TRACKS: Dual Accounting and the Enron Control Crisis

At the time of the Enron collapse, the new fair value accounting (FVA) paradigm was progressively incorporated into the framework of Generally Accepted Accounting Principles (GAAP), to serve along with the well-established historical-cost accounting (HCA) paradigm. Naturally, the Enron debacle involved misuses of both paradigms. As a result, the FVA–and in particular the “mark-to-model” valuation procedure–became a target for keen criticism. It was suggested that, apart from its application to a limited number of marketable financial instruments, the time of FVA had not yet come. In this paper, we reject this criticism and discuss the basic conditions that facilitated the abuse of FVA. We argue that despite the obvious advantage of value relevance information offered by the FVA paradigm, the lack of well-designed and effective, adequate control systems produced opportunities for the abuse and manipulation of FVA. We claim that the current control systems, designed for and capable of providing effective safeguards for HCA, are not suitable for FVA, and do not supply adequate safeguards for FVA. Furthermore, these existing accounting control systems turned into gauges for new standards and thus into barriers for FVA-based standards. These, among other reasons, caused the FVA to develop at a slow pace, creating a hybrid accounting system in which HCA and FVA are used simultaneously. We argue that the dual accounting system distorts the coherency of the reporting system, increases potential income management and “window dressing,” and nullifies the effectiveness of the existing control systems. We also stress that a well-designed and carefully implemented control system is indispensable for a properly functioning FVA model. We note that the proposed Statement of Auditing Standards, “Auditing Fair Values,” is an important step in the right direction.