Enron and Off-balance Sheet Financing - Case Study Example

Topic: Enron and off balance sheet financing Introduction: This paper seeks to discuss what could be learned from the experience of Enron and its off balance sheet financing. We will therefore answer different relevant questions on what are the roles of the Enron management, the auditors , the regulatory agencies, the accounting standard setting bodies as to the cause and resolution of the problem on the collapse of Enron as one of the companies in the industry where it belong. An examination is also made on adequacy of present accounting standards as to possible prevention of similar event in the future. 2. Analysis 2.1.1 Brief background of Enron Enron was an energy-related company engaged in traditional energy related services, trading energy commodities, futures transactions, and other finance activities. In December 2001 Enron filed for bankruptcy, the largest corporate failure in US history. The bankruptcy filing followed investment write-offs and related earnings restatements totalling more than $1 billion, caused by the consolidation in Enron’s financial statements of debt the had been previously “hidden”. It is argued that “bad” accounting practices had inflated earnings and capital employed by the use of off balance-sheet financing. Such practices had not been blocked by Enron’s auditors, Arthur Anderson, and it is claimed that the rules which applied to the company in the US were not robust enough to prevent such accounting practice; this has led to criticism of the auditors and of financial reporting practice and those who regulate it. In the wake of the collapse there has been much activity designed to tighten up the rules relating to financial reporting and auditing, including legislation (the Sarbanes- Oxley act) and new rules imposed by the Securities and Exchange Commission and the New York Stock Exchange. The impact of these changes is still unfolding but extends worldwide as they affect all companies which seek a listing in the US. 2.1.2. Objective of study The objective of this case study is to try to understand why Enron collapsed and how financial reporting practice failed to alert investors and other stakeholders to the problems of the company in time to avoid the huge losses sustained. In particular, it focuses on the accounting areas of income recognition and off balance-sheet financing which are said to lie at the root of the problems. Information needed to understand and analyse the issues involved are taken from newspapers, magazines articles and internet sources. In order to attain the objectives the following questions need to be answered: 2.2.0 Questions: 2.2.1 Why is accounting being blamed for the losses sustained by investors as a result of the collapse of Enron? Is this criticism fair and do financial accounting and reporting practices need to be reformed? Hartgraves, A.L. and Benston, G. J. (2002) said that critics harshly criticized Enrons auditor, Arthur Andersen, for allowing Enron to exclude from its financial statements (Financial Terms, 2005) the SPEs it sponsored, thereby keeping a substantial amount of debt off its balance sheet and recognizing substantially higher profits from transactions with SPEs. SPEs refer to special purpose entities. Auditors are practising professionals who have the duty, through their opinions, to see to it that the financials statements of the companies they audit must comply with the generally accepted accounting principles (GAAP) which also refers to the accounting standards issued by the Financial Accounting Standards Board (FASB). Arthur Anderson, however blamed the rules which when applied to the company in the US were not good enough to prevent such accounting practice. By blaming accounting, it is implying that accounting could speak or make decision for itself; hence it would seem unfair to do. It should be people that should be blamed and these are not limited to accountants as reported by Wee (2001) in article entitled ‘Enron in Perfect Hindsight’ as follows: But truth is, this sad saga has no shortage of culprits -- accountants, the companys board, stock analysts, shareholders, and the press all bear some of the responsibility for not realizing sooner that something untoward was going on at Enron (see BW Cover Story, 12/17/01, "The Fall of Enron"). 2.2.2 Does it matter what accounting policies are adopted by a company as long as they are adequately disclosed? Accounting policies matters because they represent they represent the methods, principles, practices, rules, bases and conventions adopted by an enterprise in preparing financial statements. Said accounting policies need not only be disclosed but they must comply also with the generally accepted accounting principles. For example, the fact that the company has the accounting policy of depreciating its fixed assets under one method when the generally accepted accounting is under another method, is not being made correct by mere disclosure of the accounting policy. Although disclosure are meant to inform users of representations used in the financial statements , they are not enough to justify what would have been reflected in the financial statements as result of compliance with the generally accepted accounting principles. 