Perspective
Enron: A Case of Ethical Bankruptcy?

Kevin Michel

By Kevin Michel

By all accounts, Enron represents the largest corporate bankruptcy in history. Thousands of employees have lost their jobs, stockholders and employees with 401(k) investments in Enron stock have lost billions of dollars, and creditors face uncertainty about debt repayment. This business failure was caused by bad decisions on the part of the board of directors, management, employees, and outside advisors. Were these decisions just poor business judgments made within current laws and accounting rules? Or was the fatal flaw due to the unethical behavior of the players? Could the strict application of ethical principles have averted this financial disaster?

The causes of Enron's failure are numerous and very complex. But the incident that precipitated the chain of events was the March 2002 restatement of Enron's 2001 and prior financial statements. Partnerships that were formed by Enron to hedge risky investments and remove liabilities from the company's balance sheet had recorded losses of more than $500 million. The public accounting firm of Arthur Andersen audited Enron's year-end 2000 and prior financial statements, and it reviewed the 2001 quarterly financial statements. When it obtained previously undisclosed information, Andersen concluded that the partnerships were not independent of Enron because of a technical violation of the accounting rules (which require an outside general partner with a risk-bearing investment of at least 3 percent of assets). The "outside partnership investors" were actually Enron officials. Due to the lack of outside risk-bearing investors, it was determined that Enron should have recorded these partnership losses all along, and the restatements were announced.

Ethically, Enron officials had a duty to disclose all relevant facts about the partnerships to Andersen. (Apparently Enron was aware of the technical violation before Andersen learned of it.) On the other hand, one could argue that Andersen should have been more diligent in its auditing. The firm could have required Enron to produce evidence that it had met the accounting technicalities required to effectively ignore these partnerships and their related losses. What motivations were at work here?

For its part, Enron wanted to maintain the high price of its stock. To do this, it had to report steadily increasing earnings. Reporting the partnership losses would have had punishing market consequences. Therefore, management would have been motivated to withhold or misrepresent information that would have increased liabilities and reduced earnings. It's interesting to note that it is a felony to lie to a prosecutor, but it is not a crime for company officials to lie to their auditor.

Critics say that having the auditor hired and compensated by the company it audits is an inherent conflict of interest. They argue that, under the current system, auditors are motivated not to aggressively audit their important clients. Andersen was paid $52 million in annual fees by Enron. Some of that amount was for performing an "internal audit" of the company, and some of it was for consulting. In the aftermath of the Enron bankruptcy, the American Institute of Certified Public Accountants (AICPA) has proposed banning external auditors from performing internal audit services and financial systems consulting. In addition, recently proposed legislation calls for external auditors to be hired and paid by the stock exchanges, rather than by the audited companies. Whatever the outcome of these initiatives, it is clear that the public perception of auditor independence has been badly damaged. Not only did the perceived conflict of interest damage the process, but the admission by Andersen that some of its personnel shredded audit documents further weakened Andersen's attempts to maintain public confidence. Steps to restore confidence in the independent audit system are sorely needed.

It is important to note that Enron's chief financial officer and other employees were partners in the off-balance-sheet partnerships. There is no doubt that this represented a conflict of interest, and Enron's board acknowledged it as such. To address the conflict, and to ensure fairness, certain controls were put in place by the board to review transactions between Enron and the partnerships. However, these controls were apparently never implemented, and reviews were not performed. While the transactions between Enron and the partnerships were disclosed in the financial statements, it was asserted that they were carried out on "arms-length" terms. That assertion was clearly wrong.

Enron and Andersen argue that the use of partnerships for off-balance-sheet financing is a common practice and that accounting rules permit it. Andersen and the AICPA have argued vehemently that these rules need to be changed. But this may simply be an attempt to blame the system when it is the abusers of the system that should bear responsibility.

Even if Enron had properly structured the partnerships to enable off-balance-sheet accounting, both Enron and Andersen had an opportunity to effectively change the accounting. The AICPA Code of Professional Conduct holds that when generally accepted accounting principles (GAAP) would cause financial statements to mislead the readers, then alternative accounting must be followed. Therefore, Enron was not constrained by the accounting rules to not report the partnerships' liabilities and losses as it did. The company was free to report the flow-through effect of the partnership results on its financial statements. At the same time, if Andersen believed that following GAAP would mislead financial statement readers, it was obligated to note that in its audit report.

In August 2001, Sherron Watkins, a vice president of Enron and former Andersen employee, informed Enron CEO Kenneth Lay of the partnership problems. Her memo, which she later forwarded to Andersen, warned that Enron would "implode in a wave of accounting scandals." After receiving the memo, Lay sold $20 million of Enron stock. In all of 2001, Lay sold approximately $100 million of stock. $70 million of that total was not disclosed to the public because it was sold directly to the company. In possession of the memo, and while selling his own shares, Lay was making positive statements about Enron's stock to analysts and employees. On September 26, he was quoted as saying that the third quarter was "looking great." On September 30, just weeks before bankruptcy proceedings were initiated, Enron's stock traded at $27 per share (a market capitalization of $21 billion) which was $11 billion in excess of its recorded book value.

How might events have changed if strict ethical standards were followed? The partnership losses would have been reported as they occurred. This would have reduced reported growth and made Enron stock less attractive. If employees were made aware of the risks that Enron was taking, perhaps they would not have concentrated so much of their retirement funds in company stock. Had analysts known of Lay's large stock sales and the amount of debt that was not reported on the company's balance sheet, they might not have recommended Enron's stock as aggressively as they did up until the problems were disclosed.

In all, if relevant information had been disclosed on a timely basis as the events occurred, the markets could have absorbed the data and addressed the situation in an orderly manner. Enron stock would not have run up and flown as high as it did, but bankruptcy might have been averted.

Kevin Michel, EdD, CPA, CMA, CFM is collegiate professor of Business and Management Studies. He teaches accounting and the prior learning (EXCEL) course in UMUC's School of Undergraduate Studies. Michel is chair of an AICPA education task force and a volunteer in the Learn to Earn Center of the Harford County Public Library.