Don't Blame Accounting For Enron's Collapse

Don't Blame Accounting For Enron's Collapse

J. Edward Ketz

(J. Edward Ketz is associate professor of accounting in Penn State's Smeal College of Business. He specializes in corporate financial reporting issues.)

Several Enron managers, their auditors and friends have written op-ed pieces recently, arguing that this bankruptcy demonstrates the failure of "old economy" accounting. This thesis proceeds by claiming that the old way of doing accounting doesn't meet the new challenges of today's world, and thus we yearn for a "new economy" accounting. This is a blatant falsehood.

Financial reporting should be transparent, truthful, and complete whether it is "old economy" or "new economy" accounting. A new model for accounting won't be worth much if managers are opaque, misleading, and deficient. The issues we face are more ethical than they are technical.

Congress will soon hold hearings on the demise of Enron and why investors could not rely on the accounting reports from the company. I suggest Congress should look at several institutional features before examining the technical aspects of accounting. First and foremost is in the interesting observation that this spectacular failure is coupled with the auditor's receipt of tons of consulting dollars. Are we so gullible and credulous that we still believe that there is no correlation between auditing failures and consulting dollars? It is time for Congress to get serious about this institutional feature, and I suggest that either Congress disallow auditors from accepting consulting fees from their clients or Congress consider the establishment of government auditors.

Focus also should be directed toward Enron's board of directors. Where were they when the managers were concocting shell games-out on the golf course? It is time for Congress to encumber directors with the responsibility of ensuring that managers are transparent, honest, and complete in their financial disclosures. If necessary, give the negligent and reckless directors a time out in prison; it might encourage them to think clearly about the public good.

Several years ago Congress passed a bill providing securities litigation reform that made it easier for defendants to repel the claims by plaintiffs or to cap the damages. While problems did exist with frivolous suits, the bill also provided incentives for auditors to relax their diligence. Auditors could reason that less work would be possible since the probability of large losses from shareholder lawsuits is diminished. It is time for Congress to rethink that bill.

Finally, the best government agency to fight financial abuses is the SEC. But the budget for the SEC is not keeping up with the abuses. Given the increase in accounting mischief by managers and auditors, I suggest that Congress increase the SEC's budget and allow the agency to prosecute more offenders.

Let's turn to the accounting issues, keeping in mind the fact that investors and brokers and analysts weren't doing their job either. Specifically, a reader of Enron's financial statements should have noticed that Enron's earnings had a lot of non-cash items, including various unrealized gains on its energy contracts. A simple cash flow analysis would have pointed out the low quality of Enron's earnings. Investors have to learn that cash is the real thing, not accounting income. When a company starts showing large non-cash components to its revenues, it is time to deepen the analysis or look at another company.

Having said that, I find it interesting that so many of Enron's problems focus on nondisclosure of various commitments. For example, Enron employed special purpose vehicles (SPVs) to raise cash. Creditors find such vehicles attractive because the new entity has assets specifically dedicated for repayment of the debt in addition to the pledge by the mother corporation to repay the debt if for some reason the SPV runs out of assets. Since corporations don't consolidate the results of the SPV with their own, utilization of SPVs allows the business enterprise not to show any of the debt. In this case, the problem lies with the FASB and the SEC. These organizations long ago should have required firms to book all commitments, regardless of the form that they take. To an extent, Enron unfortunately can say they were just following GAAP.

Even with these caveats, Enron's managers had obligations to disclose what was going on in their MDA and in the footnotes of the financial reports. Instead of coming clean and revealing what was really going on, Enron's managers chose the path of opaqueness, misrepresentation, and omission. Clearly, these managers wanted to obfuscate the circumstances by not revealing all of the financial details. My message to Enron's managers is to drop the lawsuit against Dynergy, for Dynergy has performed a service to the financial community by unplugging the cork on this dirty bath water.

I applaud Congress' efforts to investigate this corporate failure. However, committee reports aren't enough. The public needs some concrete actions by its leaders to minimize such problems in the future.