This Selected Issues paper presents updated IMF staff estimates of potential output growth for the United States, using data through 2001 that incorporates the full cyclical upswing of the 1990s and the subsequent mild recession, as well as taking into account the revisions to the national accounts released in July 2000. The paper also reviews recent investment trends and provides estimates of the extent to which the capital stock has deviated from its long-term equilibrium.


This Selected Issues paper presents updated IMF staff estimates of potential output growth for the United States, using data through 2001 that incorporates the full cyclical upswing of the 1990s and the subsequent mild recession, as well as taking into account the revisions to the national accounts released in July 2000. The paper also reviews recent investment trends and provides estimates of the extent to which the capital stock has deviated from its long-term equilibrium.

VI. Some Implications of Enron’s Failure for Market Rules and Institutions1

1. On December 2, 2001, the Enron Corporation, an energy-trading firm, filed for bankruptcy. With a reported $40 billion in liabilities, including nearly $10 billion in bond debt and $4 billion in bank loans, it was one of the largest corporate bankruptcies in history. The plunge in its share prices from $90 to near zero erased over $60 billion of market value, including a significant portion of its employees’ pension assets. Initial reports have suggested management abuses, as well as lapses in auditing and disclosure, while ratings agencies and stock market analysts have come under criticism for substandard analysis or recommendations allegedly biased by conflicts of interest.

2. Enron’s failure—and subsequent instances of accounting irregularities by WorldCom and other large U.S. corporations—have triggered intense scrutiny of corporate disclosure, accounting practices, and corporate governance in the United States, both by financial markets and by policymakers. A wide range of calls for reform have emerged on a number of fronts (the Administration’s proposals are summarized in Box 1). Most proposals rely on strengthening market-based rules and institutions to bolster market discipline, rather than on direct government regulation. This paper briefly reviews the major areas of emphasis as regards public disclosure of corporate information; accounting rules and the oversight of auditors; corporate governance; and conflicts of interest in market research.

A. Public Disclosure

3. Lack of proper disclosure was an important factor in the Enron case—the Powers Committee report (2002) states that Enron disguised key risks in its business from both its investors and its Board through a complex structure of partnerships and off-balance-sheet activities.2 This observation has raised concern regarding the adequacy of disclosure by other corporations, especially those with complex structures.

4. In recognition of the need for more transparent disclosure of risk, the Securities and Exchange Commission (SEC) has proposed new requirements for clearer language in the “Management’s Discussion and Analysis” section of financial statements, greater disclosure of critical accounting policies, and tighter disclosure rules for off-balance-sheet activities. To ensure timeliness of information, the SEC is considering requiring that annual reports be filed within 60 days after the end of a fiscal year, rather than the current 90-day requirement, and quarterly reports would have to be filed 30 days after the quarter’s end, compared with 45 days presently.

President’s Ten-Point Plan for Improving Corporate Responsibility

Each investor should have quarterly access to the information needed to judge a firm’s financial performance, condition, and risks.

Each investor should have prompt access to critical information.

CEOs should personally vouch for the veracity, timeliness, and fairness of their companies’ public disclosures, including their financial statements.

CEOs or other officers should not be allowed to profit from erroneous financial statements.

CEOs or other officers who clearly abuse their power should lose their right to serve in any corporate leadership positions.

Corporate leaders should be required to tell the public promptly whenever they buy or sell company stock for personal gain.

Investors should have complete confidence in the independence and integrity of companies’ auditors.

An independent regulatory board should ensure that the accounting profession is held to the highest ethical standards.

The authors of accounting standards must be responsive to the needs of investors.

Firms’ accounting systems should be compared with best practices, not simply against minimum standards.


5. Disclosure of other relevant information would also be accelerated under the SEC’s proposals. Certain stock transactions by insiders would have to be disclosed immediately, rather than by the tenth day of the month following the month in which the trading occurred. Companies would be required to report immediately “material events” such as: ratings changes; defaults or other events that could trigger obligations; offerings of equity securities not included in a prospectus filed with the SEC; and waivers of corporate ethics and conduct rules for officers, directors, and other key employees. Currently, many such events are not disclosed until the subsequent regular quarterly filing, if at all.

