Accounting has being blamed for the losses suffered by investors as a result of Enrons collapse, as it is generally seen that the accounting process as at Enron were misleading and inaccurate.

University Degree Business and Administrative studies

Financial Accounting Synoptic Jane Coghlan

U50092 03058884

Accounting for Enron

Since the Enron scandal was made public in 2001, which lead to its end in December of that year, much has been written on the matter of creative accounting, earnings management, financial transparency and fraud, and much more is likely to come as the investigation into Enron continues. This essay discusses the reason for Enron’s accounting practices and the effect it has had on investors, accounting practices and accounting standards in this area.

Accounting has being blamed for the losses suffered by investors as a result of Enron’s collapse, as it is generally seen that the accounting process as at Enron were misleading and inaccurate. Whilst this is true to a point, it is important to note that accounting masked the losses made, but the business Enron did led to the losses themselves. The US standards set for financial reporting have been strongly criticised for their lack of ‘substance over form’ since the recent scandals (Baker and Hayes, 2004, p.2) and therefore were seen not to be showing investors the most accurate view of Enron’s business and financial health. Baker and Hayes (2004, p.3) bring up the US Financial Accounting Standards Board suggestion that financial information should ‘represent what it is intended to represent’. This statement can be easily manipulated by accountants and auditors by allowing them to show their accounts how they intend their accounts to be shown, fairly or not.

With the emergence of Enron’s bad accounting, it was becoming more apparent that they were not the only company using these bad practices (O’Brien, 2005, 209). This therefore suggests losses were not only sustained by Enron’s investors but throughout the market as a whole. With a general loss of trust in the capital market, this makes investments expensive as a result of investors expecting higher returns and better security on their investments (CIMA, 2002, p.2). It is noted by Neves (2003, p.104) that after Enron’s collapse, companies who had been ‘trading counter parties’ to Enron had large falls in their share price and other companies within the industry had been affected indirectly. With regards to investors, Holtzman et al. (2003, p.25) indicate that the effect on investors is short-term, but recognises that with increased investor scrutiny other big companies have fallen, for example WorldCom and Tyco, therefore heightening the lack of confidence for investors in the capital market.

Akhigbe et al. (2005, p.5-6) argues that Enron’s bankruptcy and collapse lead to two possibilities. Firstly of a negative reaction for the energy sector shares generally, but that it also could lead to an increase of the share price in this sector, at least in part, by increased demand as investors’ trade out of Enron.

Furthermore, it is apparent that the auditors of Enron’s accounts, Arthur Andersen, are also partly to blame for the scandal. As Enron’s auditors they were obliged to make sure Enron’s accounts were adequately representative and that the accounting was preformed within the Generally Accepted Accounting Principles (GAAP) guidelines, but with pressure to accept Enron’s accounting practices and the large revenue Enron generated for both consulting and auditing, Arthur Andersen accepted Enron’s accounting methods (Bansal and Kandola, 2003, p.2). In addition, Arthur Andersen were also the auditors behind more than one other misguiding financial accounts, such as Sunbeam, Waste Management and WorldCom (see, for example, Cullinan, 2004, p.860; Ribstein, 2002, pp.6-7).

Conversely, it is argued by Morrison (2004, p.363?) that the downfall of Andersen was influenced by politics and that the rival accounting firms were ‘pushing Andersen off the bridge’ and taking on Andersen’s clients. Morrison (2004, p.338), a former employee of Arthur Andersen, goes on to say that Andersen were not the auditing firm of the Special Purpose Entities that were to lead to Enron’s ruin and subsequently Andersen’s, this is an argument that suggests Andersen’s were wrongfully accused, at least to a degree.

Although Enron themselves provided misleading accounts, Stelzer (2004, p.22-23) comments that not only were they and their auditors partly responsible, but the securities analysts also played a part in the scandal. It is argued that the securities analysts can be heavily influenced by the large rewards they receive by getting investment-banks to invest in stocks that may be underperforming, as the investment-bankers will not invest large sums if the shares and company’s prospects are panned by the analysts, therefore the analysts are also holding back information (Stelzer, 2004, p.23).

