Four years later it is still difficult for many people to understand how huge companies like Enron and WorldCom with billions of dollars in revenue and stock prices close to the ceiling could in a matter of weeks declare bankruptcy. And the people who should have been able to predict the fall, i.e. the investment bankers, the rating agencies, the analysts and the most prestigious accounting firm in the country did not appear to have a clue. Most shareholders upon receiving the beautiful annual report assume that the company is in fine financial shape since one of the largest and most respected accounting firms in the country has signed off on the report. Now accountants are just people including the lead partners who actually supervise the audits. But they are as corruptible as anyone because in order for fraud to occur, as one financial observer commented, there has to be “complicity”.
So now the question arises, how can a “company manipulate its earnings?” For example, during the annual audit one of the young outside accountants assigned to the company discovers that the company’s internal accountants have been “booking something incorrectly”. It doesn’t “conform to generally accepted accounting procedures”. It may not appear on the surface to be a major problem but it is significant enough to put downward pressure on the earnings per share if it is corrected. The company, therefore, will not look as good to the Wall St. community and the share price will drop. This inevitably happens when the street analysts publicly downgrade the stock. The smallest decrease in earnings per share (EPS) can cause a rush to sell and the stock price drops like a stone.
Now the Chief Financial Officer (CFO) and the Chief Executive Officer (CEO) are concerned for another important reason. They own millions of dollars in options and since the stock price has been going straight up, these options are worth millions more. But if the EPS drops, the options will drop also and could possibly end up worthless. The executives have probably made financial commitments based on the future value of the options and now they are faced with losing it all and having to deal with the financial embarrassment that follows. When the lead partner of the accounting firm informs the CFO of the problem, the CFO is in shock. He had been relying on his internal accountants who in turn were relying on the outside accounting firm who told them that what they were doing was O.K. The lead partner is now saying they were wrong. Oh, my! It is at this point that the CFO involves the lead partner by telling him that the Board of Directors had been considering switching accounting firms and that the CFO had talked them out of it. The CFO had told the Board that he and the lead partner had a very good working relationship and didn’t advise changing. Now the lead partner was on the spot. A client of this size represented millions of dollars in fees and to lose it would mean personal financial loss for him. Furthermore, any reduction in the EPS could mean the loss of the CFO’s job. In that case the lead partner would lose his support and the client would go to another accounting firm to say nothing of the possibility of the lead partner being degraded. So he tells the CFO that he won’t press the issue this time but let’s not do it again.
So what happens the following year? Is it fixed? Of course, not. A young accountant points out the “inconsistency” once again but this time the lead partner tells him to keep his mouth shut. The lead partner is now inextricably involved in the company fraud. And the EPS would drop even more if the books are corrected. Now the young accountant is caught in the trap because he has financial commitments also that he cannot jeopardize. Nothing more is said about the discrepancy. The books are bogus and the shareholders are fleeced. The executives, on the other hand, are making a pile. It is outright fraud. When the annual report is published once again the following year no one says a word and the stock continues to rise. Everybody involved gets a bonus.
Now specifically how does the company continue to support the rising EPS figure? The simple answer is to “book fraudulent revenues.” You claim you made more sales than you really did. How does the company get away with this? Well, large corporations normally book income when they ship the product not when they get the cash. Many corporations wait 90 days or more for their cash. So any fraudulent sales reported goes immediately into the income statement, the net income increases and therefore the EPS increases. Then a bogus receivable is recorded on the balance sheet. But payment is never received because the sale was never made. It is difficult for any outsider to determine that some receivables are bad since the bad are included with the good. The ordinary investor looking at the financial statements at the end of the year could not possibly detect the fraud. And bogus receivables will be on the balance sheet every year in increased amounts because in some years business is bad, but the EPS has to go up. The catch is that eventually all the receivables are bad and there is no cash. Somebody knowledgeable eventually snoops around and discovers the fraud, discloses it publicly and the banks begin demanding payment on their loans. Even worse they refuse to make any further loans to carry the company over. The house of cards collapses. Enron, for example, was selling 30 year energy contracts and booking the total sale on day one. The income came in slower than the expense outgo. In addition huge Enron revenues were being drawn down to support “lousy” business deals organized into limited partnerships with the CFO, Andrew Fastow, acting as general partner. This in itself was a conflict of interest ignored by Fastow. However, he also was collecting huge management fees as the general partner and Enron was footing the bill. Enron was being milked by Fastow and this contributed to the astronomic Enron debt. Much of this money was going to members of his family and friends. Actually it was Fastow’s responsibility to keep an accounting of the debt and when asked at one point what the extent of the indebtedness was, he was unable to say. He did not know.
