Enron Scandal: Impact on Accounting

Accounting for Enron

1. Why is accounting being blamed for the losses sustained by investors as a result of the collapse of Enron? Is this criticism fair and do financial accounting and reporting practices need to be reformed?

Accounting has been blamed for the losses sustained by Enron, as it allowed the company to hide details of its dealings from its investors, until the company’s financial situation was so bad that the firm was forced to go bankrupt almost overnight. Enron’s downfall has been characterised as “excessive interest by management in maintaining stock price or earnings trend through the use of unusually aggressive accounting practices.” (Healy, 2003) As part of this, Enron used “‘mark-to-market accounting’ for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions.” (Thomas, 2002) Under mark-to-market accounting practices, companies with outstanding derivative contracts or purchases on their balance sheets when accounts are being prepared must adjust them to “fair market value” (Thomas, 2002) As a result, predicted long term gains or losses on these contract are applied to the company’s profits immediately, similar to depreciation, or asset write downs. The main difficulty encountered when doing this for long-term futures contracts in energy markets is that “there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods, as Enron did.” (Healy, 2003)

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Another accounting technique Enron used to hide significant debts was the use of special purpose entities (SPEs), which Enron took to “new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities.” (Thomas, 2002) Enron also used these SPEs to hide details of assets which were excessively declining in value, thus avoiding having losses from asset write down and depreciation charges on the company books. This practice was applied to “certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public.” (Thomas, 2002) The accounting treatments around SPEs meant that the losses sustained on these asset write downs would not appear on Enron’s accounts. Enron promised share issues to the investors in the SPEs to compensate them for taking these assets on but, as the value of the assets fell even further, Enron found itself unable to meet these commitments from share issues.

These creative accounting techniques began to be suspected by investors in October 2001, when Enron several new businesses failed to perform as well as expected. Enron was hoping these new businesses would cover its losses on the SPEs but, in October 2001 the company was forced to announce a major series of write-downs of its own assets, including “after tax charges of $2.87 million for Azurix, the water business acquired in 1998, $180 million for broadband investments and $544 million for other investments.” (Healy, 2003) These write downs amounted to twenty two percent of the capital spent by Enron on developing its business between 1998 and 2000. In addition, Enron sold Portland General Corp., the electric power plant it had acquired in 1997, for $1.9 billion, at a loss of $1.1 billion over the acquisition price. (Healy, 2003) The losses incurred as a result of this caused investors to question whether Enron’s strategy was feasible in the long tem, and in markets other than derivatives.

In summary, whilst the accounting concepts and strategy underlying the gas derivatives trading was a reasonable attempt to produce value for investors, “extensions of this idea into other markets and international expansion were unsuccessful.” (Healy, 2003) However, whilst the mark to market and SPE accounting techniques used by the company helped hide this fact from investors, the stock markets as a whole were guilty of “largely ignored red flags associated with Enron’s spectacular reported performance” (Thomas, 2002). This aided and, in the eyes of the management at Enron, vindicated the company’s expansion strategy by allowing Enron access to plenty of capital cheaply and easily. As such, accounting cannot be entirely blamed for the losses sustained by investors, as the investors themselves simply assumed that the value Enron appeared to be generating “would be sustained far into the future, despite little economic basis for such a projection.” (Thomas, 2002) As a result, whilst accounting made it easier for Enron to mislead its investors, the facts show that investors themselves were more concerned with Enron’s reported profits and growth, than analysing the roots causes and business model.

2. Does it matter what accounting policies are adopted by a company as long as they are adequately disclosed?

A “very confusing footnote in Enron’s 2000 financial statements” (Thomas, 2002) described the transactions in question one, however according to analysts, “most people would be hard pressed to understand the effects of these disclosures on the financial statements, casting doubt on both the quality of the company’s earnings as well as the business purpose of the transaction.” (Thomas, 2002) By early 2001, several market analysts had begun to question the clarity and transparency of Enron’s disclosures. One analyst was quoted as saying, “The notes just don’t make sense, and we read notes for a living.” (Thomas, 2002) Enron publicly denounced and abused these analysts however, because of these actions, investors began to view Enron’s accounting policies, and disclosures, with greater and greater scepticism. Indeed, despite the fact that Enron’s disclosures were adequate in the regulatory framework, they were still not in the spirit of managerial responsibility to shareholders.

