As we saw in the introduction, the public's perception of the accounting profession took a bit of a beating in the early 2000s. One of the prime causes of that drop in public's perception of integrity and honesty is undoubtedly the Enron Corporation example. So what was so special about Enron? After all it was just one of many, too many accounting scandals that plagued the corporate sector in the USA in the early 2000s. What was so special about Enron, was that this particular demise caught the attention of the government. Not only that, it lead to a significant review of accounting practices and sparked Sarbanes-Oxley, of which we will talk a little later. So what happened with Enron, and what caused this government interest? Well, the Enron case is a prime example of investor deception by numbers. The corporation was originally a relatively small, yet important, natural gas transmission and distribution business. Enron over time transformed itself into much more than that. It became an energy giant, trading in commodities and services throughout the 1990s. In the mid 1990s, financial analysts criticized Enron on its debt level. The debt levels probably reflected the significant investments that Enron made in transforming itself to the energy giant it then became. Enron management pursued those critics relentlessly, aggressively as they did with accountants, lawyers, financial media, that they'd ask questions of Enron's business operations. Enron's growth, meanwhile, sparked its sharemarket success. So the company went from strength to strength. Shareholders, relying on analysts' forecasts, and those analysts' forecasts were invariably ‘buy’ recommendations, which only turned to neutral recommendations in 2001. And if we take a closer look at the share price graph, we see that, that happened at a time when the share price was already very much in decline. So how did this happen? Well at the same time as analysts were recommending buys to the shareholders, assets and profits, in fact, were inflated or even nonexistent. Selling assets at inflated prices with a buy back promise at the same time to buy back at higher prices. Only recording the revenue, not the buy back that would occur in the future. Meanwhile, debts and losses were parked in offshore entities, and those offshore entities didn't appear in the financial statements. So what financial analysts saw was only a very partial picture of the truth of the accounting statements of Enron. So how did the auditors miss it? Well there's a variety of possible reasons here. Could it be the bullying by Enron's executives? Remember that Enron had just aggressively retaliated to the financial analyst who dared question the debt levels on Enron in the mid 90s. Could it be the culture at Enron? An aggressive business culture focused on growth, growth by borrowing significant amounts of money? Could it be accounting loopholes that allowed Enron to park those losses in those offshore entities it owned, without revealing the existence of those losses. Could it be sophisticated fraud from the top down? Again, an entrenched culture in the corporation that also captured the internal auditors. Conspiracy by executive management, perhaps, from the top down. Or could it be that the share market itself didn't quite invest the time and due diligence necessary to scrutinize the business operations of Enron, probably captured by the irrational exuberance plaguing the share markets in the late 1990s and early 2000s. Perhaps a final point worth noting here is that the external auditor of Enron was also providing Enron's internal auditing services, potentially a compromise of the independence of the external audit. So how was accounting involved in this context of Enron? One of the then Big Five accounting firms and Enron auditor, Arthur Andersen's performance was significantly scrutinized in the aftermath of the Enron demise, by the media, by the regulators, and by government. And despite being cleared of any legal wrong doing, the impact of the scandal ultimately destroyed the firm. So that Arthur Andersen decided to surrender its CPA licenses and its right to practice in 2002. That in itself then turned the spotlight on the audits that Arthur Andersen did for a variety of other problematic companies, including Sunbeam and WorldCom.
