Lessons from America’s biggest bankruptcy

By Nayana
The US-based Enron Corporation, despite being a "Fortune 10" company, was not well-known in Sri Lanka. Nevertheless the mere fact that a corporate giant of that size (its turnover was measured in billions) could suddenly plunge into bankruptcy in a country that prides itself as the model of successful free enterprise is a lesson for the whole world.

It was not a bankruptcy brought about by any sudden adverse economic event but rather by an accumulation of greed and deception. It is an affair in which Enron’s auditors, the supposed watchdogs of the private sector, appear to be heavily implicated.

Briefly, the facts are as follows: The Texas-based Enron described itself as a provider of products and services related to natural gas, electricity and communications to wholesale and retail customers. It made its fortune following the deregulation of the US energy sector in the early 1990s. With an ever-increasing demand for energy, success came easily. However the company’s hunger for profits led it into ever more inventive and risky dealings in the futures market to the point where it reportedly began trading in gas that would not have been produced for another ten years. The inevitable difficulty in predicting prices that far ahead eventually took its toll and the company started running up losses which they sought to conceal from their creditors and shareholders.

It was in this context in 1999 that Enron’s Vice-President and Chief Financial Officer (CFO) launched a series of private limited partnerships in which he served as the managing partner, simultaneous with his posts at Enron. The accounts of these partnerships, also known as special purpose entities, were not consolidated with the accounts of Enron and could therefore be used to hide losses.

In July 2001, with the bubble about to burst, the CFO relinquished his operating position at these partnerships and sold his interests to a non-executive officer at Enron.

In August 2001, with the price of Enron stock rapidly falling, the President and Chief Executive Officer of Enron resigned. In October Enron disclosed that shareholders’ equity was reduced in the third quarter of that year by $ 1.2 billion related to the company’s repurchase of its common stock, which previously had been issued as part of a series of transactions involving the aforesaid partnerships. The company described this reduction in shareholders’ equity as the correction of accounting errors. In the same month Enron terminated the services of its Chief Financial Officer.

In November 2001, Enron filed papers with the US Securities and Exchange Commission (SEC) announcing its intention to voluntarily restate its financial statements for the years 1997 through 2000 and first and second quarters of 2001. The effect of these restatements was to reduce previously reported net income for the previous four and a half years by 16 per cent.

Enron also declared its intention to file a restatement recording the previously announced $ 1.2 billion reduction to shareholders’ equity as well as various income statements and balance sheet adjustments as a result of a determination by Enron and its auditors that three unconsolidated special purpose entities should have been consolidated in the financial statements pursuant to generally accepted accounting principles.

On November 9, 2001, Dynegy Inc. announced its intention to acquire Enron for approximately $9 billion in Dynegy Inc. stock and the assumption of $ 13 billion in debt, but that deal eventually fell through. In the meantime Enron disclosed that it had initiated an action plan for the restructuring of its business that would negatively impact its fourth quarter earnings. It also disclosed that the call-up of significant debt amounts would be accelerated if the company’s debt rating fell below investment grade, which it did before end November.

In these circumstances Dynegy terminated the merger agreement, and in December 2001 Enron filed for bankruptcy protection under Chapter 11 of the US Bankruptcy Act.

Federal investigations and civil lawsuits followed. Enron’s Auditors, the prestigious firm of Anderson, was drawn into the controversy and the Head of its Houston Office was sacked. Officers of both Enron and Anderson were found to have shredded documents after investigations had officially commenced. They now face possible criminal charges.

Not only has Enron become the biggest bankruptcy in US corporate history, but doubts have also been expressed about the ability of the audit firm of Anderson to survive in the face of multi-million dollar lawsuits. Meanwhile Enron’s shareholders find that their stock is worthless and its employees have discovered that their pension funds were used to buy shares in the special entity partnerships that led to the company’s downfall. Meanwhile the American SEC is being pressed to explain how this sorry saga could have occurred in a system that prides itself on high standards of self-regulation and transparency.

Robert K. Herdman, Chief Accountant of the Securities and Exchange Commission (SEC), testifying before the U.S. House of Representatives Committee on Financial Services last month put the case for transparency thus:

"Transparency in financial reporting — that is, the extent to which financial information about a company is visible and understandable to investors and other market participants — plays a fundamental role in making our markets the most efficient, liquid, and resilient in the world. Transparency enables investors, creditors, and the market to evaluate an entity. In addition to helping investors make better decisions, transparency increases confidence in the fairness of the markets. Further, transparency is important to corporate governance because it enables boards of directors to evaluate management’s effectiveness, and to take early corrective actions, when necessary, to address deterioration in the financial condition of companies. Therefore, it is critical that all public companies provide an understandable, comprehensive and reliable portrayal of their financial condition and performance."

Yet he was constrained to admit that Enron’s announcement of its intention to restate its financial statements — a virtual admission of incorrect accounting to the tune of US dollars 1.2 billion — had followed several other widely publicized restatements by other companies. There was concern that such restatements may shake investor confidence in the entire system of financial reporting and capital markets, while also having a devastating impact on employees whose retirement funds were invested in the company’s securities.

