Understanding Accounting Ethics: Chapter 3

1. Understanding Accounting Ethics:Chapter 3 Enron, A Failure in Independence and Objectivity

2. Enron’s Rise and Fall By January 2001 employed 25,000 people 7th largest U.S. company by revenue Voted by readers of Fortune magazine as one of the most admired and innovative companies in the country November 8, 2001, restatement of recognizing 1.2 billion dollars of hidden debt December 2, 2001, filed for bankruptcy

3. Enron’s Rise: Key Dates July 1985: Houston Natural Gas merges with InterNorth 1989: Enron begins trading natural gas commodities. November 1999: Launch of Enron Online, "an internet-based global transaction system which allows Enron's customers to view real-time prices from Enron's traders and transact instantly online". Within two years the platform is averaging 6,000 transactions a day worth about $2.5bn. December 2000: Chief executive Kenneth Lay steps down, but stays on as chairman. Enron's president and chief operating officer Jeffrey Skilling to take over in February. December 28, 2000: Shares hit a record high of $84.87 - making Enron the country's seventh most valuable company.

4. Enron’s Fall: Key Dates February, 2001:  Andersen “Enron Retention Meeting” March 2001: Bethany McLean article in Fortune magazine August 14, 2001: Jeffrey Skilling resigns after just six months. August 15, 2001: Sherron Watkins letter to Kenneth Lay. August 20, 2001: Lay exercises Enron share options worth $519,000. October 2001: Accounting firm Andersen begins destroying documents relating to the Enron audits. October 16, 2001: Enron reports losses of $638m run up between July and September and announces a $1.2 billion reduction in shareholder equity. November 8, 2001: Enron restatement December 2, 2001: Enron files for bankruptcy

5. From Enron’s Restatement “Enron's previously-announced $1.2 billion reduction of shareholders' equity primarily involves the correction of the effect of an accounting error made in the second quarter of 2000 and in the first quarter of 2001. As described in more detail below, four SPEs known as Raptor I-IV (collectively, "Raptor") were created in 2000, permitting Enron to hedge market risk in certain of its investments. … As part of the capitalization of these entities, Enron issued common stock in exchange for a note receivable. Enron increased notes receivable and shareholders' equity to reflect this transaction. Enron now believes that, under generally accepted accounting principles, the note receivable should have been presented as a reduction to shareholders' equity.”

6. The Diagnosis of the Powers Report “The fundamental flaw in these transactions was not that the price was too low [i.e. Enron accepted terms disadvantageous to itself, because one of its own officers was representing the Raptors].  Instead, as a matter of economic substance, it is not clear that anything was really being bought or sold.”

7. A Ponzi Scheme?

8. Bethany McLean in Fortune March 2001 “Is Enron Overpriced?”

9. Sherron Watkins, August 2001 “To the layman on the street, it will look like we recognized funds flow of $800mm from merchant asset sales in 1999 by selling to a vehicle (Condor) that we capitalized with a promise of Enron stock in later years.  Is that really funds flow or is it cash from equity issuance?” 

10. Imploding in a Wave of Accounting Scandals “I am incredibly nervous that we will implode in a wave of accounting scandals….I realize that we have had a lot of smart people looking at this and a lot of accountants including AA & Co. have blessed the accounting treatment.  None of that will protect Enron if these transactions are ever disclosed in the bright light of day.”

11. Andersen’s Enron Retention Meeting, February 2001 “A significant discussion was held regarding the related party transactions with LJM [a general name for two Enron SPEs, one of which had ownership in the Raptor SPEs] including the materiality of such amounts to Enron’s income statement and the amount retained “off balance sheet”.   “…We discussed Enron’s reliance on its current credit rating to maintain itself as a high credit rated transaction party. “…We discussed Enron’s dependence on transaction execution to meet financial objectives…”

12. Andersen’s Conclusions “…Ultimately the conclusion was reached to retain Enron as a client citing that it appeared that we had the appropriate people and processes in place to serve Enron and manage our engagement risks.  We discussed whether there would be a perceived independence issue solely considering our level of fees.  We discussed that the concerns should not be on the magnitude of fees but on the nature of fees.  We arbitrarily discussed that it would not be unforeseeable that fees could reach a $100 million per year amount considering the multi-disciplinary services being provided.  Such amount did not trouble the participants as long as the nature of the services was not an issue.”

