Statement on Auditing Standards No. 69
(New York: AICPA, December 1992), paragraph 06. 43 “Audit Committee Communications,” Statement on
Auditing Standards No. 90 (New York: AICPA, 1999).
Rule 203 of the AICPA Code of Conduct makes it clear that a mechanical application of formal GAAP
pronouncements can lead to inappropriately misleading ?nancial reporting:
A member shall not (1) express an opinion or state af?rmatively that the ?nancial statements or other ?
nancial data of any entity are presented in conformity with generally accepted accounting principles or
(2) state that he or she is not aware of any material modi?cation that should be made to such statement
or data in order for them to be in conformity with generally accepted accounting principles, if such
statements or data contain any departure from an accounting principle promulgated by bodies
designed by Council to establish such principles that have a material effect on the statements or data
taken as a whole. If, however, the statements or data would otherwise have been misleading, the
member can comply with the rule by describing the departure, its approximate effects, if practicable,
and the reasons why compliance with the principle would result in a misleading statement.
Reconciling the qualitative requirements of Rule 203 with formal GAAP pronouncements requires the
exercise of professional judgment. That is, it requires principles-based rather than rules-based
accounting. The rule seems to have been widely ignored by accountants.
In the 1969 criminal case U.S. v. Simon, Judge Friendly held that an accountant cannot escape conviction
for fraud by showing that ?nancial statements he knew were misleading had nevertheless been prepared
in accordance with rules-based GAAP. 44 This important Federal Court decision played a central role in
the WorldCom and Adelphia trials. It adopted a principlesbased view of accounting. The auditors of
Continental Vending Machine Corporation were charged with violating U.S. securities laws by certifying
?nancial statements they knew to be false. An af?liate of Continental Vending, Valley Commercial
Corporation, borrowed money from Continental and loaned it to a Continental manager who the
auditors knew would be unable to repay the debt. The audited ?nancial statements of Continental
showed the Valley receivable as an asset, and an ambiguous and obscure footnote provided some
details. In the trial, the defense argued that the footnote disclosure explaining the receivable from
Valley complied with the letter of GAAP and that the auditors had followed Generally Accepted Auditing
Standards (GAAS). The District Court judge instructed the jury that mere compliance with professional
accounting standards was not a suf?cient defense, and the appropriate test was whether the ?nancial
statements fairly represented Continental’s ?nancial position. The jury found the defendants guilty, and
in the appellate court Judge Friendly ruled that the District Court judge did not err in his instructions to
the jury.
44 U.S. v. Simon (425 F.2d 796, 1969) in the Second Circuit, certiorari denied, 397 U.S. 1006 (1970).
The generality of the Simon case (also referred to as Continental Vending ) is unclear. The decision was
handed down in the Second Circuit, and is not binding in other jurisdictions. 45 Nevertheless, the
decision played a central role in the recent WorldCom and Rigas (Adelphia) scandals (see below), was not
overturned by the U.S. Supreme Court, and has been cited and reaf?rmed in several important cases,
many of them outside the Second Circuit. 46 Perhaps the uncertain generality of Simon helps explain why
the case has attracted little commentary by the accounting profession, including auditors, standard-
setters, textbook authors, and academics. Isbell [1970], Sterling [1973], and Zeff [2003b] are rare
exceptions. After the Hochfelder case, Causey [1976] and Chapman, Zitek, and Yellin [1976] also drew
some attention to it. Not even the central role of Simon in the WorldCom and Adelphia cases seems to
have drawn commentators’ attention away from rules-based GAAP. The ruling in Simon is not
contradicted by the courts placing substantial weight upon rules-based GAAP. Under Simon , compliance
with rules-based GAAP is persuasive evidence the ?nancial statements fairly represent the company’s ?
nancial position, but it is not suf?cient. Further, willful failure to comply with GAAP normally is
associated with an intent to mislead, and will fail the test in Simon. The implied assumption in the Simon
ruling is that GAAP rules normally but do not always re?ect principles (see, e.g., Schipper [2003]). Simon
gives rules-based GAAP a role that is analogous to generally accepted precedent in common law, and the
audit profession a role that is analogous to the common law judiciary. Common law is created by court
or tribunal decisions resolving disagreements among private parties. It thus originates in markets, not in
legislation or other state action. If a case arises with important circumstances that are covered by no
authoritative precedent, common law judges must make a decision that, if it survives appeal and
especially if it is cited by authoritative courts, establishes a precedent for resolving similar
disagreements in the future. The decisions of all courts are not equally authoritative, and are not
necessarily binding in different jurisdictions. If a disagreement involving materially different
circumstances needs resolution, it must be decided by imagining how it would have been resolved in
common practice if the circumstances had been anticipated and provided for.
