TELEVISION these days has bombarded viewers with Reality-based shows. It all started with American Idol where aspirants have to go through the nasty comments of the opinionated Simon. Then, GMA 7 launched the Star Struck only to find out that ABS-CBN’s Star Circle Quest has been transformed into the same concept as theirs.
Then, we have shows like Extra Challenge, with the concept same as Fear Factor although the challenges are quite different. That prompted ABS-CBN to change Victim, an offshoot of ABC 5’s Wow Mali to Victim Extreme, matching the idea of the competing television station.
Last year, we have ABS-CBN’s Meteor Garden. So chinovela soaps came in and everybody just loved F4. GMA 7 followed the bandwagon. This time, we have fantasy soap with Mulawin and Marina. If you merge both, you will have Marilawin.
It is apparent that when one starts the trend, everyone follows and modifies it. That is how the television industry works. One station would publish viewer’s rating saying that they are number one. Later, the competing station would affirm that they too are number one. Which one is reliable?
Competition is just tight. Sometimes, they resort to black propaganda. They spread information to discredit each other. And it becomes a don’t-try-this-at-home personal attack.
When I am home, I rarely switch on the television. I used to stay up late to watch the news for the past years. But this time, I have realized that all news is biased. Uh. So now, I am at my desk reading Marc Faber’s Riding the Millennium Storm, unless Karmina Constantino or Catherine Yang is on the screen.
* * *
THIS TIME, I will chronicle the rise and fall of one of the world’s largest energy company, Enron. The case has been the eye catcher to those in the accounting academe, and to the whole business community as well.
Enron started from the merger of the Houston Natural Gas and InterNorth, a Nebraska pipeline company. During the process of fusing two different companies, Enron incurred large amounts of debt and, as the result of deregulation; it no longer had exclusive rights to its pipeline. Thus, they needed a business strategy that would generate profits and cash flow. A young consultant, in the name of Jeff Skilling created a new product and changed the perception of the company and the industry as a whole, which became known as “energy derivative.”
Skilling positioned Enron and transformed its image as a trading business. With the formation of Enron Finance, of which he headed, it sought domination in the market for natural gas contracts, acquiring more contracts and more suppliers than any of its competitors. Under his leadership, he started recruiting MBA graduates in the country and rewarded the employees with corporate perks, including concierge services and a company gym. He also rewarded them with merit-based bonuses that had no cap permitting traders to ‘eat what they killed’
A bunch of young talents brought Enron to the limelight. Its reputation in the outside world grew as the internal dealings began to take into the darker tone. Skilling instituted the performance review committee, which was known as a scheme of reviewing employees based on the company’s values. It turned out that the real performance review’s measure was the amount of profits they could produce.
This happened during the economic boom of the US economy, which was coincidental to the sudden rise of the company. It was during the mid 1990’s that Skilling assumed as the chief operating officer, convincing Ken Lay to adopt the bank model in the electric energy industry. With this, both Enron’s corporate leaders traveled across the nation selling the idea to the major energy companies and regulators. They have also succeeded in lobbying for the deregulation of the energy utilities. And before the end of 1997, they acquired Portland General Electric Company, and at the same time they developed the Enron Capital and Trade Resources, the nation’s largest wholesale buyer and seller of natural gas and electricity. It increased the revenue to $7 billion and the number of employees to more than 2,000. It simultaneously developed Enron Online (EOL) an electronic commodity trading website. It became the counterpart of the company in the electronic platform, as the electronic environment provided safe transactions to the traders. The broadband communication flourished together with the rise of the company’s stock price from $40 to $90.56, an all time high in less than a decade.
The FASB regulated the trading business, employing the “mark-to-market accounting” approach. The method dictates that whenever the companies have outstanding and related derivative contracts, it must adjust them to fair market value, booking unrealized gains and losses to the income statement. It also added the one-size-fit all method which states that it requires companies to disclose all of the assumptions and estimates underlying earnings providing disclosures that were so voluminous that it would be of little value.