2.2.3. To what extent did Enron use off balance-sheet financing in its operations? Were these transactions appropriately treated and adequately disclosed in the financial statements of the company? What consequences did the accounting treatment of these transactions have for Enron and its investors? It appears that the extent of use off balance-sheet financing in its operations is really huge. This is the reason why Enrons auditor, Arthur Andersen, is harshly criticized for allowing Enron to exclude from its financial statements the SPEs it sponsored, thereby keeping a substantial amount of debt off its balance sheet and recognizing substantially higher profits from transactions with SPEs. (Hartgraves, A.L. and Benston, G. J., 2002) Resorting to off-balance sheet financing was one of the causes of bankruptcy in billions of dollars. This fact is reported by the report of Reuters (2001) when it said: Enron, its energy trading empire in ruins, filed for Chapter 11 bankruptcy protection on Sunday and hit rival and one-time suitor Dynegy with a $10 billion breach of contract lawsuit for pulling out of a last-ditch merger effort. The filing in federal bankruptcy court in the Southern District of New York sought protection from creditors while Enron, burdened with at least $16 billion in debt, tries to reorganize its finances. Under Chapter 11 of the U.S. bankruptcy code, a company can continue to operate while it and creditors work out a reorganization plan. As to whether these off-balance sheet transactions are appropriately treated I submit that they are not and the statement of proper disclosure will not be an issue if there is no proper treatment of the accounting transactions in the first place. There was improper treatment because the SPE should have been part of the liabilities in the balance sheet (UNEP DTIE, 2003). In other words disclosure will complete what was properly done but will not be able to complete what was improperly done. The consequences of the wrong accounting treatment of the transactions for Enron investors and its would-be investors are really bad. For Enron, it collapsed as a result of loss of trust and confidence of some of the existing stockholders with their discovery that their financial statements are bloated or window dressed. With the loss credibility and confidence of some of the existing stockholder, the effect was to influence investors to lose their trust as well to the company and correspondingly the fall of stock prices for Enron, which is a an indicator of the value of the corporation. 2.2.4. Would similar treatment of off-balance-sheet transactions be permissible in the UK? If the issue of permissibility would mean that UK companies and auditors, where FRS -5 is the rule, could not do what happened in Enron, we will have to take the statements of experts on the matter. Michael (2002) said: A fellow IASB board member Geoffrey Whittington said: "We dont know that UK standards could have coped better with an Enron than US standards. FRS-5 was fine in its day but there are some very clever people out there who find very clever ways to dress things up favourably in the eyes of the stock market. You cant anticipate the devices such people will come up with." For the uninitiated, FRS-5 aims to oblige companies to clarify the impact of off-balance sheet assets on their general financial situation. For example, if a company has a sale-and-leaseback agreement on terms that would require it to repurchase the asset if it got into difficulty, the liability should be disclosed. The auditor must then make a statement that the accounts give a "true and fair" representation the "substance" rather than the "form" of the off-balance sheet arrangements. Comment: When the court regulating would come into the picture to implement the standard, it could use the ‘substance’ of the transaction and it experts hope it will work but as Geoffrey Whittington said people could be unpredictable. To make case more interesting Michael (2002) also reported: Perhaps unsurprising, FRS-5s chief architect is less keen for a revolution. Allan Cook, now the technical director of the ASB, said: "I would want to see proof that it is not working. One could tweak it but the general approach is correct." And there are some aspects of off-balance sheet financing, such as the securitisation - or effective sale - of income streams that have their vocal supporters. John Woodhall, the global head of Clifford Chances securitisation practice, said: "This is a legitimate tool which is driven by disclosure. Theres a lot of ill-informed chit-chat out there and to say all securitisation is like Enron is rubbish." Comment: It is hope that the happened in Enron will not happen in UK and it would seem the UK experts are more ready. 2.2.5. Are principle-based types of accounting standard like FRS 5 more effective in dealing with accounting abuses than the more rule based standards in the US? It would appear yes because principle-based would go for the substance of the transaction and not just for the form in case of rule-based as that in the United States. Blanchard III, R. (2003) on Accounting Concepts for the Actuary, said: Accounting standards may take the form of general principles, relying on interpretation and judgment by the financial statement preparers before they can be implemented. Alternatively, standards may take the form of a series of rules, limiting the flexibility and use of judgment allowed in their implementation. This is a natural trade-off, with advantages and disadvantages to each approach. Principle-based standards are potentially very flexible with regard to new and changing products and environments. As such, they should also require less maintenance. But they do have certain disadvantages, such as being more difficult to audit relative to compliance, and concern over consistent and reliable interpretations across entities. To the extent that they rely on individual judgment to interpret and implement the standards, there is a danger that they can be used to manipulate financial results. Comment: It appears that there is no perfect approach to a given a problem. It appears the inherent characteristics of the principle-based standards include the greater difficulty to audit as far as compliance is concerned as well as more possible concern over consistent and reliable interpretations across entities. Of these inherent limitations, the author admitted that individual judgment to interpret and implement standard could result to possible manipulation of financial results. If we try to relate this principle in the case of Enron, it