45 The U.S. Court of Appeals for the Second Circuit is one of 13 regional courts of appeals in the federal
system. Its territory comprises Connecticut, New York, and Vermont. Judge Henry Friendly was one of
its most famous jurists, known for having written many important and enduring opinions. 46 Subsequent
cases include: Hochfelder v. Ernst & Ernst (1974) in the Seventh Circuit, U.S. v. Weiner (1978) and Sarno
(1995) in the Ninth Circuit, Natelli in the Second Circuit, and Maduff Mortgage v. Deloitte Haskins & Sells
(1989) in the Oregon Court of Appeals. SEC v. Arthur Young & Co (1979) in the Ninth Circuit exonerated
defendants who showed good-faith compliance with formal GAAP pronouncements.
Setting aside, for the moment, the political/regulatory in?uence on GAAP, from a market perspective,
the SAS 69 hierarchy seems analogous to the structure of common law: FASB as a specialist accounting
court; EITF as a lower court; the various AICPA Industry Audit and Accounting Guides, Practice Bulletins,
and Accounting Interpretations as administrative interpretations; and auditors as administrative judges.
47 Like common law precedent, rules-based GAAP under Simon is persuasive, but will not alone determine
whether the ?nancial statements fairly represent the company’s ?nancial condition in all circumstances,
and audit judgment therefore needs to be applied. This suggests that accounting textbooks and
instructors might balance their coverage of GAAP pronouncements with coverage of judging whether the
?nancial statements fairly represent the company’s ?nancial position. It also suggests that researchers
might focus less on GAAP pronouncements, for example, when studying international differences or
international convergence on uniform rules such as IFRS, and more on what companies actually report
(see Ball, Robin, and Wu [2003] and Ball [2006]).
Perhaps learning from their mistake in the HealthSouth case, the Department of Justice did not charge
Enron executives Skilling and Lay with violating rules-based GAAP. They were charged with several
counts of misleading investors and employees, by misrepresenting the company’s earnings and ?nancial
position and by withholding materially bad news. On one count, in its closing arguments the prosecution
stated: “Abracadabra, just like that. A penny to meet the consensus estimates. That’s fraud. It’s wrong.”
Another count did not contend accounting rules were violated when Enron shifted a business unit to a
different segment for reporting purposes, to hide a loss, but simply argued investors were mislead. The
prosecution argued: “They didn’t disclose these problems to the marketplace, and the investor didn’t
know and didn’t understand what was going on. . . . It is a crime to omit material information about your
business. . . .” Another charge involved lying about Enron’s performance on a non-GAAP ?nancial metric
called “total contract value.” No violation of GAAP was alleged; the prosecution simply argued that
deliberately misleading investors is a crime. The extent to which Enron’s ?nancial statements did or did
not conform to rules-based GAAP is subject to debate, and has not been resolved in court to my
knowledge. Nevertheless, the Lay and Skilling convictions were for knowingly failing to present a fair
picture of Enron’s pro?tability and ?nancial condition, and the issue of whether Enron followed GAAP was
47 The economic role of specialized private (i.e., market) judiciaries is described in Milgrom, North, and
Weingast [1990]. The argument that they already exist in the audit industry makes calls for an
“accounting court” (Spacek [1958], Stamp [1970]) appear misplaced.
In appealing his conviction for accounting fraud, WorldCom ex-CEO Bernie Ebbers argued that the
prosecution had not alleged, let alone proven, that WorldCom’s accounting violated rules-based GAAP,
and hence his conviction was ?awed. In essence, he claimed that the sole standard for U.S. ?nancial
reporting is GAAP. The Court of Appeals for the Second Circuit dismissed this argument in no uncertain
terms, with words that bear repeating at length: 48
Ebbers argues that the indictment was ?awed because it did not allege that the underlying accounting
was improper under GAAP, and that the district court should have required the government to prove
violations of GAAP at trial. He claims that where a fraud charge is based on improper accounting, the
impropriety must involve a violation of GAAP, because ?nancial statements that comply with GAAP
necessarily meet SEC disclosure requirements. . . . We [The Court of Appeals for the Second Circuit]
addressed a similar argument in United States v. Simon. . . . We see no reason to depart from Simon. To
be sure, GAAP may have relevance in that a defendant’s good faith attempt to comply with GAAP or
reliance upon an accountant’s advice regarding GAAP may negate the government’s claim of an intent to
deceive. Good faith compliance with GAAP will permit professionals who study the ?rm and understand
GAAP to accurately assess the ?nancial condition of the company. This can be the case even when the
question of whether a particular accounting practice complies with GAAP may be subject to reasonable
differences of opinion. However, even where improper accounting is alleged, the statute requires proof
only of intentionally misleading statements that are material, i.e., designed to affect the price of a
security. If the government proves that a defendant was responsible for ?nancial reports that
intentionally and materially mislead investors, the statute is satis?ed. The government is not required in
addition to prevail in a battle of expert witnesses over the application of individual GAAP rules . . . In a
real sense, by alleging and proving that the ?nancial statements were misleading, the government did, in
fact, allege and prove violations of GAAP according to the AICPA’s Codi?cation of Statements on
Accounting Standards, AU §312.04, “[f]inancial statements are materially misstated when they contain
misstatements whose effect, individually or in the aggregate, is important enough to cause them not to
be presented fairly, in all material respects, in compliance with GAAP.” Thus, GAAP itself recognizes that
technical compliance with particular GAAP rules may lead to misleading ?nancial statements and imposes
an overall requirement that the statements as a whole accurately re?ect the ?nancial status of the
company. To be sure—and to repeat—differences of opinion as to GAAP’s requirements may be relevant
to a defendant’s intent where ?nancial statements are prepared in a
48 United States of America v. Bernard J. Ebbers , U.S. Court of Appeals for the Second Circuit (argued:
January 30, 2006; decided: July 28, 2006). Docket No. 05-4059-cr http://www.ca2.uscourts.gov/.
