Arthur Andersen: The fall of America?s oldest accounting behemoth!

By Chaahat Khattar

Arthur Andersen, the Limited Liability Partnership (LLP) firm was founded in 1913 and till 2001 it was one of the Big Five accounting firms in the world.

One single but probably the biggest client of Arthur Andersen (“Andersen”) led to Andersen’s fall, which could never be overturned. Anderson won its case in the judicial proceedings but could never win back its clients.

Enron and Arthur Andersen: When greed gets greedier

Enron was an America energy company, which was making suitable profits till late 1990s when it decided to turn itself from America’s leading energy company to America’s leading company. Post the merger of Northern Natural Gas Company and Houston Natural Gas, the newly formed company Enron had huge chunk of debt on its books. The top executives wanted to get away from the same too soon.

The game started with Enron Oil Corporation. Back in 1987, two oil traders made bets for Enron whether the price of oil would go up or not. To Enron’s fantasy, oil prices always went up. The gambling continued for years. The traders had traded Enron’s reserves but managed to save the firm by bluffing the markets. But that did not last too long. Very soon, Louis Borget the then CEO of Enron was convicted of falsifying the accounts and diverting the funds into offshore companies. Arthur Anderson during that time was known as the whistleblower for Enron as it always alarmed the board director of the Enron about the dubious policies of Borget.

As soon as Borget was out, Jeffrey K. Skilling came into the picture. He was a Harvard management graduate and Kenneth Lay; the Chairman of the company hired him to manage the ballooning debt of the company. The first most crucial and red flag step which was taken by Jeff was adoption of mark to market accounting. In mark to market accounting, the profits of a project could be booked in the books of accounts on the basis of future presumptions. So basically it was booking of profits from just an idea. The policy was signed and approved by Arthur Anderson. In other terms it was nothing but Hypothetical Future Value accounting, which added billions of dollars to the bottom line of Enron. This way Enron’s profit could be actually whatever Enron wanted.

Enron invested over 1 Billion USD for a power project in India, which various analysts predicted, would be waste. They knew that India could not afford to pay for the electricity Enron would be selling to them. Instead, Enron paid over Billions of dollars in bonuses to its executives as a result of mark to market accounting policy, which hypothetically predicted the future success of the power plant. As a consultant, Arthur Anderson did not raise any red flag for such a risk investment as well.

On the stock market front, the top executives of Enron were adopting pump and dump policy where they shot the shares of Enron to the top and then sold out their options to bank millions of dollars.

Enron soon ventured into services industry as well where it created Enron Broadband services which aimed to provide Video on Demand services. It signed the deal with Blockbuster and as a result of mark to market accounting policy, it booked heavy profits on its books but in reality, the company suffered heavy loss over the same.

Arthur Andersen assisted Enron in merging with Portland General Electric (“PGE”), an electricity distribution company based out of California. This gave access to a deregulated electricity market to Enron. Rolling blackouts became too common then and Enron usually created artificial shortage of electricity in California, which led to increased electricity prices. Since the traders were betting against the prices of electricity, they ended up making millions for Enron that way which made up for the lost numbers on the books of accounts of Enron.

Enron’s debt was reaching the peak and it had to do something more interesting. Then Enron’s CFO Andrew Fostow backed and supported by Arthur Anderson decided to go ahead with the concept of structured finance. It was nothing but a method of cheating to cover cheating and creating a momentum of everlasting cheating. It largely involved restructuring of debt or basically shifting of debt through creation of over 3,000 bogus companies. Andrew Fastow, Enron’s CFO, led the company in the use of special purpose entities (SPEs) to increase capital and improve Enron’s rating. SPEs are partnerships with an outside party that allow the company to increase its ROA and leverage without required reporting of debt on the company’s financial statements. Thus, Fastow was able to hide Enron’s debt through approximately 500 SPEs, including “troubled” hard assets such as overseas energy plants and broadband operations. These entities are required to have at least a 3% interest from an independent party to qualify for the off balance sheet requirement; if the interest requirement is not reached, the entity must be reported as a subsidiary to the parent company. Moreover, related party transactions hindered transparent financial statements. Enron did not maintain an arm’s length with its partnerships. In fact, it used these partnerships to raise debt and then backed these debts by issuing its own stock. In several cases, it backed such debts by promising to issue its stocks in value terms rather than in terms of numbers of shares, which would have been the norm. LJM Fund, the biggest SPE was particularly audited and approved by Arthur Anderson which clearly knew that these SPEs were having Enron’s Assets as collaterals against the debt they were holding. Arthur Anderson accepted Enron’s decision not to consolidate the derivative related liabilities of these entities with the corporations overall liabilities.