It would seem that this criticism on accounting can be looked upon as being fair as it was the accounting practices that lead to Enron’s off balance-sheet financing and misleading financial reports. That said, Benston and Hartgraves (2002a, p106) remark on how the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB) and the American Institute of Chartered Public Accountants (AICPA) have been heavily criticised for the lack of clarification of certain accounting practices, inferring that had there been more detail on how to treat items, in Enron’s situation Special Purpose Entity’s, then the case may not have been as extreme. In addition, it can be argued that a mistake made at one firm should not necessarily make the whole profession be called into account. Nonetheless, it is notable that Enron was not alone in misrepresenting their accounts, but they happened to be caught out (see, for example, O’Brien, (2005), p.209; Ribstein, (2002), p.6).

It is also argued that before Enron made public the scale to which they manipulated their earnings, the stock market in America was in decline from 2000 and historically there is a link with market decline and the turn out of scandals, though he does note this is a grand generalisation (Coffee, 2003, p.5). During 2001, as the value of Enron’s shares fell, it was harder for Enron to keep their losses hidden; so it can be said that investors may have made losses with Enron in any case. However, if investors knew to what extent Enron hid their losses and mislead investors, they could have moved their investment elsewhere.

It would seem that losses Enron investors sustained were not solely down to accounting within Enron Corp, though they had a significant role, but other areas associated with accounting such as auditing, security analysts and accounting boards had their part to play.

Since Enron collapsed and the scandal of their accounting practices became public, the US Financial Accounting Standards Board (FASB) has tightened standards to deal with off balance-sheet financing and accounting manipulation as well as introducing the 2002 Sarbanes-Oxley Act. Lev (2003, p.48) suggests that accounting manipulations ‘thrive’ amongst accounting rules and therefore feels that change is definitely the way forward, either by increasing the quality of rules or moving towards principle-based accounting.

However, it is felt by some that the standards already in place are enough to combat the problem (see, for example, Bassett and Storrie, 2003, p.14; Stelzer, 2004, p.21). Bassett and Storrie (2003, p.14) continue to discuss how reforming accounting, mainly through the Sarbanes-Oxley Act, will lead to bigger financial accounting reports and more ‘guarded’ phrasing in order to protect the directors, reducing the quality and therefore becoming less user-friendly. Ribstein (2002, p.3) feels that more regulation for corporate fraud and governance is not the answer. He argues that even with seventy years of regulation, fraud is still happening.

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A positive to come out of this is the possibility of the SEC receiving a greater budget, as Revsine (2002, p.139) states an increased budget for the SEC will allow for better control over existing regulations on disclosure and to make sure auditors fulfil their responsibilities.

With the threat of jail sentences, directors will be less inclined to make future forecasts and therefore leaving investors and analysts with less information on a company’s future (Bassett and Storrie, 2003, p.15). With heavy penalties for tampering with a company’s accounts on all levels, Ijiri (2005, p.261), agues that this will affect forecasts-based accounting as there is no way of being completely sure of proposed predictions, especially under oath, therefore scaring businesses from forecasting.

SSAP 2 was issued about thirty years ago, 1972, and had set out the criteria of accountings four fundamental principles, going concern, consistency, prudence and accruals. However, this standard needed reviewing as it encouraged earnings manipulation with regards to the prudence method (Robins, 2001). This was followed up with FRS 18 – Accounting Policies (2001), which lays out the framework for disclosure and principles in order to make financial statements more coherent for its users and include relevance, reliability, comparability and understandability (Robins, 2001).

