What went wrong? Accounting fraud and lessons from the recent scandals.(Essay)

In the public eye, Enron's mission was nothing more than the cover story for a massive fraud.

--Bethany McLean and Peter Elkind

CORPORATE FRAUD, BANKRUPTCIES, AND VARIOUS ILLEGAL ACTS HAVE

always been part of the business environment. Every time fiascos erupt there is a shock, but business history records dozens of major failures, frauds, and other measures of massive corruption each decade. The big ones often hit during recessions or periods of other economic problems, as expected. The high-risk firms are the most vulnerable to economic shocks. The recent scandals are no exceptions. The most important scandals are the focus of this paper and are summarized in table 1.

Although the problems that exist are diverse, a few common characteristics stand out. The first is the obvious backdrop of corporate greed. Presumably, senior executives expect to get away with it. They also fit the financial-corporate culture described above. And earnings manipulation is part of (and usually central to) most of the scandals. Some of them used brazen and unsophisticated approaches (such as WorldCom), while others used new, sophisticated devices to defraud (like Enron). Determining the existence of criminal acts takes years.

Two industries were particularly prominent in the scandals: the energy companies and telecommunications. Deregulation allowed the stodgy energy companies that carried out such basic operations as transmitting natural gas to become high-tech energy traders using sophisticated derivatives and structured-finance deals. The result was giant profits for the lenders. Continued big profits meant increasing risks and more complex deals. For Enron and others it also meant hiding the losses in controversial and often fraudulent off-balance-sheet schemes. The telecommunications industry transformed from monopolist AT&T in the 1970s to a group of dynamic and competitive high-tech giants, all trying to integrate and dominate with new telecommunications methods. Overcapacity led to shady capacity-trading schemes booked as revenues and, despite the deceptive accounting, big losses and bankruptcies.

The various investment bank scandals are included because their deceptive practices encouraged earnings management and an environment of fraud. The recent mortgage-related scandals directly involve investment banks. Investment banking deals, especially those that were complicated and skirted the regulations, were very profitable. The banks would seemingly do any deal and locate it anywhere in the world for the right price. Rather than emphasizing financial and economic reality, analysts and brokers were encouraged to push stocks of companies doing investment-banking business with the parent company, irrespective of the underlying performance potential.

Enron and WorldCom were the largest scandals in American history in terms of the size of the companies (based on market capitalization). Both represent fraud on a large scale, although entirely different from one to the other. Enron used sophisticated fraud based on complex financial instruments, while WorldCom used an unsophisticated scheme of capitalizing operating expenses for several billion dollars. Many of the other corporate scandals around 2002 also involved relatively large companies. The shock of Enron led to congressional hearings and, after the fall of WorldCom some six months later, real financial reform with the passage of the Sarbanes-Oxley Act of 2002.

ENRON

Enron is the premier scandal, a "new economy" energy-trading company that seemed to succeed at everything it attempted. At its height, which occurred on August 23, 2000, Enron had a stock price over $90, which gave it a market value of almost $70 billion. Revenues for 2000 were over $100 billion, making it the seventh-largest American corporation (based on revenues); stated assets were $65.5 billion; earnings were $1.3 billion (if a $287 million write-off is ignored). Stock returns for Enron were large, 89 percent just for the year 2000 and 700 percent for the decade. This performance resulted in huge compensation payments to Enron chairman Kenneth Lay (a base salary of $1.3 million, $7 million bonus, plus 782,000 stock options for the year; Lay also exercised 2.3 million options, for a gain of $123 million). Manipulation was paying off. The stock would trade for less than $1 later in 2001, the debt would be rated junk and the company declared bankruptcy December 2, 2001. Despite the total collapse, many of the executives would cash out their options and be paid additional millions, while thousands of Enron employees were fired and lost all of their retirement funds invested in Enron.

In terms of scandal, Enron had it all: gigantic executive compensation incentive packages; management dedicated to meeting all quarterly earnings forecasts to maintain the compensation--often by accounting manipulation; a rubber-stamping board of directors; a chief financial officer (CFO) enriching himself through related-party partnerships and hidden side agreements; an accommodating auditor in Arthur Andersen, and an equally accommodating law firm in Vinson and Elkins; investment bankers who would structure virtually any financial deal anywhere in the world for big fees, and whose financial analysts always seemed to rate Enron a strong buy, no matter the economic reality; and a political system that often stacked the deck in favor of Enron, thanks in part to large campaign contributions and massive lobbying. People who raised doubts, both inside and outside the company, were often fired. Otherwise, there seemed to be a complete lack of ethical standards by almost everyone involved. Enron can be considered a microcosm of the entire scandal environment.