6. Efforts have also been launched at ensuring that outside parties play their proper role in interpreting and disseminating analysis of accounting information. A New York State investigation and SEC inquiry have examined brokerage practices and potential conflicts of interest between analysts and investment bankers. The New York State investigation resulted in a settlement with a major investment bank that involved a $100 million fine and commitments to disclose any fees received from companies being analyzed. The SEC inquiry will help determine the necessity of additional rulemaking and whether any laws have been violated.

7. In early May 2002, the SEC approved new rules, developed by the NYSE and NASD, which would manage and improve disclosure of conflicts of interest in cases where research analysts recommend securities in public communications. These included prohibiting analysts from being supervised by investment banking departments, disallowing analysts’ compensation from being tied to investment banking transactions, requiring securities firms to disclose compensation from investment banking clients, imposing “black outs” on trading by analysts around the time they issue their research, and requiring that analysts and securities firms disclose financial interests.

B. Weaknesses in the Accounting System

Oversight of accountants and auditors

8. The Enron case has highlighted the possible conflicts of interest that arise when accounting firms provide consulting services to firms they audit. Presently, consulting fees represent a significant portion of the revenues of accounting firms, and revenues generated from the cross-selling of non-audit business are often an important factor in the determination of employee compensation at accounting firms.

9. In response to these concerns, the SEC is considering proposals regarding the prohibition of compensation for cross-selling of non-audit-related services and stiff penalties for firms with substandard audit performance. However, the proposals currently contemplated would not require the separation of audit and consulting business, or the mandatory rotation of auditors, on the grounds that these measures would reduce the quality of audits.

10. Questions have also arisen regarding the effectiveness of the oversight of the accounting profession. Presently, the accounting profession is overseen by the American Institute of Certified Public Accountants (AICPA). The AICPA establishes auditing standards and ethics rules for the profession, but has very limited power to gather evidence or impose disciplinary actions.

11. In response, proposals have been made to establish an independent Board to supervise the accounting profession, with the SEC having primary responsibility for its composition and oversight. The SEC has proposed a new, part-time Public Accountability Board (PAB), whose nine members would be drawn mainly from the corporate and investor community. The PAB would have the authority to bar accountants from auditing public companies, a power that the present Public Oversight Board lacks. A maximum of three members would be drawn from the accounting profession and, to ensure its independence, the Board would be funded by mandatory fees on the accounting profession.

12. Two bills in Congress also address reform of accounting and corporate disclosure. The Senate began debate on July 8th of legislation introduced by Senate Banking Committee Chairman Paul Sarbanes. The Senate bill would establish an accounting oversight board which, like the SEC proposal, would have a majority of members drawn from outside the accounting profession. The board would be overseen by the SEC, and would set accounting standards. Some changes, though, would be mandated by the legislation, like a prohibition on providing certain consulting services to audit clients, and requiring disclosure of off-balance sheet transactions. The bill would require CEOs and CFOs to vouch for the accuracy of financial statements. The House passed a version of a similar reform bill in April.

Weaknesses in specific accounting rules

13. Enron’s failure has highlighted several areas where accounting rules may need to be strengthened in order to ensure confidence in corporate financial statements, including earnings management, accounting for employee grants of stock options, and rules for consolidation of off-balance-sheet activity.

