“When in doubt, blame the accountants,” said Mathew Ingram in the title of his article that appeared in The Globe and Mail on January 31, 2002. The long-suffering accounting profession, mocked for boring personalities and over-consumption of trees to produce financial reports, was now being blamed for making a company’s financial records more, rather than less, confusing.
The backdrop for the article was the spectacular collapse of Enron, a U.S. energy company that had, at its peak, the seventh largest market capitalization in the country. (Interested readers can find more information on Wikipedia under "Enron scandal.”) The bankruptcy was the largest in U.S. history up to that time.
One key ingredient in Enron's rise and fall was the thousands of entities the company created to hold some of its assets and liabilities, but which did not appear on Enron’s books. Many of these entities were controlled by Enron’s executives but financed by Enron. Because these entities were not consolidated (i.e., included in Enron’s books), Enron’s financial statement did not sufficiently reflect the risks of these related entities. These risks became apparent when conditions in energy markets turned against the company. In Ingram’s words, “It became a wobbling house of cards, until a stiff breeze from the market blew it apart."
Enron's failure had triggered a “wave of concern" about the credibility of other companies' financial information, likening the phenomenon to cockroaches—when you see one, you know others are not far behind. Investors are now taking a second look at companies such as Tyco International, a conglomerate that has full or partial ownership in 170 different companies ranging from electronics to health care; the company paid for most of these acquisitions with its own shares, similar to Enron. Other large companies put under the microscope include AOL Time Warner and General Electric.
According to Ingram, one of the positive outcomes of Enron's collapse is that investors no longer believe in the idea of a company being “too big to fail.” Investors need to carefully analyze any company, regardless of size. He notes that many of Enron’s questionable transactions were actually contained in its financial statements, albeit in footnote disclosures that were often difficult to decipher. Likewise, if investors do not understand a company’s operations, they should not buy its stock.
The problems at Enron didn't go completely unnoticed. Some analysts did raise questions as to how it was that Enron was able to make the money it claimed it was making, and how these profits increased year after year. However, these few cautionary voices were overwhelmed by the numerous others who believed the company to be a “buy” or “strong buy,” as the stock price continued its upward trajectory.
In addition to Enron’s management, much blame has been placed on the company’s auditors, Arthur Andersen. The audit firm also did a considerable amount of consulting work for Enron, which could have created a substantial conflict of interest. Did Andersen compromise its independence in its audit? Or did Enron’s management deceive the auditor as well?
Ingram says that, ultimately, investors need to take responsibility for their own investments rather than put too much reliance on the opinions of others such as analysts and auditors. There are good reasons for regulators to require companies to file various reports (financial statements, prospectuses, proxy statements)—investors need to spend the time to read these reports, even if they may be boring.
Required:
Discuss the issues raised above by applying financial accounting theory.