If Enron’s meteoric rise was a case study in New Economy success stories; its collapse is a lesson for investors, accountants, analysts, regulators and politicians. Already, some of the country’s largest companies, including General Electric and IBM, have announced that they will provide more transparency in their accounting. Others are expected to follow. Could this mean permanent changes in financial reporting and regulations, or is this a short-term solution until Enron fades from the headlines? NEWSWEEK’s Jennifer Barrett talked about the issue with Bala Dharan, professor of accounting at the Jesse H. Jones Graduate School of Management at Rice University. Dharan testified earlier this month before a congressional committee on accounting issues related to Enron.
NEWSWEEK: What are the most important lessons we can learn from Enron?
Bala Dharan: The most important lesson is that the system of checks and balances must be strengthened. The board of directors and management, the internal quality of the management, the internal audit division, the risk control division–all of these are supposed to be doing the job inside the company. Outside auditors, security regulators, stock exchange and financial analysts, we expect a variety of controls to somehow protect the shareholders in the aggregate, with the primary responsibility squarely on the management. We expect top-quality management to do the job right and we expect everyone else to make sure that this happens. That failed with Enron. We have a very weak regulatory enforcement system. If the auditors fail, we don’t have the mechanisms to make sure the cost of failure is high enough for the auditors and financial analysts and regulators and management. The management and directors are hiding behind liability insurance, auditors are too. And analysts don’t have enough of a liability at this point. People, when they fail, they don’t pay. Mechanisms needed to make sure that failures don’t take place are not there. This will definitely change at some point.
In testimony before the House Committee, you said the Enron debacle will likely rank as “one of the largest securities fraud cases in history.” Do you think Enron is the exception when it comes to such practices? Or was it simply the one that got caught?
I don’t point my finger at one person or a group; that’s not my role. That’s the role of the investigators. But, that said, maybe there will be one or two smaller cases like Enron. The Global Crossing bankruptcy was the fourth or fifth largest corporate bankruptcy, with billions of dollars lost. It was an incredible amount. But Enron took the spotlight away from Global Crossing. Maybe we will also see some cases in Europe, among European telecommunications companies. Within the U.S., I’d expect one or two companies to make some major accounting changes. It may not be the same size and scope as Enron.
General Electric and IBM, for example, have announced they will provide more transparency in their accounting. Do you think others will follow? How much of a difference will it make to investors who are trying to get an accurate picture of a company’s financial situation?
I think there will be a whole rash of companies that will change or provide additional disclosures, whether voluntarily or because they are being told to do so by more cautious auditors. The auditing firms are under tremendous pressure not to let another Enron happen under their watch. What investors should look at is whether a company says it will provide this information, but it disparages the information. For example, General Electric said, if we have to publish a telephone book of information, so be it, we’ll do it. But they made it sound like the market is forcing them to do this, though they really don’t need to do it. To me, that is not a good sign.
These companies are missing the lessons of Enron completely. They think the shareholders’ and country’s reaction to Enron is not permanent, but transitory, and they just have to provide a little more information and then things will go back to normal. Companies need to realize that their audience is not just financial analysts and not just a small group of people that they can somehow influence, but the average investor who has already lost 50 to 60 percent of his or her portfolio in the last two years. They will not tolerate this anymore, they will not look at this anymore and think this is normal. Companies that take a proactive role, say they are sorry they didn’t provide that information before though they should have, and that they will do so in the future because it’s the right thing to do, will be rewarded by shareholders.
How much of the problem lies with outdated accounting practices or standards that simply don’t work as well with New-Economy business models? And how much with companies that provide false information in their books, and to investors?