In another example of inadequate disclosure policies, Satava et al (2003) examined the celebrated Royal Mail Case and the implications of the case for the accounting practice today. Satava’s arguments claimed that the case was “not about the utilization of secret reserves, but about the non-disclosure of repayments by the Inland Revenue of over provisions for tax, and that defence counsel for the auditor succeeded because of the weak factual case presented by the prosecution.” (Satave et al, 2003) In summary, the duty of accountants to adequately disclose their accounting policies can often conflict with attempts by the same accountants to use these policies to benefit the company. As a result, these conflicts of interest often result in only materially adequate disclosures of substandard accounting policies.

3. To what extent did Enron use off balance-sheet financing in its operations? Were these transactions appropriately treated and adequately disclosed in the financial statements of the company? What consequences did the accounting treatment of these transactions have for Enron and its investors?

The main way Enron used off balance sheet financing was in its extensive use of SPEs to give it ready access to finance without having to report any debts it incurred in its accounts. The company contributed assets, and debt secured against those assets, to an SPE in exchange for control of the SPE, and the SPEs then borrowed large amounts of capital which was used to finance Enron, without any debt or assets showing up in Enron’s accounts. Enron also sold assets to the SPEs at above market value, and thus reported profits on these sales.

Enron used huge numbers of SPEs in this way, the most well known of which were LJM Cayman LP and LJM2 Co-Investment LP. “From 1999 through July 2001, these entities paid Enron managers more than $30 million in management fees, far more than their Enron salaries, supposedly with the approval of top management and Enron’s board of directors.” (Healy, 2003) The SPEs in turn created yep more SPEs, known as the Raptor vehicles, which enabled Enron to invest heavily in a bankrupt broadband company, Rhythm NetConnections, during the dotcom boom. To finance this investment Enron made a share issue worth $1.2 billion. However, in order to complete this deal, Enron increased shareholders’ equity to reflect this transaction, which has been claimed to violate accounting standards and principles. Additionally, accounting rules actually meant that Enron should have included information from the LJM and Raptor SPEs in their accounts, rather than continue to use them as off balance sheet financing. (Healy, 2003)

In addition to these minor violations, Enron revealed in October 2001 that several other SPEs had violated the accounting standard that required at least 3 percent of the entities to be owned by other investors, with no interest in the parent company. Again, by ignoring this requirement, Enron kept the financing it obtained from these entities off its balance sheet, enabling it to understate its liabilities and losses on this source of financing. However, on October 16, 2001, Enron announced that “restatements to its financial statements for years 1997 to 2000 to correct these violations would reduce earnings for the four-year period by $613 million (or 23 percent of reported profits dating the period), increase liabilities at the end of 2000 by $628 million (6 percent of reported liabilities and 5.5 percent of reported equity) and reduce equity at the end of 2000 by $1.2 billion (10 percent of reported equity).” (Thomas, 2002)

In addition to the accounting failures, Enron only disclosed the minimum amount of details on its investments in the SPEs, and the amount of financing it had gained from them. The company claimed that it had hedged some of its investments using special purpose entities, but failed to inform investors that Enron shares were being used as part of this hedge. Moreover, Enron allowed several of its senior managers, including its chief financial officer Andrew Fastow, to become partners of the special purpose entities. Thus, these employees were able to make large amounts of profit, in both cash and shares, from the off balance sheet financing provided by companies they partly owned. (Thomas, 2002) This was a clear failure to fulfil their fiduciary responsibility to Enron’s stockholders, and contributed to the extent of the company’s downfall.

4. Would similar treatment of off balance-sheet transactions be permissible in the UK?

Tollington (2001) is one of the foremost academics claiming that financial accounts no longer provide a true and accurate representation of the value of a business, due to the widening between the values accounting policies place on assets, and the market values of said assets. His paper argues that “the definitional requirement for ‘transactions or events’ appears to restrict their recognition,” and therefore disclosure on balance sheets, which enables similar off balance sheet transactions in the UK.

Equally, ‘white-collar crime’ has massively increased in recent years, with some estimates stating that over half a trillion pounds of criminal proceedings are laundered through the world’s financial markets each year. (Mitchell et al, 1998) The majority of this is moved in large quantities, and this cannot be done successfully without willing accountants, who can use creative accounting to hide any money laundering outside the scope of company accounts. However, new money laundering regulations mean that accountants, and related professionals, are now supposed to report any fraud or money laundering wherever they find it, and this applies as much to illegal activity the UK as to anywhere else.

