Emile Woolf : Accountancy Magazine March 2011

Posted with Authors Permission by David McKibbin (@Creditplumber

www.thecreditplumber.com) on Scribd.

CAN RULES-BASED ACCOUNTING FACILITATE FRAUD? ENRON RE-VISITED

We are approaching the tenth anniversary of the collapse of Enron. Have the
lessons been learnt? Enron was the US energy giant that failed only 12 months after
its share price rated it seventh largest corporation in America. A handful of
tenacious journalists penetrated the miasma of filed data and revealed that the bulk
of its reported earnings were unmatched by cash. The share price collapsed and
bank support for its energy trades dried up. In late 2001 it filed for bankruptcy.

I once reported on an audit firm whose client’s business was the production of pre-
fabricated, collapsible squash courts. It sold these to municipal sports centres in
Europe, and secured guarantees for its invoices under the government’s export
drive. It then discounted them under a revolving credit facility with its bank, new
invoices being matched and offset against earlier ones. When the facility limit was
reached the bank obligingly raised it - until it exceeded £5 million. At that point the
owner and his family fled the country, not to be seen again.

There never were any squash courts. The only collapsible item was the company
itself, and the only fabrication was the documentation needed to support the
outrageous scam. The bank and auditors were too busy matching invoices to notice
that there was no cash coming in. A trifling, unsophisticated foretaste, perhaps, of
the Enron syndrome: the ability of accounts to generate cashless earnings.

Exploiting accounting foibles

The camouflage at the core of Enron’s machinations was obviously far more
intricate. Two devices enabled it to produce accounts that appeared to support
borrowing levels. First was the “mark-to-market” accounting aberration. If Enron
contracted with the state of Oregon to supply several million kilowatt hours of
electricity in five years time in return for $100 million, it was able to enter, as
earnings on day one, the market’s anticipation of what that contract would yield on
delivery – say $15 million, reflecting the market’s own embedded assumptions on
electricity price fluctuations over that period.

The other device was Enron’s creation of thousands of special-purpose entities

(SPEs) to keep liabilities off its balance sheet. The company would sell parcels of gas
or oil leases to an SPE partnership with other investors. The leases would serve as
collateral for loans that the SPE would make available to Enron. Complex paperwork
ensured that Enron did not “control” the SPE, so the liability did not appear in its
accounts, although many SPEs were managed by unidentified “senior officers” of
the company itself. Banks and co-investors were always reassured by Enron’s
guarantee to make up shortfalls on SPE asset sales with its own shares.

Burying the truth

When the tangled web of exotic transactions was unraveled two startling facts
emerged: (i) there were questionable practices galore, but no proven illegalities;
and (ii) the best source for discovering what was really going on was Enron’s own
published filings.

The journalists who analysed these could see, for example, that in Q2 of 2000 $747
million of Enron’s reported earnings were unrealized; margins were plummeting;
cash flows had all but dried up; its rate of return on capital was less than it paid on
external borrowings; and, in four of its last five years, it paid no taxes. The US tax
code didn’t recognize mark-to-market accounting: companies were assessed on
realized income only. All this was discernible from the company’s own published
disclosures.

Enron illustrates the hazards of information overload. The only valid criticism of its
published disclosures is that there was too much. The ultimate violation was not
that the accounts lied. Rather, they buried the truth in an impenetrable data-jungle.
There could, instead, have been a simple statement of the percentage of reported
earnings realized in cash.

As accounting standards relentlessly pile on the pages, driving intelligibility into

extinction, this is the real lesson of Enron. And we know from accounting travesties
exposed in the banking crisis that it has still not been learnt.

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