would appear that the possibility of abuse in the manipulation of financial results is still there. Why has Enron case happened when what were applicable in the US were the rule-based standards? Before we can answer this question, we need to undertand the characteristics of rule-based standard. As far rule-based On the other hand, Blanchard III, R. (2003), said: Rule-based standards are generally considered easier to audit for compliance purposes, and may produce more consistent and comparable financial reports across entities. Disadvantages may include a lack of flexibility with regard to changing conditions and new products, hence requiring almost continual maintenance at times. A concern also exists that rule-based standards are frequently easier to “game”, as entities may search for loopholes that meet the literal wording of the standard but violate the intent of the standard. Comment: Based on the above, we should notice that entities may search for loopholes that meet the literal wording of the standard but violate the intent of the standard. It appears that under the rule-based standard, the standards are more specifically or positively worded than the under the principle-based but that they face constrained interpretation that could still result to manipulation in the manner of literally complying by intentionally avoiding. The standard setting body need not be limited by these theoretical undertones because a wise and broad-minded standard setting body could always include the definitions for words to not specific and which could still approximate the concept of principle-based standard. In other words, the hands of a regulating body like the SEC or the standard setting body like the FASB must not allow its hands to be tied which the seeming trade off of advantages and disadvantages of the two forms or types of standards. They could always make a modification to address the demand of the times. Moreover rule making, need not be too detailed. Rules could be broad enough to afford an objective interpretation. If we apply then this concept of rule based as what happened in Enron, it would seem we are constrained to say that its management could have tried avoiding responsibility by being too literal but not substantially complying with the American accounting standard. With these developments, where would a principled-based standard as that in FRS address the concern that was encountered and experience with the case of Enron? It would seem that there is still another side of the equation which may be neglected to be included, that is the propensity of the enterprising business to result to such kind of violative practice due to the lure of money. In other words, standards are just standards, they may prohibit hermitically any slight violation under the sun, but man is always free to violate the same with due suffering of course of the consequence if they could not justify them selves in the eyes of the law. Or perhaps on the other hand, the standards are really tightly made but they are just not implemented. Standards will always be standards but if they are not implemented then they would not be meeting their designed objectives. 2.2.6. What has been the overall impact on corporate reporting of Enron and other recent financial scandals? The overall impact on corporate reporting of Enron and other recent financial scandals is for the investing public to lose their trust also in the financial system of corporations in the listed stock exchange (American Century Proprietary Holdings, Inc., 2006). They will lose their trust in the practice of the accounting profession in terms of auditors trying to connive with the corporations instead of protecting the interest of the Public. In relation to this, Ackerly, T. (2002) said: The financial scandals involving large U.S. companies such as Enron and WorldCom prompted a number of legislative and regulatory initiatives in the spring and summer of 2002, all designed to “clean up the mess” and restore public confidence in the financial markets. These efforts culminated in the enactment on July 30, 2002 of the Sarbanes-Oxley Act (the “Act”), sweeping legislation that affects every company publicly traded in the U.S., including companies based outside the U.S. In addition, there have been important developments on issues not addressed by the Act. The extraterritorial scope of the Act has raised a number of concerns. The U.S. Securities and Exchange Commission (“SEC”) has broad authority to create exemptions from the requirements of the U.S. securities laws generally; in addition, the Act specifically directs the SEC to promulgate regulations implementing many of the Act’s provisions. For these reasons, and because only a few implementing regulations have been published to date, there remain open a large number of questions concerning the Act’s impact on non-U.S entities. These issues are both conceptually difficult and politically sensitive. On the one hand, the SEC is mandated to implement the law as enacted by Congress. As SEC Chairman Harvey Pitt said in a recent speech in Brussels, the Act addresses problems that are “global in dimension,” and the SEC will be “fully faithful” to the “letter and spirit” of the Act. On the other hand, Chairman Pitt adopted a conciliatory tone on the subject of extraterritoriality. He said, “We are aware of the fact that [many of the Act’s] requirements . . . can conflict with internal corporate structures and legal requirements in home jurisdictions.” He concluded by asking interested parties from outside the U.S. to “let us know when our proposals conflict with local law or local stock exchange requirements. . . . [W]e does promise to listen, and do our best to harmonize the application of our rules with foreign sovereign requirements.” Comment: As with any kind of situation, governments come up with additional laws to address seemingly unique situations, hence the enactment of on July 30, 2002 