good faith attempt to comply with GAAP. The rules are no shield, however, in a case such as the present,
where the evidence has showed that accounting methods known to be misleading—although perhaps at
times fortuitously in compliance with particular GAAP rules—were used for the express purpose of
intentionally misstating WorldCom’s ?nancial condition in arti?cially in?ating its stock price.
This reaf?rmation of the principle in Simon clearly states that, at least in the Second Circuit’s view, the
ultimate criterion for ?nancial reporting is fair representation of ?nancial condition, and while
compliance with technical GAAP rules is persuasive, it is not suf?cient.
The principle in Simon also was applied in the Adelphia case involving the Rigas family. In this case, the
prosecution successfully argued that Adelphia’s reclassi?cation of certain debt in its ?nancial
statements was false and misleading, because it lacked economic substance and was designed to
mislead investors. The allegation was not that the accounts did not comply with GAAP. Here too the
initial conviction was appealed at the Second Circuit on the grounds that guilt requires proof GAAP was
violated. The Court of Appeals disagreed, citing Simon to the effect that (Pet. App. 22a) “GAAP neither
establishes nor shields guilt in a securities fraud case.” The appeals court also noted (Pet. App. 23a) that
good faith compliance with GAAP might indicate an absence of intent to defraud, but does not per se
shield a defendant from criminal liability.
As noted above, the standard U.S. unquali?ed audit report states that the ?rm’s ?nancial statements
“present fairly, in all material respects, the ?nancial position of the company at year end, the results of
operations, and its cash ?ows, in conformity with generally accepted accounting principles.” Section
302(a) of the Sarbanes-Oxley Act requires a similar certi?cation. The SEC view of this requirement is:
We believe that Congress intended this statement to provide assurances that the ?nancial information
disclosed in a report, viewed in its entirety, meets a standard of overall material accuracy and
completeness that is broader than ?nancial reporting requirements under generally accepted
accounting principles. In our view, a “fair presentation” of an issuer’s ?nancial condition, results of
operations and cash ?ows encompasses the selection of appropriate accounting policies, proper
application of appropriate accounting policies, disclosure of ?nancial information that is informative and
reasonably re?ects the underlying transactions and events and the inclusion of any additional disclosure
necessary to provide investors with a materially accurate and complete picture of an issuer’s ?nancial
condition, results of operations and cash ?ows.
In a recent public lecture, Zeff [2006] argues that the present form of the audit certi?cation should be
changed, as follows:
My premise is that principles should supplant, or at least supplement, rules in the conduct of the audit,
just as they are being proposed to govern the setting of accounting standards. It should not be enough
that the auditor’s opinion re?ects little more than a ticking off of the company’s accounting methods
against the rules of GAAP, even as challenging as that assignment is today. To serve the readers of ?
nancial statements and make the opinion paragraph of the auditor’s report meaningful and not just a
boilerplate, the auditor should be expected to treat “present fairly” as a substantive issue, and not as a
“rubber stamp” of GAAP. Toward this end, I think that shareholders and the market would be better
served by decoupling the auditor’s opinion into whether the ?nancial statements “present fairly” and
whether they are in conformity with GAAP.
I do not understand either the need for change, or the rationale for “decoupling.” If one views ?nancial
reporting in common law terms, and not merely in terms of codi?ed GAAP, the ultimate criterion for ?
nancial reporting in the United States already is fair representation of ?nancial condition. In other
words, the system currently in place does not limit the auditor’s role to rule ticking, even if the recent
scandals indicate that some or many managers and their auditors believe it does, accounting textbooks
routinely reinforce it and, as argued in the following subsection, bureaucratic regulatory oversight
encourages it.