For a company, such as Enron, it is possible that valuation estimates have considerably overstated earnings. Further, in the company’s financial statements, it showed a $1.41 Billion of pretax profit for about one-third of its reported pretax profit in the previous year.
To satisfy the Moody’s and S&P’s credit rating, Enron had to make sure that the company’s leverage ratios within acceptable ranges. Its senior management lobbied to ratings agencies to raise the company’s credit rating but to no avail. However, they employed different bags of tricks – reducing hard assets while earning paper profits. This reduced its debt-to-total assets ratio and return on assets (ROA). Like many companies, Enron used special purpose entities to access capital and hedge risk, increasing its leverage and return on assets without reporting debt on its balance sheet. They used the SPE to borrow large sums of money from a financial institution to purchase assets or conduct other business without reporting assets and liabilities in the balance sheet.
Enron conducted business in a more complex manner through different SPEs. The most controversial were LJM Cayman LP and the LJM2 Co-Investment LP. In turn, the LJM partnerships invested in another group of SPEs known as the Raptors vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company. However, in the 2000 financial statements of Enron, it described the transaction and confused the business world. It caused doubt on both the equality of the company’s earnings as well as the purpose of the transactions. Because of that action, the market perceived the company with greater skepticism, thus eroding its trust and reputation.
The effects happened so fast. CEO Ken Lay announced his retirement owing to the pressures of the group of creditors. He was replaced by Skilling, who bragged about the rise of its $80 stock to $126 per share in the next months. It had become apparent that the odds are against his prediction, as Enron and Blockbuster announced the cancellation of their video-on-demand deal. Then the risky deals made through the hedging process began to show, causing a huge cashfall and the stock price lowered to $40 and continued to slide to $30 per share. The lack of the disclosure on the substance of the related party disclosure with the SPEs brought the company to its demise.
Unquestionably, the Enron debacle has brought critics on the media to focus on the adequacy of the company’s disclosure and the integrity of the independent audit practice. The scandal threatened to undermine the independence in the financial markets in the United States and abroad.
In a characteristic move, SEC and the public accounting profession have been among the first to respond to the crisis. SEC Chairman Pitt called a meeting to expedite to update the outdated reporting and financial disclosures standards. This was done in order to restore the confidence in financial reporting by the investors. The Big 5 accounting firms, on their part made a joint statement committing to develop improved reliance on the disclosure of the related party transactions. In addition, they called for the maximization of the financial reporting system in the United States to make it more timely and relevant.
The auditors, Arthur Anderssen LLP, acknowledged its role in the fiasco, defending its accounting and auditing practices. The CEO committed to cooperate the firm to cooperate in the investigations as well as to leadership potential solutions. However this does not exclude from the liability they will assume on the implications of the crisis.
The Enron story has produced many victims, the most tragic of which is a former vice-chairman of the company who committed suicide, apparently in connection with his role in the scandal. Another 4,500 individuals have seen their careers end abruptly by the reckless acts of a few. Lessons learned are the best. And this was the case of Enron. Sometimes, when a company looks too good to be true, it usually is.
* * *
THE RISE and fall of Enron has produced the necessary literature in the field of auditing. The invaluable lessons of the crisis served the business community well. The issues of independence of the auditor and the auditor’s responsibilities in detecting fraud and error must be addressed accordingly.
The auditor’s performance of his duties and responsibilities may result to civil administrative or even criminal liability. This stems from the contract between the auditor and the client and the general duty of care required in carrying out any professional responsibilities.
These duties and responsibilities, as discussed in the engagement letter, of which was tackled in our classroom discussion in the audit planning stage, have evolved over a long period of time. It was clear, based on the different auditing textbooks of Richuitte and Arens that the topic on the legal liability of the auditor should be explored before touching the depths of the specific technical phases of the practice of auditing. Along with this, the Code of Professional Ethics served as the guide in determining the responsibility of the auditor. The concept of due care and liability will arise from the violations of the contracts of the auditors. It was also discussed in the code of ethics that independence must be maintained by the auditor in the expression of the fairness of the statements of financial position.
