Accounting for Enron

Law professor James D. Cox scrutinizes the Enron scandal--the largest corporate bankruptcy in U.S. history--and the failures of the accounting profession to provide fair warning of the company's problems.
March 31, 2002


School on scandal:Cox explains Enron inequities

School on scandal:Cox explains Enron inequities.

Enron had liabilities in hundreds of partnerships. Does the fact that those liabilities were hidden constitute a failure to disclose the truth?

Under existing accounting principles, it is possible to create special-purpose entities such as what Enron had--hundreds of them, and lots of companies have hundreds of them--and to get the risks and liabilities offshore. Accountants had to assess the likelihood that these liabilities would come back to Enron. Accountants failed to make that assessment; the liabilities came back in huge amounts to cause Enron to go into bankruptcy.

These special-purpose partnerships allow a sponsoring company, in its own financial statements, to eliminate losses and debts from the partnership. Is that an accounting standard that ought to be reformed?

The Financial Accounting Standards Board has had on its agenda for nearly twenty years a wholesale review of how companies report their consolidated assets, liabilities, and earnings. This project has been effectively moribund because of pressure placed on the FASB by firms whose reporting practices may change as a result of reform efforts--changes that could well take the direction of requiring greater transparency with respect to "off-book" liabilities such as those dumped into special-purpose entities.

How legitimate is the concern about an inherent conflict of interest when accounting firms engage in consulting relationships with firms they audit?

Enron had accountants who had a very solid financial relationship with Enron independent of performing accounting services.

So here they are coming in and evaluating the accounting system and record-keeping functions, and at the same time they are the record-keepers. For every dollar of audit services that Arthur Andersen was able to bill Enron, they provided one dollar of non-audit services. There are accounting firms that derive 60 to 80 percent of their total revenues from non-auditing functions. The real question is, are we sure that accountants really serve the role that we envision for them, which is being independent assessors of how transactions are to be recorded and disclosed on the books? If we could only make one change, then we would sever the consulting business from the auditing.

How tough is it for auditors to stand up to management, and how common is it--as with Enron and Andersen--that outside auditors would come to work for the company?

There has always been something like a revolving door; that's almost a natural progression given the symbiotic relationship that exists between the accountants in charge of the job and the client. The feeling has been that strengthening the audit committee of publicly traded firms--which the Securities and Exchange Commission did a couple of years ago--would bolster the independence of the accountants. The idea was to make the audit committee totally composed of outside directors who are financially literate, and to require them to meet regularly with outside auditors. But it's going to be hard for the auditors to be independent as long as they realize that there are substantial revenues to be gained by not being too outspoken.


Does this case also show that corporate boards of directors can be too easily seduced into complacency at the expense of their oversight responsibilities?

We know the Enron board was fully aware of a couple of the entities that were created, where the senior officers had a financial stake. And they had a code of ethics that barred such conflicts of interest. That creates a curious situation where good ethical practices can get turned on and turned off by a board. And we wonder what exactly is the driver for that, how well were they informed about the consequences of these special-purpose partnerships?

What made the whole house of cards start falling down was the revelation that Enron had created some special-purpose partnerships in which its executives had a financial stake and from which they had profited mightily. And on close scrutiny, it was realized that those partnerships created situations where some of the liabilities had to come back to Enron. That revelation created doubts about all the other partnerships, and on news of this, Enron's stock started declining because of a lack of faith in management. The decline in Enron stock then ratcheted up its obligation to issue more shares on some of the partnerships--it was sort of like a reverse Ponzi scheme, a race to the bottom.

Does this case suggest a caution as well about the advice of Wall Street analysts, since they may be more beholden to investment-banking interests--who presumably benefit from stock prices being pumped up--than to investors?

Yes. Recent events have revealed that analysts face serious conflict-of-interest problems. Press accounts last spring were filled with stories of analysts holding shares in companies for which they prepared reports--and pointed to a strong correlation between investment-banking services provided and the investment bank providing analysts' reports touting their clients.


Would a careful investor have noted that Enron, while representing itself as one of the fastest growing corporations, was facing a cash shortage?

A careful investor could not. I have looked at some parts of its financial statements, and they're absolutely impenetrable. The description of the special-purpose entities and the role they played in Enron was not decipherable even to a rather skilled law professor. And the fact that this collapse caught markets by surprise indicates that even the best-advised funds were caught flat-footed on this one.

How serious is the concern that other companies may have exaggerated earnings because of misleading accounting practices?

It's a very serious problem. There has been a fourfold increase in the space of four or five years in the number of earning restatements--that is, a correction of earlier released net income figures.

Enron developed into a new kind of global corporation, specializing in speculative futures. Does that sound like a solid foundation for business?

The company suddenly went from pipelines to providing services, and that makes it much more difficult for an accounting firm, not to mention the average investor, to evaluate what numbers really are relevant in assessing its performance. They were dealing in very sophisticated trading transactions built around an instrument that only exists on a computer screen. So it was very difficult for auditors to figure out whether the transactions had the effect that Enron was saying they had.

More than half of Enron's employees' 401(k) assets, about $1.2 billion, were invested in company stock, which is now nearly worthless. Should there be new rules on company-mandated one-stock plans?

Absolutely. The poorly diversified employee is especially at risk in this environment, where we are constantly reducing the safety net in terms of public funding for retirees. You don't take care of yourself very well if you're not diversified. Microsoft employees may benefit by having all of their investments in Microsoft. But that doesn't have to be their retirement money--it can be their discretionary earnings. Diversification or retirement plans should be a requirement; I think we should be paternalistic, at least with respect to retirement plans.

How badly has the accounting profession been damaged by this unraveling?

This is a dark day for the accounting profession. Here we have a major accounting firm that made a major mistake, and that came from being too close to the client. So the notion of auditors being independent has become somewhat laughable. Accountants have been very good at winning arguments on Capitol Hill over many years. They'll change at their own will only when they realize that if they don't, they're going to be ground into the dirt by external forces.

Early on, Treasury Secretary Paul O'Neill made the statement that the Enron collapse is just a consequence of capitalism. Was he being realistic?

It's true that businesses fail. But you want to be sure that the reporting process along the way allows investors to assess what the risk is. That doesn't mean that they have to be able to predict it perfectly, but there's lots of evidence here that investors didn't know the gravity of the ticking time bomb that was inside Enron. The business was failing, but how transparent were its financial statements in alerting people to the possibility that it would fail?

One of the true treasures that America has is the international reputation of the strength and vitality of our capital markets. That depends on transparency in reporting. With many more disasters like Enron, we won't have this national treasure, and it will be very hard to get it back.

Cox specializes in corporate and securities law. His books include Financial Information, Accounting, and the Law. He has published extensively on market regulation and corporate governance, and has testified before Congress on insider trading and market reform.