In view of the many cogent reasons to view the ultimate standard for acceptable ?nancial reporting in
the United States as being largely principles based, why did a rules-based view of accounting become so
dominant? I propose the primary answer is regulation. If this hypothesis is correct, and if a “rule-
checking” mentality was in part responsible for the scandalous reporting behavior, then regulation is
one of the scandal culprits. Some clues reside in history. 49 Toward the end of the nineteenth century,
the public joint stock company became a dominant form of business organization in the United States.
In 1895 the ?rst large audit ?rm (Haskins & Sells, now part of Deloitte & Touche) was founded. In 1904 the
?rst professional accounting organization was founded, and in 1916 it was reorganized into the American
Institute of Accountants. In 1917, the accounting profession and the Federal Trade Commission together
approved a uniform set of accepted audit principles and procedures. The Institute promulgated best
practice in other ways, most notably in regular commentary in its member publication Journal of
Accountancy and in 30 Special Bulletins it issued between 1920 and 1929. By 1929, when it revised the
1917 document on accepted practice, the Institute was acting alone as an authoritative professional
body, without apparent regulatory in?uence.
49 This summary draws on Storey [1964], Carey [1969, ch. 6], Moonitz [1970], and Zeff [1984, 1972,
During 1932 to 1934, in the aftermath of the Great Crash of 1929, the American Institute of Accountants
debated and adopted six “broad principles of accounting which have won fairly general acceptance,”
and recommended a standard-form audit report certifying that the ?nancial statements “fairly present,
in accordance with accepted principles of accounting consistently maintained . . . .” The Institute then
was a private-sector professional association, and a precursor to the AICPA. The SEC was established
around the same time by the Securities Exchange Act of 1934, which empowered the Commission to set
the rules governing ?nancial reporting and disclosure of public companies. 50 Initially, the SEC deferred
on accounting matters to the accounting profession. In its Accounting Series Release No. 4 , the SEC
delegated authority to establish accounting standards to the private sector, and the AICPA’s
Committee on Accounting Procedure (CAP) started issuing Accounting Research Bulletins, the precursor
to contemporary Statements of Financial Accounting Standards. In 1953, the CAP issued ARB 43,
codifying its previous pronouncements. The Commission’s in?uence on ?nancial reporting has grown
substantially over the past 75 years. Its regulation of ?nancial reporting is conducted primarily by its
Of?ce of the Chief Accountant, which states its mission as “establishing and enforcing accounting and
auditing policy to enhance the transparency and relevancy of ?nancial reporting, and for improving the
professional performance of public company auditors in order to ensure that ?nancial statements used
for investment decisions are presented fairly and have credibility” (SEC). From the outset the
Commission strongly opposed departures from historical cost accounting (Walker [1992], Zeff [2007]). At
various points since, the Congress, the SEC, and also the Treasury have intervened explicitly in
standard-setting, notably in 1963 and 1967 (accounting for the investment tax credit), in 1974
(accounting for in?ation), in 1978 (accounting for oil and gas exploration), in 1993 to 2005 (accounting for
employee stock options), in 2000 (accounting for business combinations), and in 2008 (fair values for ?
nancial assets). 51 Even when there has been no explicit intervention, the political/regulatory presence
of Congress and the SEC has been a latent force in the background of FASB decision making. The
Commission issues multiple Staff Accounting Bulletins, which “re?ect the Commission staff’s views
regarding accounting-related disclosure practices” and “represent interpretations and policies followed
. . . in administering the disclosure requirements of the federal securities laws.” 52 It also issues
“interpretive releases” on ?nancial reporting and other matters. 53 Its Accounting and Auditing
Enforcement Releases outline its actions to
50 51
Seligman [1982] provides a useful history of the SEC. Beresford [2001] provides an insider’s view of the
business combinations issue. 52 http://www.sec.gov/interps/account.shtml. 53
enforce ?nancial reporting rules via civil lawsuits and administrative proceedings. 54 When the SEC was
created in the aftermath of the Great Depression, a proposal that the auditing of public ?rms be taken
away from the private sector and assigned to a new government agency was debated but not enacted.
In 2002, in the aftermath of the accounting scandals, the Sarbanes-Oxley Act created the PCAOB,
tightening regulatory oversight of the audit industry to a degree almost comparable to public
ownership. In sum, ?nancial reporting in the United States has become increasingly regulated over time.
