ENRON’S TENTH ANNIVERSARY: THE CONTEXT FOR ITS ACCOUNTING CRIMES

Approximately ten years ago, the truth emerged about Enron, that once snappy company with a different business model.  As the world learned, we should have focused on the ethics, culture, strategy, and business model of the firm, which unfortunately is a very old story.

This is the first in a series of essays to commemorate the ten year anniversary of Enron.  It is important to remember the catastrophe of Enron’s financial reporting, lest we forget and suffer the consequences again and again.

What happened at Enron occurred primarily because of the business climate.  It was a time of crime without punishment.  The decade of the 1990s is replete with stories about accounting miscues for which the SEC and the Department of Justice did little or nothing.  Why our protective institutions did so little is another study, though the hypothesis of a nexus between Washington politicians and business people is a simple yet powerful explanation.

Accounting frauds are nothing new.  Abraham Briloff described untoward actions by managers and auditors in Unaccountable Accounting, More Debits Than Credits, and The Truth About Corporate Accounting.  He documented many accounting distortions, improprieties, and frauds that took place during the 1960s and 1970s; in fact, he named so many examples that one might conclude that accounting fraud flourished during this era.

Unfortunately, despite numerous commissions and inquiries, the ethics of business managers during the 1990s differed little from those days.  Improper accounting still occurred, and audit firms either could not or did not stop them or even report them once discovered.  We review five such examples (Boston Chicken; Waste Management; Sunbeam; Cendant; and Sensormatic Electronics) which prove that Enron was not an aberration.  Enron was merely playing the game as so many had done before.

Boston Chicken

In 1993 Boston Chicken’s IPO was very warmly received by Wall Street, as were millions of dollars of the Company’s debt in the bond market.  Earnings reports fueled investor expectations,  while Company subsidiaries’ losses bypassed the parent’s income statement.

How was this accomplished? Managers played a game called finance area developers (FADs).   Boston Chicken created franchisees called FADs to which it loaned money, often up to 75% of the necessary capital, and it had a right to convert the debt into an equity interest.  During the start-up phase, the FAD typically lost money.  Boston Chicken reported its franchise fees and interest revenue from the FADs, but reported no losses.  If and when the FAD started to generate profits, Boston Chicken would exercise its right to enjoy an equity interest in the FAD, and begin reporting the franchisee’s profits into its income statement via the equity method of accounting.

The problem with this arrangement was that the accounting used did not reflect the economic substance of the FAD transaction.   Clearly, the FADs were “subsidiaries” from inception given their operating, financing, and investing decisions.  Boston Chicken controlled these FADs, so they were not really independent entities.  The economic truth was that Boston Chicken was the parent company and the FADs were its subsidiaries, regardless of the legal form under which the FADs were constructed.  Boston Chicken ought to have employed the equity method throughout, not just when the debt was converted into equity.

Reality ultimately dawned on market participants in 1997.  In just a few months, the Company’s stock lost over half its value, just desserts for giving the market financial indigestion.  While Boston Chicken disclosed these facts deep in the bowels of its financial statement footnotes, this fact does not exonerate the Company’s management and auditors, as disclosure does not redeem bad accounting.

Waste Management

Founded by Wayne Huizenga and Dean Buntrock, Waste Management hauls trash in the US.  Ironically, its financial statements in the 1990s were also garbage.

The creative accounting employed by Waste Management was quite simple, for much of it dealt with depreciation and amortization charges.  The Company minimized depreciation charges by increasing salvage value estimates, as well as asset life assumptions.  It also lied about the useful lives of landfills and refused to write down the value of landfills to their fair values.  This very simple fraud pumped up profits by $2.9 billion after taxes.

Sunbeam

Sunbeam CEO “Chainsaw” Al Dunlop resurrected an old chestnut of accounting gimmickry: recognize revenues whether or not a firm does anything to earn them.  Specifically, Sunbeam designed a new policy called a “bill and hold” program in which the Company’s customers (i.e., retailers) would supposedly “buy” goods, but postpone shipment until a later more desirable date.  The problem was  that customers didn’t pay cash, and they had a right of cancellation.  Under these circumstances, such sales transactions exist only in the mind of Sunbeam’s managers.

