Question

In 2000, the high flying company Enron completely collapsed taking venerable accounting and audit firm Arthur Anderson along with it. There were some warning signs, but right up to the end, an examination of the company’s financial statements showed a healthy company with no reason to be concerned. Of course, the numbers were fiction, as were many of the operations of the company itself. This meltdown ultimately led to passage of the Sarbanes- Oxley Act of 2002, which requires the CEO, CFO, CIO and all of their supporting managers to certify that the financial information being reported is correct and accurate. Penalties for failure to comply are severe.

Plato wrote of the analogy of the Cave – prisoner’s only experience of reality is what they see reflected in the shadows on the blank wall in front of them. Think about the financial statements discussed above. How are they real and how are they simply reflected shadows? And if they are simply reflected shadows, what do we need to do as managers to ensure that they are an accurate reflection of the business, and not just a shadow?

Answer 1

The financial statements discussed above are simply reflected shadows of the ethics, morals and principles of the managers of an organization. Managers are agents of the shareholders (who are the principals). Managers often present a false financial picture of a company by using means like window dressing the books of accounts.

In the case of Enron the managers of the company inflated the revenue of the companies and deflated its costs to present a false picture that the company was on a strong financial ground (when in reality the company was struggling). This was done by the managers in their role as agents whose role was to add more value for the stakeholders and drive the growth of the company. When the managers failed to meet these objectives they cooked up the books and presented a false picture to the investors and other stakeholders of the company.

As managers, to ensure that the financial statements are an accurate reflection of the business and simply not reflected shadows, we (i.e. the managers) should balance and align the interest of the agents and the principals. When the interest of the agents and the principals are aligned then the agents will have no incentive or hidden motive to present false picture through cooked up books. This will ensure that financial statements are an accurate reflection of the business and are not merely reflected shadows.