The problem with some accounting policies is that they can be susceptible to manipulation and lead to earnings management within a company. For example, accruals accounting requires a lot of judgement on when to recognise revenues and match associated costs. Management control earnings by bring forward revenue and postponing expenses to give accounts a ‘smoother’ look (see, for example, Lev, 2003, p.41; Stolowy and Breton, 2003, p6). Nonetheless, in the UK, Financial Reporting Standard 5 (FRS 5) requires companies to show the substance of their accounts over legal form, which should reduce the level of earnings management and manipulations of financial information.

Not all companies can fit into the same accounting policies as others, which is the reason for the choice given. Different types of business work better with different accounting policies, for example, treatment of depreciation will vary in a company dealing in steel to a company in electronics (Bassett and Storrie, 2003, p.5).

It may be necessary for more detail to be set on what is required for policies to be disclosed adequately, for example, in Enron and WorldCom, notes were made in their accounts disclosing their accounting policies, however it was clearly not enough showing how companies use rules to their advantage. Previts et al. (2003, p.170) discuss how the US Securities and Exchange Commission (SEC) introduced rules in 1997, through FFR 48, to increase accounting policy disclosure in the company accounts, however the scandals that followed lacked disclosure in their accounts.

In the case of Enron, they moved from a prudent income recognition approach, where actual costs were accounted for with actual revenue, to what is known as ‘mark-to-market’ accounting. This form of accounting allowed Enron to predict future cash flows from long-term contracts, as long as twenty years, as revenue and the present value of expected costs as expenses. The problem was some of the contracts Enron had entered into were dubious and the costs associated questionable. This was key to Enron’s revenue recognition and was used to make predictions of energy prices and interest rates far into the future that boosted their accounts (see, for example, Healy and Palepu, 2003, pp.9-10; Thomas, 2002, p.43).

O’Brien (2005, p.207) talks of how Enron’s use off balance-sheet financing and fraud to boost their profits and keep the appearance of liabilities low, as well as sustaining good credit ratings and keep their share price growing. To do this, Enron’s main method was the use of Special Purpose Entities (SPE). Healy and Palepu (2003, p.9) discuss two areas in which Enron managed its earnings and balance sheet. Firstly was the accounting of complicated long-term contracts, mark-to-market accounting, which required forecasts of their future earnings, as mentioned above. Second was their use of Special Purpose Entities. This is supported by Benston and Hartgraves (2002a, p.108), who discuss six key areas they felt Enron manipulated their accounts, also centrally based around their use of SPE’s. This is also seen when looking at the period between 1993 and 2001, when Enron had set up more than three thousand Special Purpose Entities (Baker and Hayes, 2004, p.772).

It would appear that Enron wanted to achieve a look of sustained and constant increase in profit and wanted to avoid showing the volatility of their investments, for example Enron’s investment in Rhythms NetConnections soared from $10 million to $300 million in value and accounting standards required rises and falls of investments to be recorded at the end of each quarter in the income statement. But Enron was worried that the value could just as easily decrease and they did not want to show that in their accounts (Kavanagh, 2003, p.165).

As Enron used mark-to-market accounting, they recognised gains before they were actually made. Therefore when these gains were not actually realised, to avoid showing the losses on the balance sheet, Enron set up Special Purpose Entities to hide these losses. These SPEs allowed Enron to make particular transactions that they would otherwise not be able to do without showing substantial losses. Enron were unable to commercially hedge their investments, which had greatly risen in value but were expected to fall, for example Rhythms NetConnections, using the Special Purpose Entities allowed these investments to appear to be hedged, in accounting terms, but did not actually transfer any risk to a third party (Wilson and Campbell, 2003, p.7). In order for a Special Purpose Entity to not be consolidated on the balance sheet, an independent owner or party must control the SPE and the owner must have equal to or at least three percent of equity interest in the SPE’s assets and be in control of the SPE (see, for example, Craig and Amernic, 2004, p.833; Benston and Hartgraves, 2002b, p.247; Holtzman et al., 2003, p.26; Wilson and Campbell, 2003, p.9; Reinstein and McMillan, 2004, p.956). This we know was not the case at Enron, as the Chief Financial Officer of Enron would head these partnerships and invest in them. He was obviously not an independent third party and therefore goes against the theory of ‘being at arms length’.