The accounting model itself is okay. The only ones complaining about the model needing to be fixed are auditors like Arthur Andersen. I don’t think the model needs to be fixed, though clearly it needs to be improved. We also need to improve the enforcement side of the system. Our problem in the U.S. has been mostly on the enforcement of the rules, not the rules themselves. I’d say 30 percent is the existing rules needing to be changed, but 70 percent is in the enforcement of existing rules by management, auditors and regulators. There is a third part to it too. When the world changes, the way we implement accounting needs to change too. But to do that, we need a set of managers who understand accounting… Part of the reason that Enron happened was because the finance and the accounting people didn’t understand and educate one another as to the true consequences of financial disclosure.
I know you have tracked Enron for several years. Were you surprised when Enron disclosed in November that it had vastly overstated earnings?
My reaction actually was not a surprise. We had talked in my classroom as well as in other academic conferences about Enron before. I had been using Enron as a case since March of 2001. I didn’t have any sense of any problem early on. But by August we had enough indications, or red flags, that there was something amiss with the numbers. When things blew up in October there were already expectations.
What were some of the red flags?
The first was its related-party transaction disclosure. Any company that has transactions that are done with other companies controlled by them as well have to disclose that. It’s a required footnote. A related party could be the president’s brother, chairman’s wife. You expect something like in a small company, but for the seventh largest company, it’s surprising. So those are more problematic because we want to know why they would do this. With Enron they had a long footnote about how they were doing a variety of transactions with senior officer of Enron. It’s a very dangerous type of disclosure.
Those disclosures were also of extreme concern for Enron. It was discussed widely. They wanted to make sure they disclosed as little as they could to shareholders. Congress has released a memo from [Enron lawyer] Jordan Mintz on June 4, 2001, to [former CFO] Andrew Fastow that read in part: In order to minimize disclosures to shareholders, these are the things you need to do. They were trying to figure out how to minimize the extent of the disclosure. Even the fact that they were disclosing so little was a red flag. Another red flag was that Enron was really not making much money–the profit margin was less than one percent of revenues. Whereas Goldman Sachs, my gold standard for trading companies, was earning something like 18.5% of revenues. There was a clear difference in profitability between Enron and these companies. Even if you were to compare Enron with other companies in the same industry like Williams; its profits were 8.5% of revenues. Enron’s return-on-equity was also quite low–much, much less than Goldman Sachs.
So, what did you think when Enron declared bankruptcy?
It was not a surprise. By the end of November, the damage had been done. The last major trading day before December 2 and on November 28, the last major trading day, the stock fell to 61 cents. It opened at about $3.90 a share that day and then it closed at 61 cents. Essentially, that was the end of Enron. There were 345 million shares traded that day in Enron. That’s a record. The subsequent bankruptcy filing should not have come as a surprise.
If Enron had not gone bankrupt, do you think a lot of these questionable accounting practices would have come to light?
Very slowly, perhaps, but bankruptcy facilitates a quicker discovery process. There are new regulators and financial overseers appointed by the bankruptcy judge; a lot more openness is expected. And it clearly brought the financial media into the picture. They have brought to light many accounting practices that even accounting scholars did not know about. For example, how Enron was able to take loans but report them as prepaid forward contracts. It is an unusual and somewhat ingenuous way to report a loan. You are borrowing money and reporting it as revenue. It’s a remarkable transaction. They are potentially not breaking the law but finding massive loopholes. This would never have been discovered if not for the bankruptcy and the attendant media attention and the public disgust. That has certainly made it possible for people to talk about reforms in financial disclosure practices. Accounting used to be a boring subject; no one wanted to talk about it. That’s changed.
What do you think the long-term effects of Enron’s collapse and the ensuing investigation will be?
I certainly hope and believe that this is not a short-term phenomenon. Though the focus on Enron itself might be short term, the impact, in terms of regulatory changes, won’t be. Congress is very interested, the Security and Exchange Commission is interested in permanent changes. None of them will say in a month, Let’s go back to whatever we were doing before. I am very confident that there will be new changes in regulations and in enforcement of regulations. If I am wrong then investors will be waking up in three years with another Enron. Then the political consequences for the politicians and the regulators would be much worse.