Another serious problem that disturbed some of the smarter people in Enron was the fact that Enron itself was often borrowing billions of dollars for short periods of time, i.e. weekly or monthly and then using the cash for long term projects. These had to be repaid long before the project produced any revenue. This could cause a liquidity crisis if a loss occurred at which time the banks might refuse any further short term loans. Enron could not stay in business without these loans. This eventually, of course, happened. It is interesting to note that the savings and loan industry toppled in the 1980’s for the very reason that it was using short term loans for long term investments. It was considered a “classic financial blunder.” And so with Enron.
Enron was able to function in the way that it did because the stock market “bubble” that produced high stock prices made it possible to use “aggressive accounting” (fraud) to push the stock prices even higher. This is done by inventing “phantom profits” which make the company grow even more and the bottom line to look even more outrageously profitable. Enron, WorldCom , Adelphia and Tyco to name just a few were in reality gigantic Ponzi pyramid schemes. They used slightly different accounting methods but in essence they were using money from new investors to pay off old investors. This was the way Fastow operated his limited partnerships. As the price of the stock rises, more investors are attracted and the capital gains to the initial investors increases hugely. Thus more investors are attracted and so on. Until eventually the seemingly successful business implodes because you’ve “run out of suckers” and cash. Enron, for example, invited their banks to invest in “the shell companies they used to hide debt and siphon off money.”
The Enron scandal did not emerge suddenly for it was building for a decade. Enron started out as a natural gas pipeline company but when deregulation came on the scene much through the efforts of Ken Lay, the CEO of Enron and a personal friend and supporter of the Bush family, the company became one that “dealt in contracts.” It became more like a Wall St. investment house and was the market maker for the deregulated natural gas industry. From there it began making markets in electricity and selling long term contracts. This, of course, lead to the California catastrophe caused by energy company market manipulation to drive prices up. One dirty trick was to pull energy companies offline to create shortages and prices went through the ceiling. Much to the anger and consternation of Californians. There are actually Enron memos that show that Enron was without question “rigging the markets” to harm the state of California. In addition there was a division in Enron that produced fraudulent profits in order to puff up its stock price. And it also devised bogus energy transactions to again puff up Enron’s profits “at the expense of the state of California”.
So what we have here was a method of operation that completely ignored ethical standards. It was an environment of callous greed and criminal behavior but also startling incompetence and shocking arrogance. The executives were inadequate and blinded by avarice. The bankers, accountants and lawyers were more interested in their huge fees than investigating the company’s questionable policies. Brokers and investors did not have a clue as to what was going on and were interested only in making huge profits. The CFO and his cronies supported by the CEO and the Board of Directors indulged in bad business practices and spent much of Enron’s huge revenues supporting them.
The end result to those involved was devastating. Arthur Anderson, the prestigious accounting firm that was signing off on fraud, went up in smoke. Thousands of innocent employees who had nothing to do with Enron lost their jobs. Andrew Fastow, the Machevellian mind behind much of the bogus business deals, has pleaded guilty to all counts and will serve 10 years in prison. His wife has already completed a year sentence. Still to be tried and sentenced are Ken Lay, the founder and CEO and Jeffrey Skilling, the replacement CEO when Lay moved on. Incidentally, shortly after Skilling appeared on the cover of BusinessWeek as the new brilliant CEO, he resigned ostensibly for “personal reasons”. Some time later he admitted that he left because the company stock had dropped 50% but denied that anything was amiss in the company. Not too long after, the company declared bankruptcy.
References:
Eichenwald, Kurt. Conspiracy of Fools. Random House. 2005.
Frey, Stephen. Shadow Account. Ballantine Books. 2004.
Krugman, Paul. The Great Unraveling. Norton. 2003.
Wednesday, June 15, 2005
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1 comment:
you have a good grasp on the essentioals of the story. looking forward to reading your next
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