Kavanagh (2003, p.162-163) discusses reasons why Enron used SPEs excessively. Enron could have borrowed money for certain transactions and to make investments, but this would have affected their gearing and had an overall negative affect on their rating.

An example of this is when Enron and California’s Public Employee Retirement Systems (CALPERS) jointly owned an SPE called Joint Energy Development Investments (JEDI). Enron wanted CALPERS to invest in other SPE’s that were connected with Enron, but it was felt CALPERS would only invest in one Enron SPE at a time. This therefore meant CALPERS share of JEDI was to be bought out. As no other third-party was found, Enron set up Chewco, which borrowed the required $383 million to buy out CALPERS half of JEDI. This way, Enron did not show extra debt on their accounts and did not appear to have 100 per cent control of JEDI which would have definitely resulted in Enron consolidating JEDI’s assets on its financial statements (Kavanagh, 2003, p.163).

O’Brien (2005, p.207), points out that Enron did not fulfil the rules for a SPE accounting treatment, but points out that had Enron kept within the rules for SPE’s, their financial statements would still have been misleading as a lot of Enron’s debt would have remained off the balance sheet.

Lev (2003, p.45) mentions that Enron’s use of SPEs were in the most part legal, however large amounts of losses were still hidden from investors. Chewco was one of the SPE’s that Enron ran. It however did not meet the standards for non-consolidation. This was the case with many of Enron’s SPEs, where no independent group managed the SPE, there was no identifiable equity owner and they were not following the three per cent equity requirement. Chewco didn’t even meet the three per cent requirement from the start (Kavanagh, 2003, p.163). Kavanagh (2003, p.164) continues to discuss how Chewco had Enron’s Chief Financial Officer managing it, which also violates the rules of non-consolidation of an SPE.

Enron’s disclosure was also questionable. Enron did disclose to some extent their dealings with the SPE’s, however they were inaccurate, complex and discrete way using footnotes, a method permitted by the US GAAP (see, for example, Baker and Hayes, 2004, p.780; Reinstein and McMillan, 2004, p.964). Akhigbe (2005, p.194) explains, it was so complicated investors couldn’t follow the footnotes easily. Benston and Hartgraves (2002a, p.121) also discuss how these footnotes were used and mislead investors with regards to Enron’s financial statements.

It is clear that Enron not only used SPE’s excessively to hide their losses, but accounted for them inadequately and mislead investors and creditors by their use of footnote disclosure.

Enron’s use of disclosure and accounting treatments resulted in investors loosing money they had tied up in shares, depending on when investors bought and sold their shares (Clayton et al., 2002, p.15). However, before Enron’s collapse, investors enjoyed high share prices and if investors sold at the right time, their wealth would have improved greatly. Enron themselves also benefited from these transactions to a certain point as it raised their share price and made it a company that everyone wanted to invest it. However, these transactions may also have contributed to increased losses made by Enron not dealing with the problem.

A large number of Enron’s employees had invested into the company their tax deferred 401 (k) retirement plans in Enron’s shares, which had some investors see their assets increase at some points to millions of dollars, but were left with virtually nothing (Benston and Hartgraves, 2002a, p.106). Due to the accounting errors Enron made, eventually led to the downfall of their company and great losses to their employees and other investors.

In the UK there are two main standards that would not sought to prevent such off balance-sheet transactions in the UK. Firstly, Financial Reporting Standards 5 (FRS 5) – Reporting the Substance of Transactions, which preceded SSAP 22, states that a SPE brings benefits to a company that are no different than if the entity was a subsidiary, therefore the entity should be treated like a subsidiary. This was not the case in the US, where Enron used the legal form to non-consolidate their SPE’s. Secondly, Financial Reporting Standards 2 (FRS 2) – Accounting for Subsidiary Undertakings, makes it clear that SPE’s should be consolidated on the balance sheet, backing up FRS 5. These two standards, particularly FRS 5 do not allow for much manipulation, though it can still leave room for abuse.

