Some tentative thoughts on accounting scandals. Charles Oliver asks if current US accounting scandals mean that the US in 2002 is like Japan in 1989. I have some fears that he may be right.

Japan soared for a long time on a mistaken belief about the health of its companies and economy. It turned out that the books were cooked. Japanese accounting rules allowed companies to take bonds and split them between principal and interest (coupons and zeroes) and value the two parts equally. Of course, they weren’t equally valuable. So companies would sell the more valuable piece for a paper profit, and keep the less valuable piece on their books at above market value. Companies were hiding losses and pretending to show profits in this way for decades.

At the time, analysts in the US were smug. This practice wasn’t permitted under US accounting standards. Japanese companies made terribly made investments, but hid their mistakes. Eventually the chickens came home to roost and the Japanese economy went downhill. Japanese policy made things worse, trying subsidies and bailouts instead of forcing liquidation of mistakes. There was little policy credibility, and investors were unwilling to return.

Now we’re seeing accounting gimmicks here in the United States that hid losses and bad investments (at the root of Enron’s problems, despite all the chicanery, were bad investments … if their gambles paid off, we wouldn’t even know how the books were cooked). The outstanding questions are: how deep is the problem? and what will be the policy response?

The problem appears on the surface to be deep, in so far as more companies keep coming out with revisions to their financial statements. How deep we don’t yet know. However deep it is, it’s past and done. We need to ferret it out, but there’s nothing we can do to change the past.

The only variable left out in the open is the policy response. Legislatures are political animals and aren’t good at making accounting rules (remember that Congress asked the Financial Accounting Standards Board to lighten up in 1993 and not require companies to expense options). Congress (and the Democrats who controlled the chambers nine years ago) have little credibility here. Political animals seek easy and palatable solutions that either protect cronies and contributors or play on mass sentiment. Japan hurt themselves by refusing to allow the market to play out and liquidate bad investments.

Tough accounting standards are in order, but they won’t come from Congress. Congress needs to get out of the way of FASB. Fortunately, Senator Paul Sarbanes (D-MD) took this very same position on Meet the Press this morning. Corporate America’s credibility is at stake, and they know it. The recent scandals mean that cooking the books in the near term is not an option — there’s too much scrutiny.

Of course, smart people will figure out how to game the system. Any new rules will be overcome in time, and then we’ll be back to square one. This is really an intractable problem, and one that the market is likely not to solve with absolute certainty. The problem is that government intervention is only likely to make matters worse.