AOL Time Warner reports a net loss of $54.2 billion in the first quarter. This staggering number comes just a day after a news report that among the bankruptcies involving the 50 largest companies during the past five years, auditors made no reference to such a possibility for 38 of them.
In the most notorious example, Ernst & Young gave Loehmanns, a clothier, a clean bill of health just 18 days before the firm filed for Chapter 11 protection.
Something is rotten here. As an economist, I’m troubled by the apparent and willful disarray in corporate accounting and public auditing.
Why? Because truthful and accurately descriptive accounts are crucial to the function of a modern mixed-market economy such as we have here in the United States.
This is one of the subjects that introductory economics texts skim blithely over in the first or second chapter. Setting and enforcing the rules of contract and commerce is a function of government that all but the most libertarian economists describe as legitimate and necessary.
But we’re so used to the wealth that modern market economies can produce, we can easily forget how the system works and what can happen when the system doesn’t work.
People have been enterprising, and commerce has existed, since before the dawn of recorded history. But it wasn’t until 500 years ago that humans developed many of the institutional innovations that have brought so much prosperity.
And for those anti-market ideologues who decry the “unbridled competition” aspect of market economies, it’s important to note that these crucial innovations largely involved cooperation rather than competition.
Enterprising businessmen in northern Italy and the Low Countries — what are now The Netherlands and Belgium — developed and perfected modern accounting, joint stock, limited-liability corporations, insurance, options and futures contracts in the fertile period roughly spanning 1450 and 1600 A.D.
Double-entry accounting, insurance and joint-stock corporations allowed business enterprises to expand beyond what was possible when resources and management were limited by the purse and eye of one individual.
Stock corporations allowed people to put their savings to work in productive enterprises without having to manage the business themselves. Insurance reduced the risk of loss to individual owners or shareholders from shipwreck — important when so much of business was seaborne commerce — or other perils.
Modern double-entry accounting helped owners know what was going on in increasingly far-flung businesses. It gave owners and managers a tool to deter malfeasance by far-off agents. And increasingly uniform accounts gave passive investors improved, though not perfect, information about what was being done with their money.
Good, informative accounts also made it easier for bankers to assess the degree of risk inherent in lending to any business, proprietary or incorporated. Good information and reduced risk always cause more effective use of resources than is possible with bad information and great risk.
This institutional innovation in commerce sounds mundane compared to the ebb and flow of religious wars and the flowering of art that occurred in Europe at the same time.
But in terms of effects on our lives today, these developments by merchants in Milan, Antwerp and Amsterdam were perhaps the most profound. Success at putting capital to productive use is what sets the industrialized economies of the world apart from the rest.
But for capital markets to function well requires that there be honesty and transparency in public financial statements. Fiascos like Enron cut at the heart of investor confidence, which makes economies grow.
To be sure, financial statements and stockholder information are still much better now than 125 years ago, when financiers and railroad barons such as Leland Stanford, Henry Frick and Jay Gould regularly defrauded those who invested in stocks of firms they controlled.
The U.S. economy grew well in the late 1800s despite this lack of transparency, not because of it. The establishment of the Securities and Exchange Commission was a victory for capitalism, not over capitalism.
And on the whole, U.S. investors get better information and better treatment than their counterparts in nearly any other country. That is why so much Argentine, Japanese and Middle Eastern and European money flows to the United States.
But frauds like Enron are a cancer in the body of capital markets.
Accounting firms that note no financial problems in reports issued less than three weeks before a firm files bankruptcy papers erode public trust. And while AOL Time Warner’s loss of goodwill was known long before that firm issued its earnings statement, the fact that a firm is forced to announce a loss equal to the annual GDP of several developing counties combined makes many question the reliability of financial statements over the preceding decade.
The United States has done well over the years with a mix of public and private supervision of corporate accounting. The governmental SEC requires certain periodic reports and disclosures. Private bodies such as the American Institute of Certified Public Accountants (AICPA) and Financial Accounting Standards Board (FASB) spell out detailed standards for accounting and auditing.
But somehow the system has broken down. Public confidence in corporate financial disclosure is at its lowest point in decades.
Unless private sector institutions move quickly and decisively to cure matters, citizens will demand that the government take action. Our nation’s continued prosperity and growth depend to a significant degree on the outcome.
© 2002 Edward Lotterman
Chanarambie Consulting, Inc.