As Mahoney [2009] concludes, “U.S. law has evolved from a system that was mostly contract-enabling to
one that includes an increasing number of one-size-?ts-all rules.” In parallel, codi?ed ?nancial accounting
rules have become both more numerous and more detailed. Is this a coincidence? Codi?cation of law into
formal rules seems a natural consequence of regulation, for several related reasons. First, a codi?ed
rulebook suits both the administrative mentality of government regulatory employees and the desire
for certainty of the regulated: The regulated can construct an administrative bureaucracy to interact
with that of the regulator. 55 Park [2007, p. 625–26] expresses this explanation as follows:
Rulemaking re?ects the mentality that securities regulation is a technical enterprise that should be left
to experts who have created a comprehensive, ef?cient, administrative scheme. Principles-based
enforcement actions re?ect the demand that regulators punish conduct violating principles re?ecting
public values. For the most part, the regulated prefer a predictable regulatory regime, which rulemaking
provides, while the public prefers decisive responses, which can be provided by principles-based
enforcement actions.
Second, interpretation of principles is an inherently judgmental process, and involves the risk of being
found wrong. Career bureaucrats are not widely viewed as not having either strong incentives or the
requisite skill set to make judgments and take risks. Third, regulators receive their authority from and
work under codi?ed statutory law, not civil law, so their domain of operations naturally is heavily rules
based. 56 The hypothesis that regulation induces a rules-based view of the world helps explain several
important ?nancial reporting facts. Initially, it suggests that parallel increases in regulation of reporting
and codi?cation of U.S. ?nancial accounting rules over time are related. It also suggests regulation was a
contributor to the accounting scandals, many of which involved ?nancial reporting that complied with
the letter but not the principle of
http://www.sec.gov/divisions/enforce/friactions.shtml. Note the application of the Stigler [1964,
1971]–Peltzman [1976] theory of regulation. 56 Anyone doubting the SEC’s preference for rulemaking
need only visit http://www.sec. gov/rules/?nal.shtml and http://www.sec.gov/rules/pcaob.shtml.
accounting rules (see section 2.3 above). In addition, the regulatory preference for rules goes a long way
toward explaining why the United Kingdom has been comparatively free of accounting scandals. Like the
United States, the United Kingdom is a common law country, but unlike the United States it historically
has enjoyed very light regulation of its ?nancial markets and ?nancial reporting, and has more closely
followed principles-based reporting standards. By any standard, the United States is a litigious country
(e.g., Coffee [2007]), which raises the question of whether private litigation also encourages a rules-
based view of ?nancial reporting. This is dif?cult to assess, because private litigation has been in?uenced
substantially by the Securities Acts. Most notably, the courts allow private plaintiffs to sue for
damages arising from a violation of Rule 10b-5 of the Securities Exchange Act (e.g., Mahoney [2009]), a
practice that has come under much criticism for increasing the prospects and hence the frequency of
private litigation (e.g., Committee on Capital Markets Regulation [2006]). Consequently, we do not
observe separate effects of statutory and private litigation, and one can only conjecture what the
separate effect of private litigation on a rules-based view of ?nancial reporting might be. My own view is
that a pure common law system, absent regulation, would operate much as in the Simon case, described
in section 5.2 above: Rules-based GAAP would be persuasive evidence that the ?nancial statements fairly
represent the company’s ?nancial position, because rules would tend to codify generally accepted best
practice; willful failure to comply with GAAP would suggest an intent to mislead; but compliance with
rules-based GAAP would not necessarily imply ?nancial statements satisfy the overarching principle of
fairly representing the company’s ?nancial position. That is, there would be rules, but they would be
subservient to principles. Ironically, in the aftermath of the accounting scandals, Section 108(d) of the
Sarbanes-Oxley Act directed the SEC to conduct a study on the adoption of a principles-based
accounting system and deliver it to Congress by July 30, 2003. The duly-delivered report argued in
idyllic terms for the best of both worlds: for what the Commission termed “objectives-oriented standard
setting,” which it explained as follows (emphasis in original): 57
In our view, the optimal principles-based accounting standard involves a concise statement of
substantive accounting principle where the accounting objective has been incorporated as an integral
part of the standard and where few, if any, exceptions or internal inconsistencies are included in the
standard. Further, such a standard should provide an appropriate amount of implementation guidance
given the nature of the class of transactions or events and should be devoid of bright-line tests. Finally,
such a standard should be consistent with, and derive from, a coherent conceptual framework of ?
nancial reporting.
U.S. Securities and Exchange Commission, Of?ce of the Chief Accountant [2003].
