Lessons from Enron

Abstract

Some of you know that I have been the Arthur Andersen & Co. Alumni Professor of Accounting at Lehigh University since 1982. A few will know that my relationship with Andersen goes back to 1963, when, as an undergraduate, I was recruited by Fred Zimmer for a summer internship in Andersen's Chicago office. The legendary Leonard Spacek was just finishing up as Andersen's managing partner. Thus, the string of embarrassments afflicting Andersen--Waste Management, Sunbeam, Boston Chicken, Global Crossings, the Baptist Foundation of Arizona, and Enron--hits me particularly hard. A Watershed Event I am not alone in finding the Enron tragedy to be highly instructive, the kind of watershed event that comes along once in a generation or so, the jaws of the kind of disaster from which victory--the good name of the accounting profession--might be snatched. Below I outline some of the lessons to be learned but do not claim to have originated them. Most observers are well aware of the pressures exerted upon the accountancy profession in its role as the public watchdog investors trusted and the countervailing power to corporate financial-reporting interests. Enron is only the latest, most vivid example of the confluence and intensity of those pressures. Accounting Does Not Cause Companies to Implode, But... Public accountants do not make their clients' management decisions. Instead, they advise on accounting matters and are to object when management's financial reports fail to provide the transparency necessary to alert the capital markets to the entrails of the corporation's activities. We understand that the information management wants to report regarding their performance can differ from the information investors need to make investment decisions. We also understand how the notion of countervailing power advanced by John Kenneth Galbraith can relate to business and labor, and to CFOs and CPAs. (1) But suppose that management misunderstands the accounting, or that management misinterprets the auditors' explanation of detailed accounting rules to the point that black appears to be white. Can the accounting, which should portray the economic reality resulting from decisions, actually mask that same reality, and persuade insiders that there is no danger? When expert outside accountants and attorneys bless the financial depiction of internal events, many can be misled. Thus the public accountants' responsibility for ensuring that no one is fooled encompasses both the external capital markets and the internal decision makers. Although preparers must ultimately bear responsibility for issuing misleading information, expert accounting and legal advisers can inadvertently help preparers deceive themselves, as well as those who rely on the preparers' disclosures. Generally Accepted Accounting Principles, If You Know What I Mean (laughter) Many will recognize this quotation that makes fun of the loopholes or flexibility in GAAP that can be invoked as support for a variety of financial results. Aware of how this flexibility might exacerbate the tension between managements' and investors' demands for financial information, standard setters saw the need for detailed rules, seeking to keep the corral gates closed. Preparers responsible for applying GAAP, and auditors who review their applications, gradually became dedicated to the proposition that their roles are to comply with the detailed criteria in accounting standards. Some financial-reporting decisions seem driven by the urge to tick off the boxes in checklists; participants in the process apparently forgot the goals of fairness, accuracy, and transparency. In retrospect at least, the 3 percent rule and other criteria for certifying the independence of Special Purpose Entities (SPEs) seem ludicrous. Adhering to this rule may satisfy preparers and auditors that their decision not to consolidate the SPE will hold up under SEC scrutiny. …