There have been more books and articles written about Enron than any other scandal, many written by insiders and journalists following Enron for years. Power Failure: The Inside Story of the Collapse of Enron (2003) is coauthored by whistleblower hero Sherron Watkins (with journalist Mimi Swartz), an Enron vice president who attempted to convince CEO Kenneth Lay of the seriousness of the accounting manipulations. Kurt Eichenwald's Conspiracy of Fools (2005) is the last of the significant books and probably the best in detailing the Enron story. Other books include The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron (2003) by Bethany McLean and Peter Elkind; Anatomy of Greed: The Unshredded Truth From an Enron Insider (2002) by Brian Craver; and Enron: The Rise and Fall (2003) by Loren Fox. Enron: What Happened and What We Can Learn From It, by Bentson and Hartgraves (2002) was a serious academic attempt to put the Enron scandal into perspective for the future of financial accounting and auditing.

THE EARLY YEARS

Enron started as a big, stodgy gas transmission company when InterNorth Inc. and Houston Natural Gas merged in 1985. It had the largest gas transmission system in the United States: a 38,000-mile pipeline network. Kenneth Lay soon became CEO. The name Enron was adopted in 1986. One result for the merger was a load of debt, a continuing problem when Enron executives wanted to expand rapidly--and new junk bonds did not help the leverage ratios or investor confidence. (Enron bounced around between low investment grade and junk bond ratings.)

Enron's first scandal was in 1987. The dubious response by Lay, Arthur Andersen, and others suggests their interest in profits over ethics and willingness to hide bad news. The company had a small energy-trading subsidiary in New York called Enron Oil. It was started and run by Louis Borget. Although profitable (important for a slumping Enron), it was fraudulent from the start. Part of the manipulation was moving profits from one period to the next, apparently based on orders from Houston.

Enron's auditor, Arthur Andersen, investigated and discovered several unusual transactions and potentially fraudulent acts. They reported to Enron's audit committee, but would not comment on the illegality of the acts. If material, Enron would have to disclose the impropriety to the Securities and Exchange Commission (SEC) and restate earnings. Rather than face these sanctions (and possible bankruptcy), Enron declared the problems immaterial and did not disclose the bogus transactions. Andersen went along with the decision. And, amazingly, Borget stayed on. A crooked operation seemed to be okay if profitable.

Unfortunately for Enron, Borget was still a crook. Some of the fraudulent acts benefited Enron, but Borget was interested in diverting cash for himself and accomplices. There were two sets of books, one real and one for the Houston office. There were sham transactions, kickbacks from brokers, phony companies, and various offshore accounts.

Borget skimmed some $4 million from Enron. Borget speculated using cash vastly beyond the limit amounts stated by Enron, and later bet wrong on the price of oil. Trading losses approached $1 billion before he confessed. Enron ended up taking an $85 million loss (after taxes) in 1987. Despite the earlier indications of fraudulent activities, Lay denied responsibility and blamed only the rogue traders for the loss.

The SEC and U.S. attorney's office investigated Enron, but the focus was on Borget and his cronies. Borget was sentenced to a year in jail. The trading operation was shut down. Enron restated earnings in 1988, but survived despite this lack of honesty. However, it seems the lesson that Lay and others drew from the episode was the importance of cover-ups and obfuscation. The basic internal controls and governance policies in place did not work but remained uncorrected.

GAS TRADING

Until the 1980s, natural gas was highly regulated and gas prices controlled. Gas contracts were mainly long term and relatively little risk was present for buyers and sellers. Pipeline profits were fairly low but dependable. That all changed with deregulation. With volatile gas prices subject to market conditions and the potential for lower prices, gas users moved from long-term contracts to the spot market (initially 30-day supply contracts). In this now unstable market, prices initially fell, supply dropped, and prices rose again.

This was not a profitable environment for a pipeline company. Lay's business strategy shifted to the unregulated gas sales market, which lent to Enron's gas-trading business. Enron bought and sold standard amounts of gas and became a market maker, initially from …