Cendant

Cendant provides yet another example of gaming in the 90s.  Cendant emerged from the marriage between HFS and CUC.  After combining, the HFS half of the team discovered accounting irregularities by the CUC team.

One irregularity involved the coding of services provided to customers as short-term instead of long-term.  This treatment allowed the firm to recognize all the revenue in the current period instead of apportioning it between the current and future periods.  In fact, many of these services were long-term in nature, and only a part of the revenues met the realization principle.  The Company also delayed the recognition of  any cancellations, thereby overstating current earnings.

A second problem  dealt with the Company’s amortization of different charges related to various clubs sponsored by CUC, including marketing costs.  The firm capitalized these costs as an asset and amortized them over a relatively long period.  Wall Street had previously caught CUC playing this game in the late 1980s, and hammered the firm by cutting its value in half.  Evidently CUC’s management didn’t learn their lesson.

Sensormatic Electronics Corporation

A variation on Cendant’s “coding scheme” can be found in the fraud by Sensormatic’s managers.  Ronald G. Assaf, CEO, Michael E. Pardue, COO, and Lawrence J. Simmons, Vice President of Finance, became concerned when Sensormatic was not making enough profits during certain quarters.  Whenever they had projected quarterly earnings in the past, actual earnings were never off by more than one cent.  The stock market was happy to have such a stable firm, and it rewarded Sensormatic with increased share prices.

However, when earnings slowed, Assaf, Pardue, and Simmons altered the dates in the computer clocks so that invoices and shipping documents and other source documents would record sales that actually occurred in (say) January, as if the revenues had actually taken place in December.  They continued this process until enough revenues were logged into the old quarter, and the desired financial projections were achieved…always within one penny of the original forecast.  Once they had enough revenues, the clock would be re-adjusted and the documents were correctly date-stamped.

The controller of US operations, Joy Green, stumbled onto this conspiracy.  She apparently discussed the matter with these officers, but no one else.  Her  response was feeble and inadequate.  The SEC not only sanctioned Assaf, Pardue, and Simmons for their fraud, but it also censured Ms. Green for her failure to notify the firm’s audit committee or the independent auditors.

Summary

What we have presented here is just a sample of what took place during the 1990s.  Many firms pushed the envelope, and a good number actually crossed the line that separates aggressive accounting from fraudulent activities.  Enron’s top managers saw these games and no doubt believed that they too were eligible for exemptions from generally accepted accounting principles. How can we forget that now famous satirical video created by Enron executives in which they joked about “mark-to-make believe” accounting?

We also note that the cases which settled prior to Enron’s collapse resulted mostly with a slap on the rest.  Sensormatic’s managers, for example, were fined between $40,000 and $50,000 each, pocket change for those guys.  Cases that settled after Enron have involved much bigger fines, such as Sunbeam’s former CEO Dunlap settling for $500,000.  Perhaps if the SEC had applied substantial penalties earlier, it could have persuaded more managers to employ less aggressive accounting principles.  Of course, prison sentences might have been even more persuasive.

We shall explore other aspects of the Enron saga in future essays lest we forget.  We shall explore Enron itself, the auditing profession, other gatekeepers, and the consequences of Enron.  Oh, the paradise lost because of the sins of managers and the failures of our gatekeepers!

References Related to these Five Firms

GAO, Financial Statement Restatements (2002).

Ketz, Hidden Financial Risk (John Wiley & Sons, 2003).

Schine, “The Squawk over Boston Chicken,” BusinessWeek (1997).

SEC, “Waste Management, Inc. Founder and Five Other Former Top Officers Sued for Massive Earnings Management Fraud,” Litigation Release No.17435 (2002).

SEC, “SEC Charges Walter A. Forbes and E. Kirk Shelton, Former ToP Officers of CUC International Inc., and Cendant Corp., with Directing and Profiting from a Massive Financial Fraud,” Litigation Release No.16910 (2001).

SEC, “In the Matter of Sensormatic Electronics,” Litigation Release No. 15680 (1998).

SEC, “Former Top Officers of Sunbeam Corp. Settle SEC Charges; Dunlap and Kersh Consent to Fraud Injunctions, Permanent Officer and Director Bars, Civil Monetary Penalties,” Litigation Release No. 17710 (2002).

This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.