The real value of Enron may be as a worst-case example of the need for clearer accounting rules.
New York Times; New York, N.Y.; Mar 14, 2002; Hal R. Varian

THE Treasury secretary, Paul H. O'Neill, was roundly criticized in January for saying the collapse of Enron was part of the ''genius of capitalism.'' But he had a point. The people who made the decisions leading to the Enron fiasco have been publicly humiliated, and this has not gone unnoticed by other executives.

The stock prices of companies with obscure and incomplete financial reports have suffered since Enron's collapse, and many have scrambled to supplement their official reports with additional detail to reassure market analysts. Even blue chips like I.B.M. and General Electric have pledged far greater disclosure from that provided in the past.

Companies naturally want to trumpet the good news and hide the bad, but this means that silence will inevitably be interpreted as bad news. Usually it is better to put the bad news out on the table along with everyone else, rather than suffer by comparison.

Two years ago, when the whole technology sector was booming, companies wanted to make sure their earnings reports kept up with the pack. This led to exaggeration in many cases and, apparently, to outright fraud in some instances.

Last spring, when the economic downturn was taking its toll, the same herding instincts were at work, and many companies used this as an opportunity to take big write-downs on bad investments. The market grades on a curve, to some extent, and getting a C+ when everyone else was getting C's wasn't so bad.

A wise investor will recognize that things are never as good as they appear, but they are seldom as bad, either.

Mr. O'Neill was right to remind us that the market does punish those who mislead. But still, one has to ask whether market forces alone are enough to guarantee good behavior. Is regulation of financial markets superfluous?

Let's try an analogy. One might argue that we don't need laws against reckless driving. After all, the really reckless drivers will end up in accidents, so ''market forces'' will punish them appropriately. It's not hard to see the fallacy in this argument: accidents that punish the reckless driver might well injure innocent pedestrians.

Market forces alone aren't adequate to ensure either appropriate driving behavior or adequate information disclosure, and it's for the same reason: the third parties who can be injured through reckless behavior.

Even though a driver may appropriately trade off his own benefits and costs from speeding, he would not generally take account of the costs he imposes on others. The same thing is true of a chief executive.

Options compensation packages are a case in point. They are offered to executives to give them strong incentives to maximize shareholder value. But when? When the executive wants to sell, which is not necessarily when the shareholders want to sell.

Options compensation has other problems. Senators Carl Levin and John McCain recently introduced a bill, the Ending the Double Standard for Stock Options Act. The double standard they refer to is that options are treated as an expense for tax purposes but not for earnings reports.

True, a savvy investor poking around Securities and Exchange Commission filings can usually figure out what options have been granted, and companies are required to report earnings adjusted for potential dilution from the exercising of options.

But companies prefer to report options packages in footnotes or tucked away in a table at the back of the annual report. Why make it so hard? Companies should be required to report options compensation explicitly, like any other employee compensation.

A venture capitalist I know once complained that ''the S.E.C. only sees options as an expense, whereas we see a powerful incentive mechanism.'' Well, if that's true, then companies should want to brag about what great incentives they have in bold type at the front of their corporate report, not hidden in footnotes at the back.

Options are indeed a powerful incentive mechanism, and their use can certainly be in the interests of the shareholders. But the shareholders should be able to find out easily just how much those options packages are costing them. A new rule from the S.E.C. that takes effect this year will help in this regard, but it goes only so far.

The very fact that options provide such strong incentives means that the temptation to inflate stock prices artificially will also be strong. So, increased use of options compensation may need to go hand in hand with tighter regulation. To return to the driving analogy: would you be more tempted to speed when driving a V-8 Corvette or a 4-cylinder Subaru station wagon?

Companies are now keeping two sets of books: one for the S.E.C. and one for the I.R.S. A recent working paper by a Harvard Business School professor, Mihir Desai, shows that the gap between income reported to shareholders and taxable income widened sharply in the 1990's. According to his estimates, in 1998 income reported to shareholders was an average 63 percent higher than taxable income. Of this gap, roughly 26 percent was attributable to exercising options.

Companies shouldn't have to keep two sets of books. But reconciling the accounting treatment of options isn't so easy: the I.R.S. values options when they are exercised, so there isn't any ambiguity about how much they are worth. The market value of options when they are issued is more problematic.

Standard valuation methods, like the Black-Scholes options pricing formula, make sense for established companies, but new ones just going public don't have the track record necessary to apply these techniques. Furthermore, the whole point of using options compensation is the hope that the high-powered incentives it provides will change the future behavior of the stock price.

A possible compromise for such cases might be to make sure the details of the options packages are clearly, prominently and fully disclosed and let investors apply their own valuation rules.

The ''genius of capitalism'' depends critically on having clear rules and transparent reporting. They say you've never sunk so low that you can't serve as a bad example. Perhaps that will, in the end, be Enron's greatest contribution to the American economy.