Baker and Hayes (2004, p.780) state that Enron’s use of disclosure within their financial statements did not reflect the substance of their transactions by the use of footnotes, therefore does not comply with FRS 5. O’Brien (2005, p.213) states that principle-based standards applied in the UK curb creative accounting, particularly off balance-sheet financing. This argument would therefore suggest that the UK would be less likely to experience an ‘Enron’. Nevertheless, Benston and Hartgraves (2002b, p.246) note that Special Purpose Entities were generally an unknown presence even to the majority of accountants and so making it difficult to realise a problem existed. Baker and Hayes (2004, p.769) describe how Arthur Andersen found Enron to be in line with the US GAAP and thus having reliable accounts, however it is now apparent the accounts were not transparent, resulting in a lack of economic substance and misleading information, which would not have been accepted in the UK under their standards. These UK standards stress the differences that are present between the UK and the US. It was generally seen that the difference between the US and the UK accounting standards, was that the US were mainly ‘rules-based’ and the UK ‘principle-based’. This meant that the US took legal form over economic substance and the UK vice versa. Originally, prior to the recent accounting scandals, the US thought itself to have the most revered accounting standards, which as said above were more rules-based than the UK. It was felt that substance over form in accounting should take a back seat, as legal form was more important (Baker and Hayes, 2004, p.769).

Since the Enron scandal, the US has been moving more towards the principle-based style of accounting, especially with the US public questioning what was once believed to be the best accounting standards in the world. This pressure has pushed the US into adopting international accounting standards, along with Europe, and move more towards a substance-based form of accounting (see, for example, Eaton, 2005, p.8; Singleton-Green, 2002, p.23).

As stated by Singleton-Green (2002, p.23), much of Enron’s off balance-sheet financing was against GAAP rules, therefore should not have been permissible in the US. It is important to note that the UK is not immune from an Enron type scandal, however with FRS 5, it does reduce the chances dramatically.

On the whole, it would seem that both principle-based and rule-based accounting can be subject to manipulation, as Lev (2003, p.45-46) argues, letting managers have too much judgement can lead to accounting abuses as well as manipulating the rules. Though it is now perceived that the principle-based style leaves less room for companies to mislead financial report users (O’Brien, 2005, p.213).

Vincent et al. (2003, p.74), members of the Financial Accounting Standards Committee of the American Accounting Association, maintain that rules-based standards guide businesses, provide consistency and comparability but allow no scope for judgement, where as principle-based accounting needs judgement, calls on managers expertise, but can lack in providing relevance and reliability. It doesn’t provide consistency and comparability across the board. The discussion continues to reason that managers can easily manipulate their figures by following the rules, yet providing untrue information, this then leaves auditors in awkward situations where managers appear to be adhering to the rules (Vincent et al., 2003, p.75). Lev (2003, p.45) agrees that the rules-based system is not working and contributes to the scale of financial manipulation; he feels that the quality of rules are weak and ‘fail to reflect economic reality’. The US rules based system has also been described as a ‘system that promotes abuses’, due to how Enron and other companies were able to manipulate the US accounting standards, legally as well as illegally (Ijiri, 2005, p.271).

However, Schipper (2003, p62), a member of the FASB, feels strongly that a combination of rules and principles is what the US have in place within their Conceptual Framework and what they should keep. It is in her opinion that consistency and comparability are of key importance, and as Vincent et al. (2003) mention above, this is what is lacking with principle-based standards alone.