SEC chief accountant Robert K. Herdman earlier had stated: “An ideal accounting standard is one that is
principle-based and requires ?nancial reporting to re?ect the economic substance, not the form, of the
transaction.” A similar stance was taken by the FASB (FASB [2002]). If the United States did attempt a
move toward principles-based accounting, for example by allowing domestic companies to report under
IFRS, a skeptical prediction is that the SEC would pay only lip service to the change, and that this would
be ?ne with the audit ?rms. Principles-based ?nancial reporting would require companies and their
auditors to be both able and willing to make the judgments necessary to apply broad principles in
speci?c circumstances. It also would require SEC staff to be able and willing to evaluate those
judgments. A principles-based set of accounting standards such as those embodied in IFRS soon would
be supplemented by a ?urry of implementation guidelines or rules issued by the FASB, the SEC, or
individual audit ?rms, the net effect being similar to the current system. Stated differently, the current
?nancial reporting system is an endogenous result of U.S. market and political/regulatory forces, and
hence is unlikely to change in substance (as distinct from appearance) unless those forces themselves
change (see Ball [1995, 2001, 2006] and Ball, Robin, and Wu [2003]). The most substantial change in
response to the accounting scandals—drastically increased regulation under the Sarbanes-Oxley Act of
2002—seems likely to create more rulemaking, not less.
6. Was the Sarbanes-Oxley Act Necessary?
Perhaps the most controversial issue is whether the Sarbanes-Oxley Act was necessary. Seventy-?ve
years after the only remotely comparable increase in U.S. securities regulation—the 1933 to 1934
passage of the Securities Acts and the creation of the SEC—there still is scant evidence on whether it
was bene?cial. Stigler [1964] and Benston [1969, 1973] concluded that the Securities Acts did not bene?t
investors, though the issue remains controversial to this day. 58 It therefore is not surprising that, only
six years after its enactment, the legacy of the Sarbanes-Oxley Act is largely conjectural. 59 This
section discusses the market and regulatory perspectives on the Sarbanes-Oxley Act in terms of ?rst
the deterrence and second the detection and correction of reporting negligence and fraud. It then
discusses the issue of whether the focus on heavy deterrence penalties in the United States is an
effective regulatory model (Coffee [2007]). At the outset, it is worth noting that the desirability or
otherwise of additional regulation is not the same question as whether there was market failure. The
United States has operated a mixed market-and-regulatory system of ?nancial reporting since the
Securities Acts of 1933 to 1934. It makes
Coffee [1984] provides a survey at the 50-year point. Analyses are provided by Romano [2005], Coates
[2007], Engel, Hayes, and Wang [2007], Leuz [2007], and Zhang [2007].
59 58
no more sense to argue that the market failed and hence more emphasis should be placed on regulation,
than it does to argue that regulation failed and hence more emphasis should be placed on markets.
Similarly, the Sarbanes-Oxley Act is not the only change that has taken place in ?nancial reporting in
response to the accounting scandals. It is a mistake to compare the Sarbanes-Oxley Act with the pre-
Sarbanes-Oxley system, without taking into account the changes that would have occurred in market
mechanisms, absent legislative action. It seems unlikely that managers, boards, auditors, and other
parties would have failed to change their practices. To take a small example, after paying approximately
$9 billion to settle private litigation arising from their transactions with Enron, the banks would seem
less likely to enter similar transactions with their clients in future. Markets generally are not static
mechanisms: Their institutional structure learns from and evolves in response to past events (e.g., Hayek
[1945, 1988], Wilson [1975], Nelson and Winter [1982], North [1990], Waymire and Basu [2008]).
Considerable changes in ?nancial reporting and governance norms and practices could be expected to
have occurred in response to what was learned from the scandals, though many such changes would not
be observable because they were preempted by and seemingly due to legislation. Nevertheless, some
changes were evident during the brief interval between the scandals and the enactment of the
Sarbanes-Oxley Act. For example, Leuz and Schrand [2008] document increased disclosure in ?rms’ 2001
year-end 10-K ?lings, particularly in the management discussion and analysis section, in describing
related-party transactions (an important issue in Enron), and in the ?nancial statements and footnotes.
60 The increases are larger for Arthur Anderson clients. They also report an increased number of 8-K ?
lings and conference calls. 61 Assessing the impact of the Sarbanes-Oxley Act therefore is not a simple
matter of comparing pre- and post-Sarbanes-Oxley practices, without careful speci?cation of the
counterfactual. Many of the observed changes would have occurred due to market forces. Furthermore,
it even is possible that the Sarbanes-Oxley Act inhibited (as distinct from preempted) market-based
changes; for example, its increased jail penalties described below conceivably could have deterred
managers and audit ?rms from pushing for a more principles-based system of reporting. Assessing the
impact of the SarbanesOxley Act is not as easy as the ?urry of pre- to postregulation studies might
imply: It requires careful speci?cation of the assumed counterfactual.