Whilst securitization, which incorporates the use of SPEs for off-balance-sheet financing, has been extensively reviewed in recent years, there are still concerns over the extent to which off balance sheet financing can be abused, both in the UK and abroad. The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) recently introduced new standards, and modified their existing standards, in order to more rigorously define the acceptable accounting treatments for securities. (Satava et al, 2003) Whilst some accountant and analysts are still hoping to move towards a single, global, set of accounting standards, this is likely to take several times. Other jurisdictions are also keen to create a globally accepted set of standards, and in the UK the Accounting Standards Board (ASB) is converging with International Financial Reporting Standards (IFRS), commonly referred to as IAS, to minimise the extent to which off balance sheet financing can be practiced.

Two other factors have combined with the restructuring of financial and other industries in a way that has placed additional stress on the corporate governance function, and off balance sheet transactions: greater complexity of business structures and greater emphasis on stock prices. In the last decade or so, business has experienced a surge of fluid organizational arrangements as well as a routinisation of complex transactions, with alliances, joint ventures, multifaceted sale arrangements and hybrid, structured finance arrangements becoming commonplace. (Monks and Minow, 2003) The net effect is the economic boundaries of the firm have become ambiguous and extremely fluid, a phenomenon reflected in the wonderfully euphemistic phrase “off balance-sheet financing,” where the firm structures transactions and relationships to avoid their explicit recognition in traditional accounting displays. A typical example is a firm that holds a portfolio of mortgages. It places the portfolio in a free-standing legal entity with distinctly limited scope, a Special Purpose Entity, but continues the transaction processing and possibly provides credit enhancements. In different variations, inventory, research and development or even rights to future revenue cash flows are parked in Special Purpose Entities (Griffiths, 1995).

Reporting regulations allow the Special Purpose Entity to be kept off of the firm’s formal financial statements; as long as it is disclosed, provided substantive risk has been shifted to an independent third party. (Nelson, 2003) General Electric, an aggressive purveyor of these arrangements, for example, reports sponsored Special Purpose Entities with assets in excess of $50 billion in its 2001 financial report. The “independent third party” must have (among other things) a minimum of 3 percent ownership of the Special Purpose Entity’s equity and debt, although the Financial Accounting Standards Board in the US has recently tightened these requirements to resemble that of the UK. (Demski, 2003) However, Special Purpose Entities are only one aspect of this wave of organizational and financial innovation.

This greater degree of complexity has interacted with a corporate governance environment that has been placing heightened emphasis on shareholder value (Nelson, 2003), including an explosion in the use of option-based compensation. A substantial portion of the greater complexity appears to be motivated by a concern for financial presentation, for example, “beautifying” one’s balance sheet In some cases, the effect may be as simple as a matter of timing: for instance, the timing of selected expenditures and shipments can affect current period financial results, just as can the time at which a sale is formally booked or a loan is consummated. With the assistance of hybrid financial and organizational transactions, a lease can be structured so it does, or does not, show up on the lessee’s balance sheet, thereby affecting the total debt that a firm reports, through other methods than off-balance sheet financing. However, fundamentally, Enron, used Special Purpose Entities to disguise significant amounts of debt as commodity prepay transactions. Through a series of circular or round-trip prepaid transactions, this Special Purpose Entity was the centerpiece in “allowing” Enron to borrow money but to record the amount borrowed as cash generated by operations, because prepaid commodity contracts are generally booked as trades, not loans, a distinction which would have been clearer in the UK (Deminski, 2003).

5. Are principle based types of accounting standard like FRS 5 more effective in dealing with accounting abuses than the more rule based standards of the US?

Although the foundation of financial accounting and auditing has traditionally been based upon a rule based framework, the concept of a principle based approach has been periodically advocated since being incorporated into the AICPA Code of Conduct in 1989. Enron and similar events indicated that the accountants and auditors involved have followed rule based ethical perspectives, however these rule based standards have failed to protect investors from accounting abuses. Satava et al (2003) thus described how “rule based traditions of auditing became a convenient vehicle that perpetuated the unethical conduct of firms such as Enron and Arthur Andersen.” They presented a model of ten ethical perspectives and briefly described how these ten ethical perspectives impact rule based and principle based ethical conduct for accountants and auditors, concluding by identifying six specific suggestions that the accounting and auditing profession should consider to restore public trust and to improve the ethical conduct of accountants and auditors. Their conclusions showed that principle based standards were less open to abuses that rule based standards, provided the principles were well defined.