14. Earnings management occurs when firms manipulate the time at which revenues or expenses are recognized to alter the pattern of reported earnings. Academic studies suggest that firms may seek to shift forward revenues in order to avoid falling short of consensus forecasts of earnings, reporting a decline in earnings from the previous year, or posting a loss.3 In addition, firms tend to alter discretionary accruals to boost reported earnings just prior to an initial public equity offering (IPO) or a seasoned equity offering.4 Firms may also seek to smooth their earnings over time, since stocks with a more volatile earnings stream are considered riskier and receive lower valuations.5

15. There are concerns that several techniques have been used to inflate earnings. For example, firms may book revenues for goods shipped to a distributor but for which a sale to a final customer has not been made (“channel stuffing”). Firms that sell receivables through securitizations may book as current income the “gain on sale” of the receivables. Firms may also boost earnings by booking expected capital gains on securitized assets as current income and engage in sales of nontraded securities among subsidiaries.

16. In order to address this issue, the SEC has tightened its scrutiny of financial statements in an attempt to weed out these abuses, and initiated a record number of investigations during the first quarter of 2002. The Financial Accounting Standards Board (FASB) is examining the issue of the timing of revenue recognition. In addition, investors have become more critical of accounting practices, and heightened market scrutiny has depressed stock valuations of firms perceived to manipulate their earnings.

17. The accounting treatment of stock options granted to employees has generated significant controversy. Grants of stock options by firms to their employees do not require cash outlays, and are not deducted from income under current accounting treatment. Stock options do, however, dilute shareholders’ claims on the firm, and many observers—including investor Warren Buffett and Federal Reserve Chairman Alan Greenspan—have argued that employee stock options are a form of compensation and should be deducted from income.6

18. Opponents of changing the accounting treatment of options raise concerns that rules requiring expensing would adversely affect high-tech industries, which use options extensively to attract and retain employees. However, proponents note that the rules would not restrict the ability of firms to grant options, or increase their cost, but would only make the impact on earnings more explicit. Research suggests that stock valuations react to fully diluted earnings per share (that is, after adjusting for stock options outstanding), thus suggesting stock prices may have already incorporated information on stock options grants.

19. Concerns have also been raised about how stock options grants would be valued. Supporters of the expensing of stock options make the case that option-pricing models could provide a reasonable estimate that would be perhaps no more uncertain than estimates of depreciation of plant and equipment, which are already deducted from income.

20. Currently, FASB is considering a rule that would require stock option grants to be deducted from income. In addition, the International Accounting Standards Board (IASB) plans to develop rules for accounting for grants of stock options to employees.

21. Enron’s extensive use of limited partnerships (LPs) and special-purpose entities (SPEs) to shift losses and debt off its own balance sheet has led to scrutiny of the rules for consolidation of off-balance-sheet activities back onto the sponsor’s books. Off-balance-sheet entities are used for a wide range of legitimate activities, from securitization vehicles used to finance receivables and “synthetic” leases holding commercial properties, to subsidiaries responsible for research and development projects at pharmaceutical companies.

22. U.S. regulatory and accounting experts have emphasized that a main determinant of whether an entity should receive off-balance-sheet status or should be consolidated is whether the risks and rewards of the activity have been transferred to investors in the entity. If no such transfer of risk and reward has been accomplished, then the set of transactions should be consolidated in the accounts of the party that retains the risks and rewards.7 As a backstop, U.S. accounting standards have required a minimum of 3 percent of the entity’s total capital structure be funded with outside equity.

23. In response to concerns that these requirements are too lenient and may have contributed to Enron’s abuses, FASB is considering a rule that would require a 10 percent outside equity stake to retain off-balance-sheet treatment and avoid consolidation.8 Market forces have also begun to discipline the use of off-balance-sheet accounting. During early 2002, the stock prices of firms with complex financial structures have fallen relative to the broader market, which has encouraged many firms to simplify their off-balance-sheet activity and improve disclosure of these transactions.

Accounting framework: rules versus general principles

24. The overall framework for U.S. accounting rules, or Generally Accepted Accounting Practices (GAAP), has been characterized as overly complex and rules driven. While U.S. standards are based on principles, the body of requirements has evolved to a rules-based approach. It has been argued that this results in a “check the boxes” approach in verifying a company’s financial statements, and that auditors focus on simply ensuring that the accounting treatment fulfills the letter of the law. As a result, firms are provided with incentives to tail or transactions in order to meet these narrow rules.