of the Sarbanes-Oxley Act. This and other government actions are of course understandable but it implies a meaning that the government is just reacting to situations while it could be proactive and preventing the happening of such events. But by so reacting in making a law it necessarily affected other business opportunities from non-US companies which would like to be publicly traded in the US. As admitted by author above, a large number of questions concerning the Act’s impact on non-U.S entities are both conceptually difficult and politically sensitive. Had not the US congress acted by ‘overkill’ an otherwise would local problem that could have been addressed locally? It is now a situation of supposed solution to a problem but a solution creating another problem. The challenge now is with the SEC to provide exemptions in the Sarbanes-Oxley Act. The next question is would the check be able now to provide exemptions to other non-US companies because they happened to have different internal rules in the stock exchange of their home countries. Would these actions pro or anti-American in the end? Has US Congress passed a law that would protect non-US companies when US SEC would happen to grant exemption? This I suppose will not happen if US SEC will first protect American interests before anything else. Our analysis is actually shared by Basset, R and Storrie, M (2003) when they said: Sarbanes-Oxley is the 21st-century equivalent of economic imperialism, as it arbitrarily dictates the standard of behaviour to non-U.S. accounting bodies, foreign owned companies, and non-American executives. 3.0 Conclusion and Recommendation 3.1 Conclusion: Standards play important roles in every regulation. Accounting standards for one are important in gauging the extent of compliance with regulations which are necessary to protect the interest of every one in the business world specially investors in the stock exchanges. Investors need information for decision making, First and foremost they need relevant, timely and reliable and objective information for decision making. Investors deserve a fair return of their investments and stock exchanges and the US SEC and FASB play an important role in meeting the need of investors while protecting their interests for possible manipulation of financials results which could in one way or the other mislead said the decision makers. Standards could be rule-based or principle based and each type has its own merits and demerits but law makers’ hand must not be tied with theoretical undertones because they could always make combinations of modification of the type of standards. However, the power of US Congress to make laws need not result to an ‘overkill’ on existing problem since solutions to problems could result to creation of additional problems which were not contemplated. It would be a good thing to happen if the Sarbanes-Oxley Act would result to prevention of evils like those that happened in the case of Enron or any similar or related situations, for by then Congress would have attained its purpose of being a proactive structure in society. On the other hand, the most specific law might be there in place while not allowing inflexibility in implementation to protect investors. But if the decision makers would choose to violate the law because they happen to be able to face the consequences of their actions by successfully or successfully having fought their cases in court, then that would be another angle to look at too. 3.2 Recommendation: I recommend that companies follow the standards set the standard setting bodies. This advice should be taken in the context of promoting and balancing the interest of every stakeholder in the business community. Companies my fool investors at the start but they could not stay there fooling investors all the time. There is such a thing as too good to be true. In the nature of things, what is normal is more readily acceptable. To dream for the stars is not bad but a more common statement could apply here to would be investors and that is: ‘The higher the return, the higher the risk’. Enron wanted to fly high but it could be too high to break what is natural. Bibliography: 1. Ackerly, T., (2002), The Global Impact of U.S. Corporate Governance Initiatives {www document) www.cov.com/publications/download/oid43940/314.pdf. accessed March 26,2006 2. American Century Proprietary Holdings, Inc (2006) Investment Glossary) {www document} URL http://www.americancentury.com/servlet/GlossaryManager/acb.americancentury.com/ilStSz.htm , accessed March 26,2006 3. Basset, R and Storrie, M (2003) “Accounting an Energy Firms after Enron Is the “Cure” worse than the “Disease”?” Policy Analysis No 469 , {www document} URL http://www.cato.org/pubs/pas/pa469.pdf, accessed March 26,2006 4. Blanchard III, R. (2003), Accounting Concepts for the Actuary, CAS Study Note {www document} URL www.casact.org/library/studynotes/blanchard6.pdf accessed March 26,2006 5. Financial Terms (2005) {www document} URL http://www.extension.iastate.edu/agdm/wholefarm/html/c3-05.html, accessed March 26,2006 6. Hartgraves, A.L. and Benston, G. J. (2002) “The evolving accounting standards for the special purpose entities and Consolidations.” Accounting Horizons, Vol. 16. {www document} URL http://www.allbusiness.com/periodicals/article/276158-1.html , accessed March 26,2006 7. Michael, K. (2002) Enron: regulatory crisis, {www document} URL http://lists.econ.utah.edu/pipermail/a-list/2002-February/017652.html 8. Reuters (2001), Enron files for bankruptcy, sues Dynegy, News.com, {www document} URL http://news.com.com/2100-1017-276480.html 9. UNEP DTIE (2003), Glossary of Terms & Acronyms {www document} URL http://www.financingcp.org/glossary/glossary.html , accessed March 26,2006 10. Wee, H (2001), COMMENTARY: Enron in Perfect Hindsight, Business Week Online http://www.businessweek.com/bwdaily/dnflash/dec2001/nf20011219_8118.htm accessed March 26,2006 Read More