In July 2002, the US congress passed the Sarbanes-Oxley Act as a response to the Enron scandal. It was said to be one of the most influential Acts since the 1930s with regards to corporate governance (see, for example, Eaton, (2005), p.10; Deakin and Konzelmann, (2004), p. 134; Ribstein (2002), p.3), but as Deakin and Konzelmann (2004, p.134) state, the Sarbanes-Oxley Act is very closely based on Enron, where the main provisions reflect what happened at Enron. However, as with many Acts pushed through quickly to fix a problem, the Sarbanes-Oxley Act has not achieved all it could and is thought to have more of a negative affect on confidence in America’s business market (Bassett and Storrie, 2003, p.14).

Wagner and Ditmarr (2006, p.133) note the admirable aim of the Sarbanes-Oxley Act, but also notice how directors of companies feel they should not be subject to the ‘compliance burdens’ of the Act because of the irresponsibility and dishonesty of others. Bassett and Storrie (2003, p.14) feel that the reforms caused by Enron’s demise, and those that followed, are likely to do more harm than good and that prior to the 2002 Sarbanes-Oxley Act companies were ‘healing’ themselves due to shareholder pressure. This is supported by Bassett and Storrie (2003, p.14-15) who state that companies had already installed appropriate regulations regarding the separate use of auditors and consulting firms, as well as ratings agencies taking data on companies to reflect a cash flow result.

Not only have the consequences hit Enron and its investors, but generally companies are feeling the backlash of Enron’s errors. Since Enron, stakeholders in companies have become a lot more questioning of their own companies accounting procedures due to a feeling of uncertainty that stemmed from the recent accounting scandals (CIMA, 2002, p.5). Fink (2002, p.38) states that after Enron, investors are punishing companies who appear to be using creative accounting and a great deal of off balance-sheet financing by investing in companies that appear to be more transparent. This then pushed companies to prioritise the transparency of their financial statements in order for companies to enable adequate investments (CIMA, 2002, p.2).

The scandals have ignited a situation with many conflicting views; some feel more reforms are required, where as others feel working with what is in place and harsher punishments should help aid the problem long-term.

Subsequent to the Enron scandal, the regulatory authorities encouraged auditing companies to be independent of consultation as it is clear those companies providing the two functions, for example Arthur Andersen influence the job being done in a negative way, this is seen as a positive reaction to the Enron fiasco (see, for example, Reinstein and McMillan, 2004, p.957: Revsine, 2002, p.138; Singleton-Green, 2002, p.22; Stelzer, 2004, p.23).

The conflict of interest between the roles provided by consulting and auditing firms has now been addressed, with the improved control on creative and fraudulent accounting. Since the scandals, the accounting role has become more significant as well as auditing benefiting greatly due to increased fees and increased numbers of internal management (Bassett and Storrie, 2003, p.13).

The fall of Enron has many contributories, which include the losses Enron made through business transactions, their imaginative use of SPE’s, the way the SPE’s were accounted for, manager’s self-interest and the auditor’s bad practice. Enron’s misleading and inaccurate accounts hid from investors and creditors the losses that they were taking on. However Enron were making losses by bad business decisions and investments, and it was the accounting that allowed Enron to hide the losses not make them. As Enron did not confront the losses they incurred, it is possible to say that by covering up, more losses were taken on.

In order for scandals such as Enron to become something of the past, it would seem that academics have many differing ideas. Many feel that the way forward is with the introduction of new standards and rules to combat accounting scandals, as companies like Enron and WorldCom show that the system clearly wasn’t right, but conversely it is felt that these companies were breaking the rules and that if the rules had been followed then the problem may never have arose or not to such an extent. It would appear the main problem was the lack of emphasis on substance in US accounting practices, where companies were following the rules but misleading people as they did it. With the converging of FASB and IASB, it would appear that the US are taking on a more substance based approach.

Enron has had a massive effect on financial accounting globally and how it is perceived by the public. Companies are being more heavily scrutinised from relevant accounting boards. Investors have also had an impact on companies’ financial statements by pressurising them to produce more transparent information. Due to the number of scandals that took place around this time, it surely will have a positive affect on future accounting standards and practices.

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