Financial Illusion: Accounting for Profits in an Enron World
Hake, Eric R., Journal of Economic Issues
The rapidity of Enron's decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation. The physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can vanish overnight. A factory cannot.
In December 2001, the Enron Corporation and many of its subsidiaries filed for bankruptcy protection. At the time of filing, Enron was the largest bankruptcy in U.S. history, having previously ranked as the seventh largest U.S. corporation in terms of revenue. A string of similar high-profile bankruptcies followed, amid allegations of fraudulent accounting practices and the apparent failure of American securities market regulation (U.S. Senate Committee on Governmental Affairs 2002b).
While the fortunes of these corporations changed rapidly, it was not accidental. The problems that have emerged in recent years are the result of intentional design. The past twenty years have seen the rapid adoption of innovative financial techniques, while a renewed faith in the efficiency and stability of market structures has been used to justify a reduction in funding for capital market agencies. Corporate interests have increasingly influenced the construction and passage of accounting rules and market regulations. Touted as the growth of freely competitive markets, the current drift of economic policy is more clearly caused by the growing influence of narrowly defined corporate interests (Champlin and Knoedler 1999).
For the most part, critics of these trends have been dismissed. Those who do not believe the circular logic of natural efficiency- where the existence of a practice is evidence of its efficiency--argue the recent history of deregulation has produced an increasingly fragile capital structure in industry. Loosened oversight has encouraged the exploration of the boundaries of corporate practice, creating an economy where the manipulation of financial assets has become a more important source of corporate value than the act of production and sale.
Thorstein Veblen's description of the modern corporation provides valuable insight into the tendency toward financial fragility and the role of regulation. He argued the most important asset of the modern corporation was its expected future earning capacity-an intangible and volatile asset whose price was determined by social expectations about the future ( 1978; Raines and Leathers 1996). The nature of this asset benefits the consolidation of market power. Through the mechanism of equity finance and the stock market, the corporation is able to convert expectations of future profitability into contemporary purchasing power, purchasing power that can then be used to realize those expectations or simply to divert income. Consequently, the ability of the corporation to extend its influence and reorganize industry in the future is determined by the social perception of its worth in the present. To incorporate this social characteristic of corporate value, accounting conventions have necessarily evolved. Intangible assets such as goodwill, the growing sophistication of financial instruments and structured finance, and the use of the secondary stock market to define the constantly changing value of the corporation are evidence of Veblen's "credit economy."
Because corporate value is influenced by social perception, the foundations of the corporate economy are fundamentally prone to manipulation. Seeking competitive advantage or personal enrichment, managers may aspire to manipulate the value of the putative earning capacity of some block of capital (Veblen  1978, 155). While Veblen's description of the credit economy focused on particular assets generally conceptualized as goodwill, the growth of modern finance has simply extended the range and number of assets/contracts whose values are subject to a greater degree of future uncertainty and malleability. …