Conflict of interest Part III – The Enron accounting scandal

So far, we have carried two articles on the issue of conflict of interest. One blogger suggested that I highlight specific examples so that the “theory’ that I have expounded could be better appreciated.  I did mention at the end of my last article that today we will be discussing the major accounting scandals involving Enron and WorldCom and that these were the result of human failings to uphold high ethical standards. In both cases, commercial interest took precedence over allegiance to professional integrity. It has also been suggested that the Enron’s case was the biggest audit failure in American history. As a result of these scandals, the United States Government has passed the Sarbanes-Oxley Act of 2002 to restore the reliability of the public company audit process by, among others, prohibiting auditors from rendering consulting services for the company they are auditing.

I alluded to the fact that this problem was recognized as far back as 1993 in Guyana in relation to the audits of State-owned/controlled entities. Prior to then, most of the public corporations and entities in which the State had controlling interest were audited by a private auditing firm without the involvement of the Auditor General. Many of these entities were in dire financial difficulties, yet the auditors’ reports reflected in most cases unqualified opinions and there were hardly any warning20131014watch signals from the auditors. In addition, there was no requirement to preclude the auditors from rendering accounting, consulting and taxation services for the entities in which they were the auditors, and in many cases such services were indeed rendered. Further, there was no requirement for ineligibility after providing auditing services for an entity after, say six years, and the auditors concerned in most cases served for many years beyond this period.

As a result of the above, the then Financial Administration and Audit (Amendment) Act was passed to make it a requirement that wherever the State has controlling interest, the Auditor General must be involved. The prelude to this was my dispute with the then Minister of Finance, Mr. Asgar Ally, who like his predecessor Carl Greenidge, considered the Auditor General as the external Auditor of central government activities only, and that responsibility for the appointment of auditors for the rest of the public sector rested with the Minister.  Matters came to a head when I was removed as the auditor of the Bank of Guyana.  In his famous ruling on the matter, the then President Cheddi Jagan stated, “When I was the Leader of the Opposition, I also wondered why it is that the Auditor General was not involved in the audits of public corporations. As a matter of policy, he should be involved, and if the law does not provide for this, let us amend the law”. It was the shortest meeting I have attended. Neither Mr. Asgar Ally nor I was allowed to present our arguments. We simply said, “Yes, Mr. President”, and the meeting ended.

The Act was amended to extend the mandate of the Auditor General to the entire public sector with the proviso that the Auditor General may contract the services of Chartered Accountants in public practice to assist him, if he considers it desirable. Once appointed, Chartered Accountants in public practice were precluded from rendering accounting, taxation or consulting services for entities for which they were appointed auditors. There was also a period of rotation in that Chartered Accountants in public practice were not eligible for reappointment after serving for four consecutive years. The Audit Act of 2004 has lifted that period to six years.  The former President Bharrat Jagdeo, in his maiden presentation in the National Assembly, piloted the successful passing of the amendment to the Act.

Understandably, the chartered accounting firms were furious at this new development, especially as regards the supervisory role of the Auditor General in relation to the contracted audits. In time, however, these firms became accustomed to the new arrangements, and more auditing firms became involved in the contracting out arrangements.  It was, however, unfortunate that immediately after I was forced to demit office in January 2005 because of a lack of government support and indeed hostilities at the highest level of the Executive, Chartered Accountants Ram & McRae were overlooked for future audits under the contracting out arrangements. That firm had given yeoman service to the Audit Office and stood out among the contracted auditors.

 

The Enron accounting scandal

 

Enron Corporation was an American energy company based in Houston, Texas. It was formed in 1985 by Kenneth Lay with the merger of Houston Natural Gas and InterNorth. Jeffrey Skilling joined the company several years later as Chief Operations Officer. With the assistance of some executive staff members, he used accounting loopholes, special purpose entities, and poor financial reporting to inflate the value of the company’s assets and to hide billions of dollars in debts from failed projects. Andrew Fastow, the Chief Financial Officer, and other executives also misled the board of directors and the audit committee about the accounting practices adopted.  In addition, the external auditors, Arthur Andersen, at the time one of the five largest auditing and accounting practices in the world, approved of Enron’s accounting practices.

However, the auditing firm found itself in a conflict of interest, having not only been the company’s external auditors from the inception but also rendering consulting services to Enron. During 2000, Andersen earned US$25 million in audit fees and US$27 million for consulting services.

Enron’s share price increased from the start of the 1990s until 1998 by over 300 per cent, then 56 in 1999, followed by 87 per cent in 2000. By the end of 2000, the share price was $83.13. Enron adopted a form of creative accounting called “mark-to market” accounting. This involved using market values, as opposed to historical data as the basis for recording the company’s assets. The latter, which is the recognized generally accepted accounting practice, is a conservative approach and is based on verifiable information compared with the former which is very subjective and which can result in a significant inflation of assets, profits and hence share values. In addition, debts were hidden away by the creation of off-balance sheet vehicles, complex financing structures, and according to Bethany and Elkind in their book “The Smartest Guys in the Room”, deals so bewildering that few people could understand them. In her 5 March 2001 Fortune article entitled “Is Enron Overpriced?” Bethany McLean questioned how Enron could have maintained such a high stock value which was trading at 55 times its earnings. She then reviewed Enron’s 10-K report and found “strange transactions”, “erratic cash flow” and “huge debts”. Richard Grubman, a Wall Street analyst, also questioned Enron’s accounting practices but was verbally attacked by Skilling. By mid-July 2001, Enron’s share price decreased by more than 30 per cent compared with the same quarter of 2000.

 

On 14 August 2001, Skilling resigned from his position immediately after he had sold off at least 450,000 of Enron’s shares which he held. The price he obtained for these shares was around US$33 million. Skilling admitted the next day that his decision to resign was due to “Enron’s faltering share price in the stock market”.

On 15 August 2001, Sherron Watkins, vice president for corporate development, alerted Kenneth Lay about Enron’s accounting practices. She said that “I am incredibly nervous that we will implode in a wave of accounting scandals.” Instead of seeking independent advice on the matter, Lay chose to consult with the company’s law firm, Vinson & Elkins.

This was despite a warning from Watkins that such an action would constitute a conflict of interest. As expected, the law firm saw nothing wrong with Enron’s accounting practices, as Arthur Andersen had approved of such practices.

On 22 October 2001, Enron’s share price decreased to US$20.65, down by US$5.40 in one day, after the Securities and Exchange Commission (SEC) announced that it was investigating several suspicious deals struck by Enron. Two days later, Fastow was dismissed from his position as Chief Financial Officer. This announcement caused the share price to be further reduced to US$16.41, having lost half of its value in a little more than a week. On 30 October 2001, the credit rating agency, Moody’s lowered Enron’s rating from Baa 1 to Baa 2, two levels above junk status. By this time, Enron’s shares were trading at US$7.  Both Moody’s and S&P further downgraded Enron’s rating to one notch above junk status.

The retirement accounts of Enron’s employees, which are linked to Enron’s share value, decreased by 90 per cent in one year. The SEC then announced that it had filed a lawsuit against Andersen. On 28 November 2001, Enron’s rating was reduced to junk status. As a result of the myriad of problems facing the company, Enron filed for bankruptcy on 2 December 2001 under Chapter 11 of the United States Bankruptcy Code. On 17 January 2002, Enron dismissed Andersen citing its accounting advice and destruction of documents.

To be continued

 

 

 

 

 

 

 

 

 

 

Around the Web

Comments