Recent experiences in the Enron debacle have led many to increase skepticism whether there exists a strong auditing profession, and effective arrangements in the audit. The crisis revealed doubtful management practices and provoked criticisms of auditors, causing financial failures. Failures followed soon after the publication of financial statements that showed an illusion of financial strength and profitability and were given clearance from these auditors.
Thus, the audit expectation gap arises. The general public may believe that an unqualified audit opinion guarantees the accuracy of financial statements, whereas the profession maintains reasonable assurance that no material inaccuracy exists. They may believe that the unqualified report means that there has been no fraud or error within the company, whereas auditors believe that fraud detection is only a secondary aim of the audit. They may believe that an unqualified opinion is an assurance to the future viability of the entity, whereas the auditors state that it is only a comment on the content of the statements as at the date to which they are made up. And, they may believe that the report represents an opinion on the economy, efficiency and effectiveness with the management, whereas the profession maintains that this is outside the scope of a normal statutory audit.
It is expected that the expectation gap would widen, instead of narrowing as the years go by. This is because of the heightened business activities and the motivation to make more revenues. Unfortunately, auditing is not an exact science thus escalating the issue of expectation gap.
The responsibility of the auditor for detection of the fraud is cited as one of the issues exemplifying the gap. In PSA 240 paragraph 9, it states that “Based on the risk assessment, the auditor should design audit procedures to obtain reasonable assurance that misstatements arising from fraud and error that are material to the financial statements taken as a whole are detected.” The Enron scandals have revealed long running frauds and the death of the revered accounting firm, Arthur Anderssen, which are reflections of the expectation gap. There is reasonable evidence that report users interpret the audit opinion as an expression belief by the auditor in the honesty and integrity of company directors, executives and staff.
There are rare cases in the Philippines covering the same issues such as the Enron crisis. However it does not stop the legislators to pass and lobby laws against the fraudulent practices of the companies. The statutory duties and liabilities originate from the SEC Code of the Philippines, the Bangko Sentral ng Pilipinas Act and the Tax Code. The SEC Code defines the auditor’s liability in effectivity of an untrue statement of a material fact or omits to state in the material facts in the issuance of the securities. The BSP law does not specifically provide sanctions against CPAs relative to the audit they conduct. However, if an auditor is found by BSP to be remiss in its duties as an auditor in its examination of the financial statements then his accreditation may be cancelled or revoked. The Tax Code provides, not only administrative penalties but also criminal sanctions upon CPAs who among others willfully falsifies any report or statement bearing on any examination of the audit.
The auditing standards in the Philippines, in the detection of fraudulent acts, as in the case of Enron, provides instances when a CPA performing audit functions that may be subject to administrative proceedings and penalized with either suspension or revocation of his certificate. Among such grounds are gross negligence and incompetence in the practice of the profession, (stated in the Accountancy Act of 2003), as well as issuing an accountant’s certificate covering the examination of the client’s accounts without observing the necessary auditing standards.
As in the case of Enron, the third parties refer to the users of the financial statements of the enterprise other than the client enterprise. Thus, the auditors breaches the duty of care, and the auditor is liable to pay for the damages for economic loss recovered to the third parties. It does not however automatically hold the auditor liable for the whole cause by the injured party. In our country, there hasn’t been news about the CPA being sued in court for the recovery of the damages arising from the conduct and the report he or she issued. There may have been isolated cases in the past where some audit firms have been charged before the administrative bodies by either third parties or clients. But there were no media coverage of these cases.
The crisis should serve as an eye opener not only in the accounting profession in the United States but also here in our country. The auditor should serve as a watchdog against fraudulent acts of the companies. In the Philippines, the auditor should bear in their mind that aside from the client, they also have liabilities to the general public. And soon, the standard of audit performance and the limit of the audit liability will tend to evolve over time.
* * *
For updates on Enron’s former CEO Kenneth Lay on his trial, or if you have suspicion on any company’s financial statements listed on any major stock exchange, send me a note at thespeculativebubble@yahoo.com. Or if you’re bored reading this critique of mine, visit Mysue’s blogger at mysuetan.blogspot.com