Theres no place like home or is there Accounting

Friday, 01 March 2002


    The collapse of Enron has focused some of the minds in the Australian corporate world on the quality of Australian pronouncements.

    The collapse of Enron has focused some of the minds in the Australian corporate world on the quality of Australian pronouncements. A significant focus for these commentators has been the difference between the American and Australian approach to accounting for corporate groups, particularly the criteria for the production of consolidated financial statements. Australia's consolidation rules contained in AASB 1024 and the fact Australia incorporated an interpretation from the International Accounting Standards Board's interpretative body, the Standing Interpretations Committee, on special purpose entities have been dragged out as indicators that our market may be better shielded from the prospect of an Enron-like collapse occurring because of special purpose entities being kept off the balance sheet and losses being hidden because an entity remained unconsolidated. Corporate luminaries, such as Commonwealth Bank chief executive David Murray, have come out in support of the domestic accounting rules, saying they've reviewed the relevant domestic pronouncements and that an Enron-like scenario is less likely to occur here.

    While it is comforting to see some in corporate Australia think there's no place like home when it comes to accounting standards, directors, executives and investors had better think again. This rush to praise domestic standards as a way of affirming our good fortune for having some solid accounting thinkers in this country – something that is rather novel for some in the corporate sphere – needs to be tempered with a dose of realism and a better understanding of some issues involved in Enron's fall from grace.

    The problems within Enron are not just related to any weakness, real or perceived, in the accounting literature promulgated in the US. It is possible to put the case that the accounting gymnastics that have so captured the world's attention are merely a symptom of a deeper-seated problem within the company rather than the problem itself. A report prepared by a special investigative committee composed of Enron directors gives that argument some credence.

    A 218-page dissection of the related party transactions and corporate governance failures known as the Powers Report points out that many – if not all – of Enron's corporate governance safeguards failed. Special investigative committee chairman William Powers, dean of the law school at the University of Texas, told a recent hearing of one of the many Congressional hearings looking at Enron that what the committee found in the related party transactions, financial reporting matters and other governance issues was "appalling".

    It should be noted that Powers found all parties that involved themselves in the transactions referred to in the report had a case to answer. This includes the board of directors of Enron as well as key company managers and, of course, the auditors, Andersen. "As you know, during October of last year, questions were being raised about Enron's transactions with partnerships that were controlled by its chief financial officer, Andrew Fastow," Powers told the Congressional committee. "In the middle of October Enron announced that it was taking an after-tax charge of more than $500 million against its earnings, because of transactions with one of those partnerships. Enron also announced a reduction in shareholder equity of more than a billion dollars."

    The end of October 2001 saw the establishment of the Powers-led committee. "The Enron board established a special committee to investigate these matters, and then asked me if I would join the board for the purpose of chairing that committee, and conducting that investigation. With the help of counsel and professional accounting advisers, we have spent the last three months conducting that investigation." A significant finding of the Powers Report was that key officers of the company had made significant financial gains as a result of Enron's complex web of transactions with what were wrongly accounted for off balance sheet such as Chewco, LJM1, LJM2, a partnership quaintly abbreviated as JEDI and four SPE structures used for complicated hedging arrangements known as Raptor I, II, III and IV. "Firstly, we found that Fastow-and other Enron employees involved in these partnerships-enriched themselves, in the aggregate, by tens of millions of dollars they should never have received," Powers explained. "Fastow got at least $30 million, Michael Kopper at least $10 million, two others $1 million each, and still two more amounts we believe were at least in the hundreds of thousands of dollars.

    "Second, we found that some transactions were improperly structured. If they had been structured correctly, Enron could have kept assets and liabilities (especially debt) off of its balance sheet. But Enron did not follow the accounting rules." While the above issues themselves were sufficient to turn the heads of those on the special committee investigating the financial calamity the fact there was a "systematic and pervasive" attempt by company management to window dress the company's financial state. "Enron management used these partnerships to enter into transactions that it could not, or would not, do with unrelated commercial entities. Many of the most significant transactions apparently were not designed to achieve bona fide economic objectives." Powers told Congress that the transactions described in the committee's report were very complex and that one example of the accounting plays engaged in by the Enron management with involvement in the Chewco, LJM1 and LJM2 partnerships was the series of hedging transactions engaged with by Enron with some entities called Raptors.

    "Enron was not just a pipeline and energy trading company. It also had large investments in other businesses, some of which had appreciated substantially in value. These were volatile investments, and Enron was concerned because it had recognized the gains when these investments appreciated, and it didn't want to recognize the losses if the investments declined in value," The Texas University dean explained. Hedge accounting properly done transfers economic risks from one party to another. That's what true hedge accounting is meant to achieve. Enron's hedging was a sham. "The outside parties with which Enron 'hedged' were the so-called Raptors. The purported outside investor in them was a Fastow partnership," Powers continued to explain. "In reality, these were entities in which only Enron had a real economic stake, and whose main assets were Enron's own stock. The notes of Enron's corporate secretary, from a meeting of the finance committee regarding the Raptors, capture the reality: "Does not transfer economic risk but transfers P+L volatility."

    The hedges with the Raptors were mirages, according to the investigating committee, and the other transactions were not much better. The Chewco special purpose entity – one of the SPE's integral to the mess Enron found itself in – was left off balance sheet when Enron should have consolidated the SPE into its group accounts. Current American accounting rules require an SPE to have an outside interest with at least three percent of equity at risk in the SPE for it to qualify as a structure that can live off balance sheet. Enron could not find the required 3 percent and should have brought the SPE onto its books. This had a chain reaction. Enron and Chewco were meant to be partners in a joint venture entity, which is the SPE known as JEDI. When Chewco was finally brought onto the books last year after living for five years off balance sheet the SPE known as JEDI had to be brought in to the consolidated financial statements. A financial reporting double-whammy that need not have been there had they followed the accounting rules in the first place.

    The Chewco arrangement had a feature that has become news in another context in Australia. Like the HIH reinsurance arrangements the Chewco transaction had a side agreement or side letter modifying the original transaction. An Andersen partner, Thomas Bauer, dealt with Enron executives on the Chewco transaction and Bauer told a Congressional hearing he would have refused to allow Enron to have Chewco remain off balance sheet if he was informed of the side agreement relating to the Chewco transaction at the time. "The undisclosed Side Agreement meant that Chewco's and JEDI's financial statements should have been consolidated with Enron's since 1997. I do not know why this critical Side Agreement was withheld from me in 1997. I do not know who made the apparent decision to mislead Andersen and me," Bauer testified. "Had Andersen, in 1997, been provided the materials that I received in November 2001, there is no way I would have permitted Chewco to be treated as an unconsolidated Special Purpose Entity, and a significant portion of the November 2001 restatement would have been avoided."


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