Lessons Of Enron
- Part 1
Suddenly Enron has almost become a household name around the world
because of a scandal that has severely challenged the integrity of the
accounting profession, tarnished its image and rocked the financial world.
It is only just overstating the significance of Enron to compare it with the
fallout from 9/11.In the space of four months, what was once the seventh
largest company in America, spiraled from high-flying darling of the
investment community into the largest bankruptcy in the history of the USA.
Despite umpteen Congressional Committees, it is clear that no one really
understood the company's financial statements or how the company made money.
Not the wizards of Wall Street, the financial press or the institutional
investors who were dazzled in varying degrees by ignorance, conflict of
interest and greed.
Enron started out as a lowly gas utility company in the Cowboy State of
Texas and progressed into the more lucrative but highly volatile world of
energy trading. Not satisfied with incremental growth and victim of their
own ambitions and greed, the company's executives decided that since the
company made millions buying and selling gas futures (which in simplified
terms is betting on projected gas prices), that it was time to move into
other areas. They felt that they could increase profitability by trading
other commodities such as electricity, water, high-speed internet access and
even media advertising time and spent billions on pursuing this strategy.
The problem was that the anticipated profits never materialized.
Billions in losses resulted and instead of being reflected in the
company's financial statements, they were camouflaged in a series of complex
private partnerships that investors had no idea existed. The charade seemed
to be successful and the company's stock continued to perform well for a
while until the problems started to surface. Then an avalanche of bad news
about bad investments precipitated a dizzying freefall into bankruptcy. The
Chief Financial Officer of the company who was apparently the architect and
beneficiary of many of the questionable transactions was forced out, and two
weeks later the company admitted that its profits had been inflated by in
excess of $586 million over the last five years.
Nothing but strong "buy" recommendations was the message to
investors and the stock doubled in value, tripled, split and doubled again A
huge price has been paid by thousands of employees many of whom had put in
as much of thirty years with the company and who have lost retirement funds
that they believed were secure. However the Enron situation has ironically
done a great service to the financial world by bringing to light all that is
wrong with the corporate world and the accounting, investment and financial
strategies it utilises. With everyone pleading the "Fifth' (the right
to remain silent) and the diabolical complexity of the schemes devised by
the company with advice from its accountants and attorneys, it is unlikely
that the world will ever know exactly the whole Enron story. With every new
revelation however, a slightly clearer picture slowly begins to emerge.
The company apparently used questionable accounting practices to hide its
financial problems which included huge debts and failed to disclose the
transactions fully in its financial statements for several years. Various
purported "investment vehicles " and partnerships were used to
conceal the problems and the auditors, one of the top five and largest
accounting firms in the world, (along with Ernst & Young with which this
writer has a relationship, Deloitte & Touche, KPMG Peat Marwick,
PricewaterhouseCoopers, known as the Big Five) Arthur Andersen allegedly
failed to uncover many of the accounting deficiencies during its audits of
the financial statements and compounded the problem by destroying many
documents relating to its audit of the troubled company. Very damagingly for
AA, however is the accusation that wearing its consulting hat, it offered
advice on structuring these transactions.
Among the other interesting issues that have arisen are the number of
Enron executives that are former Andersen employees and the executives who
were principals in some of the questionable partnership vehicles. There also
the professional issues for the accounting profession of consulting services
performed for audit clients, the influence of the quantum and the manner of
setting fees on audit independence and borderline accounting practices and
financial statement disclosures. The prestigious firm has even become the
butt of a joke by the US President Bush who was quoted in a newspaper as
saying that "The good news is that Saddam Hussein has agreed to weapons
inspections. The bad news is he wants Arthur Andersen to do it."
Politicians however are not untainted by the scandal since many Senators
and Congressmen from both the Democratic and Republican parties benefited
from the largesse of the company in the form of political contributions and
fund-raising activities of its chief executive. The US President himself
over the years received in excess of $823,000 in funds for his campaign and
inauguration. Among its directors is Chairman of the UK Media Watchdog and
it is known to have contributed to that country's governing Labour Party.
There have been accusations of Enron using its connections to influence
energy policy and also that as its demise became apparent approaches were
allegedly made to the Treasury Department of the United States government to
"encourage" banks to extend credit to the company. There is no
evidence of a favourable response.
Critics point to the failure of the safeguard that accounting firms
supposedly have in place to prevent events like those that occurred at Enron
because of the pressure on the firms' partners to keep clients happy and
their pockets full. While Arthur Andersen appears to have had more than its
fair share of embarrassments the other members of the revered Big 5 have
also had their own. Accounting firms themselves have publicly stated that
there is need for toughening of the rules because the ambiguity inherent in
current accounting conventions allows manipulation of profit and sales
numbers. The US has resisted international attempts to co-ordinate
accounting rules arguing that theirs are the best in the world. Enron will
probably cause them to revisit this boast.
Among the rules that will most certainly be subject to scrutiny are those
governing how an entity values its assets. The criticism is that the
Financial Accounting Standards Board which is private and controlled by
accountants, gives great latitude to companies like Enron in deciding when
to include as current, profits expected to be realized in the future. The
ability to create "special purpose" entities (such as the
partnerships which hid its losses to shift items from the balance sheet to
make it appear that the company owed less than it actually did) will also be
the subject of much debate.
The whole system of providing accounting information is now being
questioned with both Justice Department and Congressional hearings being
convened in the United States, and other countries seriously considering the
deficiencies in their own financial reporting systems. Each day a new
discovery surfaces that brings into question the soundness of the financial
infrastructure and exposes issues of conflict of interest among directors,
executives and even the prestigious accounting firm Arthur Andersen.
The development at Enron must be a complete vindication of Arthur Levitt,
former chairman of the Securities and Exchange Commission, who was in the
forefront of the fight to ensure auditor independence. By a remarkable twist
of irony and at the instance of the Big 5 led by AA and Deloitte &
Touche, he lost his job to Harvey Pitt, who had among his clients some of
those very Big 5 firms. Everyone is asking how a prestigious accounting firm
could repeatedly give its blessing on the corporation's financial
maneuvering that resulted in nebulous partnerships that gave rise to phony
profits and hid its mountain of debt.
There is now a universal call for a complete overhaul of the accounting
standards and financial disclosure practices of public companies since it is
felt that they do not allow for fair and accurate reporting of information
on entities' financial dealings. The proliferation of off-balance sheet
transactions is a source of great concern and have proven to be vehicles for
creating fictitious profits, hiding liabilities and in the case of Enron
self-dealing and enrichment by executives. The stock market in the US has
faltered badly because of a crisis of investor confidence and the much-publicised
breakdown of accounting safeguards has done nothing to bolster that
We will look at the domestic situation and enquire whether we are
tolerating or encouraging our own Enrons' albeit on a much smaller scale.