Corporate Fraud

I've just been re-reading Malcolm Gladwell's New Yorker article on the collapse of Enron. He utilises a distinction between 'puzzles' and 'mysteries':

Osama bin Laden’s whereabouts are a puzzle. We can’t find him because we don’t have enough information. The key to the puzzle will probably come from someone close to bin Laden, and until we can find that source bin Laden will remain at large.

The problem of what would happen in Iraq after the toppling of Saddam Hussein was, by contrast, a mystery. It wasn’t a question that had a simple, factual answer. Mysteries require judgments and the assessment of uncertainty, and the hard part is not that we have too little information but that we have too much. The C.I.A. had a position on what a post-invasion Iraq would look like, and so did the Pentagon and the State Department and Colin Powell and Dick Cheney and any number of political scientists and journalists and think-tank fellows. For that matter, so did every cabdriver in Baghdad.

His point is that treating Enron as a puzzle means an increase in information, however the problem arose because of a lack of judgment about the content of existing information. As he points out, a 1998 business school project at Cornell reported that:

Enron was pursuing a far riskier strategy than its competitors. There were clear signs that “Enron may be manipulating its earnings.” The stock was then at forty-eight dollars—at its peak, two years later, it was almost double that—but the students found it over-valued.

This information was in the public domain

My immediate reaction it to tie this into the work of Henry Manne, who's work on insider-trading has greatly influenced my thoughts on accounting regulation. But the Gladwell article also brought up the role of the taxation system:

one of the critical clues about Enron’s condition lay in the fact that it paid no income tax in four of its last five years... Enron wasn’t paying any taxes because, in the eyes of the I.R.S., Enron wasn’t making any money.

If you looked at Enron from the perspective of the tax code, that is, you would have seen a very different picture of the company than if you had looked through the more traditional lens of the accounting profession. But in order to do that you would have to be trained in the tax code and be familiar with its particular conventions and intricacies, and know what questions to ask. “The fact of the gap between [Enron’s] accounting income and taxable income was easily observed,” Fleischer notes, but not the source of the gap. “The tax code requires special training.”

I recently asked a senior accountant at a large US company about Enron, and his response was intruiging: they had become suspicious about Enron's reporting and had long since stopped doing business with them. The real issue isn't how to improve the level of information, but to better utilise it. Those who looked could tell that Enron was overvalued, and yet it persevered. The question is how we can better utilise knowledge, so that the general public - the man on the street - is as close to the action as the professional. Insider-trading and a simpler tax code might help.