13. “Take away To Do’s” “Inquire as to whether Andy Fastow [Enron CFO, who effectively controlled the LJM entities] and/or LJM would be viewed as an ‘affiliate’ from an SEC perspective which would require looking through the transactions and treating them as within the consolidated group. “Suggest that a special committee of the BOD be established to review the fairness of LJM transactions… “Focus on Enron preparing their own documentation and conclusions to issues and transactions. “AA [Arthur Andersen] to focus on timely documentation of final transaction structures to ensure consensus is reached on the final structure.”

14. A “perceived independence issue” The perception, that is, the thought or judgment, that Andersen lacked independence; The appearance (to a reasonable observer, aware of the relevant facts) of a lack of independence.

15. Watkins a Whistle-Blower? “Develop clean up plan: a. Best case: Clean up quietly if possible. b. Worst case: Quantify, develop PR and IR campaigns, customer assistance plans (don’t want to go the way of Salomon’s trading shop), legal actions, severance actions, disclosure.” “My 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past successes as nothing but an elaborate accounting hoax.”

16. Rules, Principles, and SPEs If an entity cannot be regarded as independent if it fails to have 3% equity, it does not follow that it will always be independent if it does have 3% equity.

17. The Consequences On June 14, 2002 the firm (Andersen) was found guilty of obstruction of justice (a felony)…Andersen’s demise was all but guaranteed. Fastow pled guilty in January 2004 to securities and wire fraud, and accepted a sentence of 10 years. Richard Causey, Chief Accountant at Enron, and a CPA and former Andersen employee, pled guilty in December 2005, accepting a sentence of 7 years. Skilling and Lay continued to maintain their innocence. Their trial ended on May 25, with the jury finding Lay guilty of all six counts against him, and Skilling guilty of 19 of 28 counts. Skilling received a 24 year sentence on October 23, 2006. Ken Lay received no sentence in a Texas court: he died of a heart attack on July 5.

18. Some lessons from Enron When someone is not trying to follow the principle underlying the rule, then he won’t even reliably follow the rule. Good character and good culture require that one follow high standards of conduct in small matters and in new circumstances. At every later step, it became more difficult and more costly to reverse course.

19. Sarbanes-Oxley and PCAOB ‘There is established the Public Company Accounting Oversight Board, to oversee the audit of public companies that are subject to the securities laws, and related matters, in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies the securities of which are sold to, and held by and for, public investors.”

20. Three standards of liability considered in Bily Privity Restatement of Torts standard Reasonable Foreseeability

21. Summary of Bily Accountants have no general duty of care to anyone other than to their clients or restricted other parties as would be recognized under privity, for any work other than auditing. For negligent misrepresentations in an audit report, they are liable to the extent allowed under the more liberal Restatement approach; For misrepresentations in an audit report that amount to fraud, they are liable under the most expansive standard of the Reasonable Foreseeability approach.

22. The dissent in Bily and the ‘Expectations Gap’ “The majority recognizes that accountants acknowledge a responsibility to third parties who foreseeably rely on audit reports in their business dealings with the audited company. Yet the majority adopts a rule that betrays the expectations of third party users whose reliance makes the audit report valuable to the audited company. Under the majority's rule, the audit report is made a trap for the unwary, because only the most legally sophisticated and well advised will understand that the report will not deliver what on its face it seems to promise: a qualified professional's actual assurance that the financial statement fairly states the financial situation of the audited company. An assurance with no legal recourse is essentially a hoax.”

23. Why Did the Code Fail? “EMPLOYEES OF ENRON CORP., its subsidiaries, and its affiliated companies (collectively called the ‘Company’) are charged with conducting their business affairs in accordance with the highest ethical standards.  An employee shall not conduct himself or herself in a manner which directly or indirectly would be detrimental to the best interests of the Company or in a manner which would bring to the employee financial gain separately derived as a direct consequence of his or her employment with the Company.  Moral as well as legal obligations will be fulfilled openly, promptly, and in a manner which will reflect pride on the Company’s name.” —From the Enron Code of Ethics (July 2000)