As former Chief Executive Officer Jeffrey Skilling described it, Enron pursued an “asset-light” business strategy. Enron’s business plan was not to concentrate on building or operating electricity generating facilities or exploring for or developing natural gas deposits. Instead, Enron would profit from its ability to understand and predict the actions of firms that produced and consumed electricity and natural gas. It would recognize and exploit arbitrage opportunities across energy markets, over time and location faster than other market participants. If Enron found any predictable behavior on the part of any market participant, it would take a financial position that allowed it to profit from this information.

Arthur Andersen well accepted the strange and noteworthy accounting principles Enron was adopting. Enron’s management and Arthur Anderson clearly recognized the tremendous discretion that generally accepted accounting practices (GAAP) afforded them in managing reported revenues, costs and profits. For example, in the early 1990s Enron began to report its contract energy sales on a gross revenue rather than net revenue basis. This means that if Enron sold a $1 million contract for electricity deliveries at pre- specified dates in the future, it would book the entire $1 million as revenue, rather than the difference between this revenue stream and the cost of purchasing the energy necessary to meet this contractual obligation as net revenue. Reporting contract energy sales on a gross versus net revenue basis would not alter Enron’s profits, because under either revenue realization scheme profits are total revenues less total costs. However, assuming that Enron earned zero net profit on this $1million contract sale, the difference in reported revenues from gross versus net revenue reporting is enormous.

Accounting had become a business not a profession, and as a business accountants went to bring in more and more money each year. On regular basis Enron paid mammoth fees to Arthur Andersen: basically USD 25 Million dollars as accounting fees and USD 23 Million USD as consultancy charges, and Arthur Andersen wanted to keep the money coming in the door. They began to think Enron was their client and forgot that Enron shareholders were really their client. Enron’s board says they were lied to, and they actually were, but there were questions they didn’t ask. Why did Enron report earnings without a Balance Sheet and Cash Flow statements? When the company went bankrupt it had $38 billion in debt, but onlyUS$12 billion showed up on its balance sheet. How is any company that doesn’t have cash flow going to pay back USD 38 billion dollars in debt?

In the very last year of Enron’s operations, Arthur Andersen was paid 1 Million USD a week fees amounting to over 52 Million USD in mere one year. On 23 October 2011, Arthur Anderson shredded 1 Ton of paper relating to Enron’s accounting and hence it was convicted for obstructing justice but the same was overruled by the Supreme Court of USA but the client Arthur Anderson lost could never been gained back again. The Court went in favor of the argument put up by Anderson that it did not know that it was breaking any law by merely shredding documents. It was a Pyrrhic victory for Arthur Anderson. A Pyrrhic victory is a victory with such a devastating cost that it carries the implication that another such victory will ultimately lead to defeat. Anderson did win the case but restrictions put up by Securities Exchange Commission (“SEC”) and accounting governing bodies coupled with devastated image among the clients of Arthur Anderson led to the application for Chapter 11 of the United States Bankruptcy Code.

Enron’s failure initiated a domino effect of accounting frauds and the bankruptcy of WorldCom (another client of Arthur Anderson) ended the reign of America’s oldest accounting firm, which went bankrupt soon after, and it left future of 82,000 people hanging in middle of nowhere.

Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller. He has keen interest and experience in authoring research papers and case studies and have contributed to various renowned journals. Chaahat can be reached at ckhattar@gmail.com