25. The accounting framework under the International Accounting Standards Board (IASB), in contrast, emphasizes general accounting principles. Company officials and their auditors are expected to apply a greater amount of professional judgment to determine what treatment is appropriate for any specific set of circumstances. This emphasis on judgment is intended to ensure the focus of auditors and companies is on adherence to the spirit, rather than the letter, of the rules.

26. Both the SEC and FASB have endorsed an evolution of U.S. accounting standards to a principles-based code such as that under the IASB. It is likely, however, that a transition to this type of system would be gradual, and would be focused mainly in areas where there were obvious advantages of the principles-based system.

Corporate governance

27. Enron’s failure also illustrated significant weakness in corporate governance. The Powers Committee suggested that Enron’s board of directors failed to grasp the nature of the risks the firm faced, and allowed employees to manage partnerships that generated significant conflicts of interest. The audit committee of Enron’s board also overlooked the company’s increasingly aggressive accounting practices, and the compensation committee neglected to review properly the compensation awarded to management.

28. This experience has triggered a range of reform proposals aimed at improving standards of corporate governance. These include: strengthening the boards of directors, especially the role of outside directors; enhancing the independence of audit and compensation committees; and emphasizing the accountability of senior management and directors in their fiduciary responsibility to shareholders. Since corporate law has been the responsibility of the states within the U.S. federal system, any changes to corporate governance issues would rest with the states.9

29. Nonetheless, market institutions have begun to take a lead in strengthening corporate governance. For example, the major stock exchanges (NYSE and Nasdaq), which include standards for corporate governance in their listing standards, have announced plans to tighten these requirements. The proposals would involve rules to enhance the role of outside directors; to set stricter requirements for the definition of “outside” directors; and introduce requirements that stock-option grants in compensation packages be subject to shareholder approval.10 Firms that failed to meet these standards would be denied the right to list their shares on public exchanges.

List of References

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  • Burghstahler, D., and I. Dichev, 1997, “Earnings Management to Avoid Earnings Decreases and Losses,Journal of Accounting and Economics, 24, pp. 99-126.

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  • Chaney, P. K., and C. M. Lewis, 1998, “Income Smoothing and Underperformance in Initial Public Offerings,Journal of Corporate Finance, 4, pp. 1-29.

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  • Degeorge, F., J. Patel, and R. Zeckhauser, 1999, “Earnings Management to Exceed Thresholds,Journal of Business, 72, pp. 1-33.

  • Pitt, H. L., 2002, Written Testimony Concerning Accounting and Investor Protection Issues Raised by Enron and Other Public Companies, Testimony before the Committee on Banking, Housing and Urban Affairs, United States Senate, March 21.

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  • Powers, W. Jr., 2002, Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp., February 1.

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  • Teoh, S. H., I. Welch and T.J. Wong, 1998a, “Earnings Management and the Underperformance of Seasoned Equity Offerings,Journal of Financial Economics, 50, pp. 63-99.

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  • Teoh, S. H., I. Welch and T.J. Wong, 1998b, “Earnings Management And The Long-Run Performance of Initial Public Offerings,Journal of Finance, 53, pp. 1935-1974.

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Prepared by Calvin Schnure.


For example, see Powers (2002), p. 17.


Currently, the granting of options is only reported in financial statements, but not deducted from income.


An important factor in making this judgment is whether the sponsor exerts control over the SPE. Control is not an issue in many SPEs, where permitted activities are narrowly limited in the vehicle’s charter.


Enron was in violation of the 3 percent rule from 1997to 2001. For a discussion, see Powers (2002).


Nonetheless, the SEC has proposed a rule that would require the Chief Executive Officer and Chief Financial Officer to certify the accuracy of their companies’ financial statements.


The NYSE proposals are currently posted for public comments and are scheduled for consideration by NYSE’s Board of Directors on August 1, 2002.