60 Ball and Shivakumar [2008] report a sharp increase in the proportion of total annual price-relevant
information that is released at earnings announcements, starting during or after 2000 but, in comparison
with the research design in Leuz and Schrand [2008], their time dating is not ?ne enough to distinguish
pre- and post-Sarbanes-Oxley effects. 61 Mahoney [2009] notes another event that confounds the effect
of the Sarbanes-Oxley Act: prosecutorial aggressiveness increased at the same time, in response to the
scandals (see also section 3.1 above).
Obviously, market and regulatory mechanisms were not suf?cient to deter the spate of accounting
scandals revealed in 2001 to 2002. Leaving aside the issue of the optimal frequency of ?nancial reporting
negligence and fraud (not zero, because deterrence costs are not zero), the scandals imply a failure of
both market and regulatory deterrence mechanisms. Much attention has been paid to the Sarbanes-
Oxley requirement that the ?nancial statements be certi?ed by the CEO and CFO, and to the Section
802(a) statutory ?nes and jail sentences of up to 20 years for a knowingly false certi?cation. I doubt the
effectiveness of heavy additional statutory penalties as a deterrence mechanism. Prior to the
Sarbanes-Oxley Act, the CEO and CFO were required to sign and attest to the ?nancial statements, and
faced a heavy combination of code law penalties (?nes and jail sentences of up to ?ve years) and
common law penalties (loss of reputation and employment prospects, damage awards under civil
lawsuits), but this did not deter the accounting frauds. Coffee [2007, p. 2] concludes from an extensive
survey of securities regulation internationally: 62
The United States is unique not in its expenditures on securities regulation, but in the amount and
severity of the penalties it imposes. . . . For example, in 2005/06, the ?nancial penalties imposed by the
SEC exceeded those imposed by the U.K.’s Financial Services Agency (“FSA”) by a thirty to one ratio,
which, even after adjustment for differences in market capitalization, still translates into a ten to one
ratio. . . . The greater use of public enforcement in the United States is more than paralleled by
corresponding disparities in private enforcement and the use of the criminal sanction. Virtually alone,
the United States recognizes the class action and the contingent fee. The actual ?nancial sanctions
imposed by private enforcement in the United States exceed those imposed by public enforcement. . . .
The pre-Sarbanes-Oxley regime in the United States relied more than any other on penalties and
enforcement to deter fraud, yet it was the epicenter of the 2001 to 2002 scandals. What reason is there
to believe that even larger penalties will have a substantial deterrence effect? In this sense, the
Sarbanes-Oxley prescription looks like “just more of the same.” A possibly relevant factor, discussed in
section 2.4 above, is that managers who commit accounting fraud frequently have a “gambler’s
mentality,” loosely de?ned as an excessively strong belief in oneself or one’s company, and in the
likelihood that real performance will improve before their fraud is detected. Increased penalties seem
unlikely to deter people who can convince themselves that they are doing the right thing. The fear of 20
-year jail sentences seems more likely to make innocent but prudent managers report excessively
conservatively. One lesson from the demise of Arthur Andersen (and the demise a decade earlier of
Laventhol and Horwath) is that market-based effects, such as reputation, bonding, and insurance, are
large. Reliable ?nancial information is
62 These data were collected earlier by Jackson [2007], who reaches similar conclusions on this issue.
valued by investors, lenders, suppliers, employees, customers, and the public, so markets place a high
value on trust. In principle, reputational and other market mechanisms deter managers and auditors
from violating that trust. However, another lesson from the scandals is that reputation effects
sometimes can work the other way. Managers with reputations built around strategies that are widely
believed to be successful, but in fact are not (as in the Enron, WorldCom, and HealthSouth cases), might
perceive an incentive to hide their poor performance. Especially if they have an excessively strong belief
that real performance will improve before the fraud is detected, they might perceive their incentive as
being to preserve their reputation in the short run by faking results. Deterrence mechanisms aim to
reduce ?nancial reporting fraud by imposing costs on the manager or auditor, conditional on the fraud
being detected. The U.S. system historically has imposed seemingly high deterrence costs, yet this did
not deter the scandalous behavior in 2001 to 2002. All things considered, I am not convinced that
increasing deterrence costs even further is an ef?cient use of resources.
Attention also has been given to the extensive inspection, documentation, and certi?cation of internal
control structure and procedures for ?nancial reporting required by the Sarbanes-Oxley Act’s Section
404, and other provisions of the Act directed at improved fraud detection. These include requiring
external auditors to have direct access to the board’s audit committee, requiring audit partner (but not
audit ?rm) rotation, prohibiting audit ?rms from supplying various consulting activities to clients, and
protecting “whistle blowers” from retaliation. In contrast to its record in deterrence, there is some
evidence the preSarbanes-Oxley system worked relatively well in detecting and correcting false
reporting. One piece of evidence is the speed with which detection occurred. As Kedia and Philippon
[2007] observe, the welfare loss from ?rms overstating their ?nancial condition is that they overutilize
both labor and capital, distorting the allocation of real resources. Only when the overstatement is
revealed do they shed excess labor and capital. The welfare loss arising from the overstatement
therefore arises from the inef?cient use of resources during the period between in?ation and detection.
