Unleash the SEC

Larry Kudlow
Posted: Feb 07, 2002 12:00 AM
If we have learned anything from the Enron mess, it is that this country desperately needs a complete overhaul and reform of its accounting standards and financial-disclosure practices. Of course, Enron's culture of deception -- including intentional falsification of documents, individual self-dealing and self-enrichment, and the deliberate misinforming of investors -- is not representative of American business life. Yet accounting practices in recent years have become a hindrance rather than a help to the investing public. This decline of honest accounting can be traced to the proliferation of the exact off-balance-sheet vehicles you hear so much about in the case of Enron. These "special purpose" entities and private partnerships are not truly independent. Rather, they have proven to be fertile ground for insider self-dealing, hiding debt and creating fictitious profits. These entities also require the services of some crafty accountants, people who will make sure that a company's balance sheets and income statements mislead rather than instruct. And that's when investors lose confidence. This is part of the "Enron effect" that we're seeing today. The stock market recovery has been blocked because of a widespread investor revolt against the breakdown of accounting safeguards and transparency. And investor confidence will not return until the accounting crisis is fixed. In his State of the Union message, President Bush called for "stricter accounting standards and tougher disclosure requirements." This was a good start, but there must be a proactive policy follow-through. The key law-enforcement agency for accounting supervision is the Securities and Exchange Commission (SEC). The Bush administration should be moving aggressively to increase the SEC budget in order to hire as many new auditors as are needed to exercise proper oversight of the accounting industry, and to formulate new accounting rules and standards. While I'm not in favor of over-regulation, basic law enforcement of accounting rules is integral to our free-market and investment system. In a sense, the SEC should become the FBI of accounting. It should make the rules and do the enforcing -- similar to how the Federal Reserve Board watches the banks. The rule of law, with proper enforcement sanctions, is vital to restoring confidence in our investment system. Only the SEC can do it. What's more, the obvious conflict of interest between auditing and consulting must be eliminated. Accounting firms can do one or the other, but not both. To inform rather than mislead investors, corporate balance sheets must be unified and consolidated to include all subsidiaries, affiliates and partnerships. New profit- and loss-reporting rules should move the system toward conservative cash-flow-based accounting standards that have clear economic meaning. Severe penalties are also a key part of the solution. So far, it is disappointing that the Bush administration's new budget has only a small cost-of-living increase for the SEC. Congress has passed a law for pay parity between SEC staff and their counterparts at the Federal Reserve and other banking-related agencies. But the Office of Management and Budget (OMB) has thus far failed to fund this congressional mandate. New SEC Commissioner Harvey Pitt is talking about yet another outside advisory board to oversee accounting changes, but in the past such boards have been overly influenced by an accounting lobby determined to obstruct real reforms. Simply, in the same way that the Federal Reserve watches the banks, oversight of the securities and accounting industries needs to come directly from the SEC. If it doesn't, we're only going to see more Enron's. Think of it this way: Just as a carpenter knows that a yardstick has 36 inches -- not 32 or 29 -- investors need to know that the information they receive is not a few inches short of the truth. And the sooner Bush and Congress can light a fire under the OMB and SEC, the sooner this accounting crisis will be resolved. Then our 100-million-strong investor class will regain confidence and return to the productive investing that will finance an economic recovery.