Business Page February 10th, 2002


Lessons Of Enron
- Part 1

Introduction

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.

Charade

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.

Huge Price

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.

Creative Accounting

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.

Interesting Issues

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."

Political Influence

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.

Failed Safeguards

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.

Scrutiny

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.

Questionable System

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.

Auditor Independence

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.

Crisis

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 confidence.

Next Week

We will look at the domestic situation and enquire whether we are tolerating or encouraging our own Enrons' albeit on a much smaller scale.