While the conclusion is subjective, my impression is that most of the ?nancial reporting fraud was
detected and revealed relatively quickly, and that failing managers and their failing strategies were
dumped relatively quickly, thus limiting the continuing losses. Miscreant managers, auditors, board
members, and counterparties were replaced relatively quickly (see Srinivasan [2005], Arthaud-Day et al.
[2006], and Desai, Hogan, and Wilkins [2006]). Another piece of evidence is the parties who uncover the
frauds. To my knowledge, there has been no systematic, reliable compilation of accounting fraud
detection during 2001 to 2002, but I am aware of no ?nancial reporting frauds that were detected by
regulators, as distinct from internal auditors, employees, external auditors, private parties on the other
side of irregular
transactions, security analysts, short sellers, the plaintiffs bar, and the press. This impression is broadly
consistent with the evidence of Dyck, Morse, and Zingales [2007]. 63 My conclusion is that the pre-
Sarbanes-Oxley system worked much better than is commonly believed in detecting and correcting the
problem that emerged in the 2001 to 2002 scandals (as distinct from preventing it in the ?rst place).
Whether the extensive provisions of the Sarbanes-Oxley Act will lead to better or earlier detection is a
matter for conjecture at this point.
Coffee [2007] raises the intriguing thesis that the United States employs an inef?cient regulatory model,
by allocating disproportionately high resources to enforcement of the law and punishment of securities
fraud after it has occurred and been detected. He describes this as “ex post” regulation, and contrasts
it with a system in which regulators consult more with companies “ex ante,” advising them on
appropriate behavior. He observes (Coffee [2007, p. 80]):
U.S. regulators are roughly comparable to those of other common law countries in their budget and
staf?ng levels, but not in the number of enforcement actions brought or the magnitude of the sanctions
imposed. Here, they inhabit a world largely of their own. This raises at least the possibility that, outside
the United States, more is done through “ex ante” regulation than through “ex post” enforcement.
Although the SEC also uses “ex ante” regulation, it seems more committed than other regulators to a
policy of general deterrence through large penalties.
Two features of the recent accounting scandals are broadly consistent with Coffee’s [2007] thesis: the
considerably lower frequency of reporting fraud in the United Kingdom, where the Financial Services
Agency regulates securities markets in a more consultative fashion and with less emphasis on
enforcement after the fact, and the comparative success of the U.S. system in detecting and correcting
?nancial reporting fraud, but not in deterring it in the ?rst instance.
7. The Long Run Cost of the Sarbanes-Oxley Act
From a political/regulatory perspective, the principal downside of the Sarbanes-Oxley Act seems to
have been viewed as its short-term compliance costs, especially for small companies and for potential
foreign registrants in the United States, and the public debate has been focused on
63 The Dyck, Morse, and Zingales [2007] data do not directly identify the party originally detecting
fraud. For example, many or most of the 14% of all frauds attributed to the media would have originated
in information detected by other parties and then revealed to the media. A similar observation can be
made about the 6% attributed to the SEC, which primarily acts on information received from other
parties, including auditors.
this issue. 64 From a market perspective, however, the principal costs would seem to be more long run in
nature. Chief among them is that the advent of the Sarbanes-Oxley Act signals an accelerated
politicization of corporate governance and ?nancial reporting. Common law countries, the United States
included, historically have enjoyed a largely common law governance system, with modest code law
intervention. They have operated a system of “shareholder value” governance, with major decision
rights attached to shareholders, who are the residual claimants on the ?rm (Alchian and Demsetz [1972]).
Increased politicization of corporate governance and ?nancial reporting places the historically
successful “shareholder” governance system at risk of degenerating into a “stakeholder” governance
system, with representation of major political blocs in writing the rules and in running corporations. This
is the system that produced the ultraconservative, low-quality ?nancial reporting system that is
associated with continental Europe (Ball, Kothari, and Robin [2000]). This system has de?ciencies from
the perspective of corporate governance and debt contracting (Ball [2001]). A major move toward such a
system would involve abandoning—not strengthening—the historical strengths of the U.S. system, in a
political overreaction to one episode of scandalous ?nancial reporting.
8. Concluding Observations
Markets need rules, and rely on trust. U.S. ?nancial markets historically had very effective rules by world
standards, the rules were broken, and there were immense consequences for the transgressors. The
system worked surprisingly well in detecting but not in preventing the problem. Was the Sarbanes-Oxley
Act an overreaction? It depends on whether one takes a market or a political/regulatory perspective.
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