Indeed, the publication of a recent amendment to Financial Reporting Standards (FRS) 5 by Great Britain’s Accounting Standards Board, sought to clarify how to account for SPEs and similar entities, with emphasis on how the principles of the FRS 5 will apply to transactions conducted with these entities. Accountancy (2004) claimed that by publishing an amendment to FRS 5, the United Kingdom Accounting Standards Board was attempting to stop the flow of off balance sheet accounting, despite concerns expressed surrounding the amended FRS 5. The article provided information on an amendment to FRS 5, “Reporting the Substance of Transactions”, namely the addition of “Application Note G, Revenue Recognition”.

The note has been prepared in response to the need for clarity in respect to questions that arise concerning the treatment of revenue and, in particular, the treatment of turnover. The amendment was published as an Exposure Draft in February 2003 for public comment and, in finalizing the document; the Accounting Standards Board took into consideration the comments received in response to the draft and has consulted interested parties. In FRS 5, in the list of contents immediately preceding the summary, the list of Application Notes is extended by adding at the end, G Revenue Recognition and sets out basic principles of transaction and revenue recognition which should be applied in all cases This thus has increased the extent to which the principle based accountancy legislation in the UK can control the extent of off balance sheet transactions, and correspondingly increased the necessary amount of disclosure. (Accountancy, 2004)

However, it has been argued by some theorists that the reform efforts may have been unwise (Culp and Nickanen, 2003), due to a need to recognise that accounting is retrospective, and Enron’s problems were evident to investors if they used more forward looking information. The share price was declining long before the disclosures, quick surveys of four issues: the state of wholesale electric markets before and after Enron, the state of regulation of wholesale electric markets before and after Enron, online trading before and after Enron, and whether swaps need regulation, shows that accounting abuses must still have an underlying business reason. It has also been argued that Enron’s use of special entities for off-balance-sheet financing is a perversion of a useful, and often appropriate, accounting technique and such perversions can equally be applied to other techniques under principle-based standards.

Equally, it has been recognised that the latitude inherent in principles, or concepts, based standards can be a double-edged sword. “Such latitude allows managers to choose accounting treatments that reflect their informed understanding of the underlying economics of transactions.” (Nelson, 2003) This latitude, however, also permits managers to “advocate reporting treatments that do not reflect the underlying economics of a transaction.” (Maines et al, 2003) Both managers and accountants must have strong ethical principles in order for their accounting under principle based standards to reflect the true value of their business, especially in difficult times Both the SEC and the Auditing Standards Board in America support this view with their focus on the quality, as opposed to simply the acceptability, of financial reporting, as well as placing strong emphasis on “the need for expert judgment and unbiased reporting” (Maines et al, 2003)

Concepts-based standards have the potential to promote the financial reporting goals of the regulatory bodies in ways that rules-based standards cannot. However, in order for this to happen, individuals must possess a conceptual framework for financial information in order to use this information appropriately in decision making. Principle-based standards reflect a more consistent application of conceptual framework, and thus enhance individuals’ understanding of the frameworks. Thus, a concepts based approach is consistent with the FASB’s stated goal to “improve the common understanding of the nature and purposes of information contained in financial reports.” (Maines et al, 2003)

Also, principle-based standards are consistent with the stated goal of the FASB to promote convergence of accounting standards worldwide. The European Commission has recently proposed that the U.S. abandon GAAP in favour of the more flexible IAS, which emphasizes ‘substance over form’ in auditors’ inspection of the accounts. (Ampofo and Sellani, 2005) As a result, a concepts-based approach likely will lead to greater agreement in standard setting between the FASB and IASB and thus will also promote international harmonization. (Maines et al, 2003)

6. What has been the overall impact on corporate reporting of Enron and other recent financial scandals?

The events surrounding the demise of Enron have led to corporate reporting procedures being called into question all over the world. It resulted in critics questioning how adequate the disclosure legislation was at the time, and also to query how a major accounting firm could conduct independent audits of a firm they were engaged in major consulting work for, when the audit fees were tiny in comparison to the consulting fees. The “scandal threatened to undermine confidence in financial markets in the United States and abroad; and the accounting profession and regulatory bodies were forced to act.” (Swartz, 2005)

