“ The day Arthur Andersen loses the public's trust is the day we are out of business.” -Steve Samek, Country Managing Partner, United States, on Andersen's Independence and Ethical Standards CD-Rom, 1999.
1996 - Arthur Andersen has an audit failure in Waste Management; Andersen paid a censure of $7 million.
1997 - Arthur Anderson has an audit failure in Sunbeam; Andersen paid $110 million to settle shareholder litigations.
January 1997- Jeffery Skilling is named president and COO of Enron. Skilling implements his assets are bad intellectual assets are good campaign to “clean up” Enron’s financial statements. Begins using the LJM partnerships run by Andrew Fastow, Enron’s CFO.
Early 2001- Jim Chanos takes note of Enron’s lack of money-making activities and begins to wonder about the LJM partnerships.
February 2001-Skilling’s promotion to CEO takes effect, he replaced Charles Lay.
Enron delivered smoothly growing earnings (but not cash flows.) Wall Street took Enron on its word but didn’t understand its financial statements.
It was all about the price of the stock. Enron was a trading company and Wall Street normally doesn’t reward volatile earnings of trading companies. (Goldman Sacks is a trading company. Its stock price was 20 times earnings while Enron’s was 70 times earnings.)
In its last 5 years, Enron reported 20 straight quarters of increasing income.
Enron, that had once made its money from hard assets like pipelines, generated more than 80% of its earnings from a vaguer business known as “wholesale energy operations and services.”
Enron’s core business was losing money—shifted its focus from bricks-and-mortar energy business to trading of derivatives (most derivatives profits were more imagined than real with many employees lying and misstating systematically their profits and losses in order to make their trading businesses appear less volatile than they were)
During 2000, Enron’s derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billion
Enron’s top management gave its managers a blank order to “just do it”
Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant were all justified.
Some warning signs disclosed by Frank Portnoy before January 24, 2002 Senate Hearings
Enron captured 95% confidence intervals for one-day holding periods—didn’t disclose worst case scenarios
Relied on “professional judgment of experienced business and risk managers” to assess worst case scenarios
Investors didn’t know how much risk Enron was taking
Enron had over 5,000 weather derivatives deals valued at over $4.5 billion—couldn’t be valued without professional judgment
From the 2000 annual report “In 2000, the value at risk model utilized for equity trading market risk was refined to more closely correlate with the valuation methodologies used for merchant activities.”
Given the failure of the risk and valuation models at a sophisticated hedge funds such as Long-Term Capital Management—that employed “rocket Scientists” and Nobel laureates to design sophisticated computer models, Enron’s statement that it would “refine” its own models should have raised concerns
Special Purpose Entities (SPEs) (Enron’s principal method of financial statement fraud involved the use of SPEs )
Originally had a good business purpose
Help finance large international projects (e.g. gas pipeline in Central Asia)
Investors wanted risk and reward exposure limited to the pipeline, not overall risks and rewards of the associated company
Pipeline to be self-supported, independent entity with no fear company would take over
SPE limited by its charter to those permitted activities only
Really a joint venture between sponsoring company and a group of outside investors
Cash flows from the SPE operations are used to pay investors
Enron’s Use of Special Purpose Entities (SPEs)
To hide bad investments and poor-performing assets (Rhythms NetConnections). Declines in value of assets would not be recognized by Enron (Mark to Market).
Earnings management—Blockbuster Video deal--$111 million gain (Bravehart, LJM1 and Chewco)
Quick execution of related-party transactions at desired prices. (LJM1 and LJM2)
To report over $1 billion of false income
To hide debt (Borrowed money was not put on financial statements of Enron)
To manipulate cash flows, especially in 4 th quarters
Many SPE transactions were timed (or illegally back-dated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations
Major issue is whether SPEs should be consolidated*—SPEs are only valuable if unconsolidated.
1977--”Synthetic lease” rules (Off-balance sheet financing) (Allowed even though owned more than 50%)
1984—”EITF 84-15” Grantor Trust Consolidations (Permitted non-consolidation if owned more than 50%)
1990—”EITF 90-15” (The 3% rule) Allowed corporations such as Enron to “not consolidate” if outsiders contributed even 3% of the capital (the other 97% could come from the company.) 90-15 was a license to create imaginary profits and hide genuine losses. FAS 57 requires disclosure of these types of relationships.
3% rule was formalized with FAS 125 and FAS 140, issued in September 2000.
The Famous “Misleading Earnings Release” on October 16, 2001
Headline: “Enron Reports Recurring Third Quarter Earnings of $0.43 per diluted share…”
Projected recurring earnings for 2002 of $2.15
If you dug deep, you learned that Enron actually lost $618 million or $0.84 per share—they had mislabeled $1.01 billion of expenses and losses as non-recurring.
Shockingly, there was no balance sheet or cash flow information with the release
There was no mention of a $1.2 billion charge against shareholder’s equity, including what was described as a $1 billion correction to an accounting error. (This was learned a couple of days later.)
The three major credit rating agencies—Moody’s, Standard & Poor’s and Fitch/IBCA—received substantial fees from Enron
Just weeks prior to Enron’s bankruptcy filing—after most of the negative news was out and Enron’s stock was trading for $3 per share—all three agencies still gave investment grade ratings to Enron’s debt.
These firms enjoy protection from outside competition and liability under U.S. securities laws.
Being rated as “investment grade” was necessary to make SPEs work
The government reacted aggressively when they became aware of the Enron scandal- Congress and the SEC introduced legislation and proposals to deal with such situations.
President Bush even announced one post-Enron plan. This plan was to make disclosures in financial statements more informative and in the management’s letter of representation. This plan would also include higher levels of financial responsibility for CEOs and accountants.
By far the biggest change brought about is the Sarbanes-Oxley Act which requires companies to re-evaluate it’s internal audit procedures and make sure that everything is running up to or exceeding the expectations of the auditors.
It also requires higher level employees, like the CEO and CFO to have an understanding of the workings of the companies and to affirm the fact that they don’t know of any fraud being committed by the company
These events have also allowed the world of academia to make many influential changes to curriculums, without adding or dropping classes.
These changes include a new emphasis on accounting ethics and on special purpose entities.
Another big change that came from the Enron bankruptcy filing was a new push to separate auditing services from consulting services.
The Sarbanes-Oxley Act will drastically improve the accounting industry in two ways.
First it creates a lot more work for many of the public companies.
The second way is that it requires tougher restrictions on internal audits and in judging how well the internal audit is conducted.
The separation of auditing and consulting will move the accounting industry forward a great distance toward increased credibility. It will decrease the occurrence of non-independence by auditors. At the same time, this will allow companies to reap the benefits of having both auditors and consultants.
Executives at Arthur Andersen and Enron did not set out to have a positive impact on the accounting industry or any industry. They set out to make as much money for themselves as quickly as possible. They were willing to do whatever it took to make that money. These thoughtless acts and greed led both companies to an eventual downfall in bankruptcy. However, the accounting industry reacted by introducing changes that would, in the long run, improve itself and the economy in which it exists. The changes that are a response to the Andersen/Enron debacle may be coming to an end. We are probably seeing the last laws, pronouncements, and statements that are a direct result of these actions. Still, the changes that have occurred leave the accounting industry and the economy stronger. Will the industry ever be perfect? Probably not, but accountants and the world must continue to strive to make it as functional as it can be. Only by this continued striving can the industry be good enough to function effectively and even thrive.