The US SEC, in Herdman’s own words, relies on an independent private sector standards-setting process that is "thorough, open and deliberative". Nevertheless, even before the collapse of Enron, the SEC had felt the need to step in with a number of review and oversight measures which Herdman described thus:

‘The SEC staff also monitors the activities of the standard setting functions of the Auditing Standards Board ("ASB") of the American Institute of Certified Public Accountants ("AICPA") and AICPA’s self-regulatory programs, designed to enhance public confidence in the audit process.... Recently, the ASB was placed under the oversight of the Public Oversight Board ("POB"), which is chaired by former Comptroller General of the United States, Charles A. Bowsher.

"The POB was created in 1977 to oversee and report on the self-regulatory programs of the AICPA’s SEC Practice Section, which until recently consisted principally of the AICPA’s peer review and quality assurance programs. Under the peer review program, accountants from outside the member firm assess the firm’s quality control systems over its accounting and auditing practice and test compliance with those systems. Under the quality control inquiry process, a committee of professionals reviews allegations of audit failure contained in litigation filed against a member firm for indications of needed improvements in the firm’s quality control systems.

"Starting in 2001, the POB’s responsibilities have been expanded to include not only oversight of the peer review, quality control inquiry, and auditing standards-setting functions, but also to improve the communication and co-ordination among the various bodies that make up the self-regulatory process and to conduct oversight reviews and other projects that are deemed to be appropriate to protect the public interest."

As an example of POB projects, Herdman cited the establishment, at the SEC’s request, of a Panel on Audit Effectiveness. This Panel reviewed company audit processes and made about 200 recommendations including revision of auditing standards for detecting material misstatements in financial statements that may be due to fraud, enhancing the peer review process, and strengthening the AICPA’s disciplinary processes.

A perennial issue in company failures is the degree to which audit firms maintain independence from their clients. In this regard, the AICPA is said to have recently strengthened its self-regulatory and disciplinary processes but even this was not sufficient to prevent what is increasingly looking like a criminal nexus between certain officers at Enron and Anderson. According to U.S. Congressional sources quoted in the press, "It is becoming clear to us that people at both Anderson and Enron tried to hide the company’s financial problems."

In a direct reaction to the Enron scandal the managing partners of the five largest accounting firms in the U.S. issued a joint statement to the effect that they intended to work with the SEC to evaluate and improve disclosures and audit procedures concerning related party transactions, special purpose entities, and issues related to market risks, including those related to energy contracts.

A few commentators in this country who have been watching the Enron affair unfold have pointed to parallels with the crash of the finance companies in the mid-1980s, where for several years their audited accounts had failed to disclose the instability of the companies concerned and the fraudulent asset transferring and other activities in which some of them had engaged.

In America there is a chance that the perpetrators of whatever fraudulent activities took place at Enron and Anderson will at least belatedly be held accountable through a combination of criminal prosecutions and massive class action civil lawsuits. In Sri Lanka there were only a few selective and dilatory prosecutions, no one has yet ended up behind bars, and there were no class action lawsuits against the failed companies or the Central Bank that was supposed to monitor them.

One of the reasons for lack of civil activism is the welfarist approach of the State which paid out billions of rupees to compensate in some measure (though never fully) the depositors of those companies that crashed and to prop up those that were tottering. This meant that in effect the public paid for the misdeeds of the errant company directors and their auditors. It also meant that there was no incentive for the private sector to improve its standards.

What follows is one disturbing example of how the accounting profession assesses the accounts of corporate bodies. It concerns the Ceylon Electricity Board whose Annual Report and Accounts for 1999 were judged by the Institute of Chartered Accountants of Sri Lanka to be runner-up for the State Sector category for its Awards for Excellence. Elsewhere on this page we highlight some of the observations of the Auditor-General in his report on the CEB accounts for the same year. No doubt the requirements of public and private sector auditing may vary in some degree, but a public sector institution should be given an endorsement only if it conforms to the standards required by that sector. In any event it is doubtful whether many of the matters mentioned by the AG in his report would have been acceptable even to shareholders in a private sector company.

Some of the flaws the Auditor-General found in the CEB accounts of 1999 that were given Award of Excellence by the Institute of Chartered Accountants:

• Deficiencies in systems and controls in 21 areas including budget, fixed assets, accounting, expenditure, purchase advances, mobilization advances, use of vehicles, losses and project monitoring.

• Award of a contract worth Rs. 237,500 to a management company to prepare a corporate plan without calling for quotations and with no proper letters of award or acceptance or performance bond. Plan which should have been handed over by May 1999 had not been received by CEB up to January 2000 but seventy per cent of contract sum paid to company.

• 31 CEB vehicles given to other institutions free of charge while CEB hired vehicles for its own use.

• Large number of discrepancies between register of land and buildings and assets verified — not explained in the accounts.

• Land worth over Rs. 894 million shown as an asset when ownership was disputed.

• Dishonoured cheques from customers amounting to approximately Rs. 5.5 million allowed to remain outstanding for over two years.

• Sum of Rs. 25.5 million due for fixing generators for various institutions allowed to remain outstanding for over five years.