Examining Abuse at Enron: How Following the Rules Helped Shield DebtPublished: April 10, 2002 in Knowledge@Emory
As with all scandals, the media is hungry. Not a day goes by that the newspapers and cable news shows don’t at least mention Arthur Andersen’s alleged accounting improprieties that may have contributed to the stock crash and ensuing Chapter 11 bankruptcy at energy trader Enron Corp. The latest news on the accounting front came last Thursday when Andersen Worldwide, the umbrella corporation that includes Andersen, named Aldo Cardoso acting CEO. Cardoso replaces Joseph Berardino, who quit in late March after the U.S. government indicted Andersen for having destroyed evidence on its role as Enron’s auditor.
The Enron debacle is undoubtedly a turning point in history for a number of reasons, in particular how it will affect the laws that govern the accounting profession. Even before new legislation, auditors were making fundamental changes. Following criticism that offering non-audit consulting services corrupts the independence of CPAs, all of the Big 5 CPA firms announced they will no longer offer consulting services to their auditing clients.
That, say experts, is likely to be only the beginning. Step one in determining the full scope of implications for auditors requires understanding the details of Enron’s business dealings and the company’s relationship to its long-time auditor, Andersen. Not an easy task. George Benston and Al Hartgraves, professors at Emory University’s Goizueta Business School, have tackled that challenge with the help of the nearly 200-page Powers Report, which was compiled over three months and published specifically to analyze the Enron situation. They gleaned additional knowledge from numerous stories in the press and from testimony at Congressional hearings. The result is an article forthcoming in the Journal of Accounting and Public Policy entitled "Enron: What Happened and What We Can Learn From It."
"The major reason we decided to write this paper now is that Congress is considering legislation that would either change the existing regulation or additionally regulate the accounting profession," explains Benston, a professor of finance and accounting, and the lead writer of this paper. "The other part is that it’s simply hard to make sense of all this."
Benston and Hartgraves, a professor of accounting, break their analysis, the heart of the paper, into three sections. First they identify six important accounting issues of primary importance to the Enron debacle, then look at Enron’s accounting procedures relative to them, and then show the financial-reporting consequences. Second, they consider issues of governance, the role of the directors, audit committee and other gatekeepers. And third, they draw lessons from the corporate catastrophe.
By now, most people are aware of at least the preliminary facts in the Enron disaster. Last October, Enron, one of the world’s largest corporations, announced it was reducing its after-tax net income by $544 million and its shareholders’ equity by $1.2 billion. On November 8, it announced that, because of accounting errors, it was restating its previously reported net income for 1997 through 2000. These changes reduced its stockholders’ equity by $508 million. On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. With assets of $63.4 billion, the authors point out that it is the largest U.S. corporate bankruptcy.
How did this happen? Andersen’s accounting practices reportedly had a great deal to do with it. That is where things get a bit challenging. "Why is it that the president or the leaders of Andersen allowed the people in the Houston office to do these things?" questions Benston. "If they weren’t destroying the firm [Andersen] they were coming close to it. We don’t yet know why they didn’t realize it." But we do know after a closer look at the Powers Report and other materials, says Benston, what those accounting practices entailed.
The authors scrutinize six important accounting procedures as they relate to activities at Enron. They are as follows: (1) non-consolidation of Special Purpose Entities (SPEs) that appear to have permitted Enron to hide losses and debt from investors; (2) sales of Enron’s merchant investments to unconsolidated (though actually controlled) SPEs as if these were arm’s length transactions; (3) recording as current income fees for services rendered in future periods; (4) fair value restatements of merchant investments that were not based on trustworthy numbers; (5) accounting for Enron stock issued to and held by SPEs; and (6) disclosure of related party transactions and conflicts of interest, and their costs to stockholders.
While each of these elements are critically important, the key to understanding the Enron-Andersen relationship, notes Benston, is in figuring out the widespread use of Special Purpose Entities or SPEs, separate entities that, in this case, took the form of limited liability partnerships. According to the authors’ research, Enron sponsored hundreds, if not thousands, of SPEs with which it did business. While many of these were used to shelter foreign-derived income from U.S. taxes, some very substantial SPEs were sponsored to conduct business with Enron domestically. Says Benston: "We wanted to know what are these things, where do they come from and why is the accounting for them so confused. If you look at textbooks you don’t see any notice of them at all. It’s hardly mentioned in the Generally Accepted Accounting Principles (GAAP) guide." (The GAAP are principles, standards, and procedures set forth by the Financial Accounting Standards Board. They consist of an elaborate set of rules that U.S. companies are expected to follow.)
To put the use of SPEs in perspective, the authors outline a brief history of its evolution in a companion paper. These "esoteric financial vehicles" were originally defined as entities created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company. They may take the legal form of a partnership, corporation, trust, or joint venture. "SPEs began to appear in the portfolio of financing vehicles that investment banks and financial institutions offered their business customers in the late 1970s to early 1980s, primarily as a means for helping banks and other companies to monetize, through off-balance-sheet securitizations, the substantial amounts of consumer receivables on their balance sheets," the authors explain. A newly created SPE would acquire capital by issuing equity and debt securities, and use the proceeds to purchase the receivables from the sponsoring company, which guaranteed the debt issued by the SPE. Because the receivables have reliably measured and limited risk of non-repayment, the relatively small amount of equity usually was sufficient to absorb all expected losses, thus making it unlikely that the sponsoring company would have to fulfill its guarantee. This allowed the sponsoring company a convenient way to convert receivables into cash while paying a lower rate of interest than the alternative of debt or factoring, as the debt holder could be repaid from the collection of the receivables or the sponsor. SPEs also allow the sponsors to remove the receivables from their balance sheets.