In a characteristic move, the SEC and the public accounting profession were among the first to respond to the Enron crisis. In a piece for the Wall Street Journal, the SEC Chairman Harvey Pitt called the outdated reporting and financial disclosure system the financial “perfect storm.” (Thomas, 2002) He stated that “under the quarterly and annual reporting system in place at the time, information was often stale on arrival and mandated financial disclosures were often, ‘arcane and impenetrable’” (Thomas, 2002) In order to reassure investors and restore confidence in financial reporting, Pitt called for “a joint response from the public and private sectors to strengthen regulations and prevent a recurrence of these events.” (Thomas, 2002)

As a result, since the Enron debacle, the global corporate reporting regulators were quick to move to stem the rising tide of public interest against their profession, displaying the banner “Enron: The AICPA, the Profession, and the Public Interest” on its Web site. (Shwarz, 2005) It announced the imminent issuance of an exposure draft on a new audit standard on fraud, the third in five years up to 2002, providing more specific guidance on corporate reporting standards than was found at the time in SAS no. 82, ‘Consideration of Fraud in a Financial Statement Audit.’ The Institute also promised a “revised standard on reviews of quarterly financial statements,” (Thomas, 2002) as well as the issuance, in the second quarter of 2002, of an exposure draft of a standard to improve the audit, transaction reporting and disclosure process.

The major piece of legislation to come out of the Enron scandal was the Sarbanes Oxley (SOX) report, which was passed by the U.S. Congress in 2002 in response to the demise of Enron and the WorldCom scandal. SOX requires firms to vouch for accounting controls and disclose weaknesses to shareholders, and almost all concerned parties have agreed that the SOX was a necessary and useful piece of legislation, that helped restore faith in U.S. companies and their financial statements. (Swartz, 2005) However, whilst no one disputes the benefits, business leaders have often complained that “the costs associated with Section 404 compliance are much higher than expected, and are an undue burden on most companies.” (Swartz, 2005) Many major companies, and some analysts, have criticised the large increases in auditing expenses, as these expenses create no direct value for businesses, and act to remove money from the economy which would otherwise be invested. Business lobbyists have also begun lobbying government bodies in the major financial centres, claiming that SOX slows business expansion and the growth in the number of available jobs (Swartz, 2005)

The level of complaints from companies about the increased costs associated with the new corporate reporting standards prompted U. S. auditing regulators, in May 2005, to move to ease the auditing expenses companies were forced to engage in, however regulators also said that the law has greatly benefited investors and there is no need for the U.S. Congress to change it at this time. (Swartz, 2005) Despite the obvious benefits that the increased level of reporting and disclosure provides to investors, many companies have complained that the compliance costs are too high, and that auditors force them to go through expensive corporate reporting procedures that accomplished little than to line the auditor’s pockets.

References:

1. Accountancy (2004) November 2003 Amendment to FRS 5 ‘Reporting the substance of transactions’: Revenue recognition. Vol. 133, Issue 1325, p. 128.
2. Ampofo, A. and Sellani, R. (2005) Examining the differences between United States Generally Accepted Accounting Principles (U.S. GAAP) and International Accounting Standards (IAS): implications for the harmonization of accounting standards. Accounting Forum (Elsevier); Vol. 29, Issue 2, p. 219.
3. Culp, C.L and Nickanen, W.A. (2003) Corporate aftershock: the public policy lessons from the collapse of Enron.
4. Demski, J. S (2003) Corporate Conflicts of Interest. Journal of Economic Perspectives; Vol. 17, Issue 2, p. 51.
5. Griffiths, I. (1995) New Creative Accounting. London: MacMillian.
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11. Satava, D. Caldwell, C. and Richards, L. (2003) Ethics and the Auditing Culture: Rethinking the Foundation of Accounting and Auditing. Journal of Business Ethics; Vol. 64, Issue 3, p. 271.
12. Swartz, N. (2005) Executives Praise SOX but Seek Changes. Information Management Journal; Vol. 39, Issue 4, p. 22.
13. Thomas, C. W. (2002) The Rise and Fall of Enron. Journal of Accountancy; Vol. 193, Issue 4, p. 41.
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