The other major application in the early years, the authors explain, was related to transactions involving the acquisition of plant and equipment under long-term lease contracts. By sponsoring an SPE to acquire long-term assets with newly acquired capital, and entering into a contract to lease the assets from the SPE, companies are often able to treat the contract as an operating lease for accounting purposes, thereby placing the asset and related debt on the SPE’s balance sheet instead of that of the sponsoring company.
Enron kept the debt off the balance sheets, but used SPEs quite differently. For example, the authors tell of Chewco, an Enron-sponsored SPE formed to buy out CalPERS (the California Public Employees’ Retirement System) $383 million limited partnership stake in a joint venture with Enron, called JEDI. Chewco was financed with a $240 million Barclay’s Bank loan that Enron guaranteed, a $132 million advance from JEDI, and $11.5 million in equity provided by outside investors (3% of total assets). Benston and Hartgraves go on to explore the details of the Chewco SPE, including the involvement of Enron executives, namely CFO Andrew Fastow, and how Enron accounted for related investments and ensure that the SPEs’ principal asset was restricted Enron stock. These intricate twists would ultimately be the company’s downfall.
"Enron used SPEs in ways that nobody had every heard of before, that I’m aware of," explains Benston. "It’s somewhat similar to three-card monte when some guy on [New York’s] 42nd Street stops you and says which card is the pea under. But the hand is quicker than the eye. It’s very hard to get it right and win. Not only did Enron form an SPE. They formed an SPE, which formed an SPE, which formed an SPE. And then they did interactions between themselves and between Enron. It’s a real mess." Was that mess created intentionally? This and other questions have yet to be answered. Even so, Benston has his suspicions: "I had a very strong feeling when I was analyzing the SPEs that they were designed to make it difficult for anyone to figure out what they did."
It seems even those who were supposed to be monitoring Enron’s behavior weren’t taking the time to figure out what was going on. Benston and Hartgraves scrutinize the role of the gatekeepers--Enron’s board of directors, its audit committee, outside attorneys and independent public accountants--in Enron’s ultimate demise. The authors note that the company’s gatekeepers were highly qualified. Enron’s audit and compliance committee, for example, was a powerhouse of expertise, including Robert K. Jaedicke, a distinguished former professor of accounting and Dean of Stanford University Business School, and Wendy L. Gramm, former Chair of the Commodity Futures Trading Commission.
Despite top credentials, scrutiny of Enron’s varied business dealings fell short. The Powers Report goes into substantial detail on the Board and the Audit and Compliance Committee’s failure to adequately understand, review, approve, and monitor the Fastow-created SPEs and Enron’s accounting and reporting practices, the authors explain. The Powers Report and testimony before U.S. Congress also criticize Enron’s outside attorneys and, much more severely, its CPAs. Together, for instance, Andersen and CFO Fastow crafted the SPEs to conform to the letter of the GAAP requirement that outside ownership, presumably independent, must be at least 3% of the SPE assets for the SPEs to avoid being consolidated in Enron’s financial statements. It’s difficult at this time, write the authors, to understand why Andersen considered Fastow to be an independent investor. From directors to CPAs, the gatekeepers seemed to be asleep at the wheel, say the authors in response to Powers findings. "If you just look at it abstractly you say, ‘Why in the world did they let this stuff go through,’" notes Benston. "I don’t know the answer to that."
Fallout from Enron has led to calls for reform, with emphasis on further regulation of the accounting profession. A key proposal would forbid CPA firms that audit financial statements from offering to their clients other financial services, such as tax preparation, internal auditing and litigation support. Individual CPAs might also be subject to a new disciplinary body dominated by non-accountants that might recommend or impose additional sanction against them.
Before these new requirements are enacted, however, regulators should identify what are the actual (rather than the alleged) shortcomings in the existing system. Benston and Hartgraves believe the Enron disaster has revealed two such shortcomings. The first is the U.S. model of specifying GAAP in terms of detailed rules, which appear to have allowed or even required Andersen to accept procedures that followed the letter of those rules, but not the basic objectives they seek to establish. Thus, the authors contend, the U.S. GAAP are substantially responsible for the Enron disaster.
"The U.S. system of having rules is a set-up for this kind of thing because people can manipulate their way around rules," suggests Benston. "We teach people financial engineering, how to cover a risk or finance a project with financial instruments that have peculiar and often very difficult to understand properties. It turns out these procedures are being used to get around the accounting.
Accountants, therefore, have to look to the substance that’s going on and cut through all of the complications. People have gotten to the point where they think it will be okay as long as they just follow the letter of the rules. That won’t do. Accountants ought to be aware of these procedures that can be used to give the appearance of adherence to accepted accounting, but which actually permit opportunistic managers to hide debt, misstate revenue, and cover up losses. If they do not, accountants will put themselves at enormous risk."
The second lesson has to do with the so-called fair-value requirement for financial instruments, which permitted Enron to increase its reported assets and net income and, thereby, to hide its losses. Benston adds that he has always been suspicious of accounting’s so-called fair-value movement. "I always thought people could deceive others by making these numbers what they wanted them to be," he explains. "Now we’re getting evidence that’s exactly what happened."
And while Enron is the high-profile accounting scandal de jour, the resulting increased scrutiny practically guarantees that others will follow.