Rice professor examines the Enron meltdown

Rice
professor examines Enron meltdown
…………………………………………………………………

BY MAILEEN HAMTO
Special to the Rice News

Enron’s
faulty business model and risk-taking culture reinforced
by questionable accounting procedures and partnerships led
to the downfall of the Houston-based energy trading giant,
according to Rice professor Bala Dharan.

Sharing his
unique insight into the collapse of Enron from business,
accounting and regulatory perspectives, Dharan, the J. Howard
Creekmore Professor of Management at the Jesse H. Jones
Graduate School of Management, recently spoke to a Rice
audience and on Capitol Hill Feb. 6, where he testified
before the House Energy and Commerce Committee.

Enron’s
flawed and failed business model is the foundation upon
which the company made many bad investments, Dharan said.
It then used misleading disclosures and accounting “gimmicks”
to “hide bad business decisions from shareholders,”
he continued. Enron’s business strategy of being a
“frictionless company with no assets” had obvious
fundamental weaknesses, he said.

“When you
remove physical assets and convert them to financial structure,
your downside tends to be worse when things go wrong,”
Dharan said.

Lack of a boundary
system that normally would help define parameters for acceptable
business investments also was a major flaw in Enron’s
business strategy, Dharan added.

“Enron’s
top management essentially gave its managers a blank order
to ‘just do it,’ to do any ‘deal origination’
that generated a desired return,” Dharan said in his
testimony. The strategy led to the company’s many failed
ventures in weather derivatives, water services and broadband
supply, among other areas, he said.

The deadly combination
of bad business strategy, bad investments and desperate
attempts to use accounting “tricks to hide bad decisions”
led Enron to free fall into the largest bankruptcy in American
history, Dharan said.

“When a
company loses the trust and confidence of the investing
public because of discoveries of accounting wrongdoings,
the net result on the company’s stock price and competitive
position is mostly devastating and long-lasting,” Dharan
told Congress. “Accounting reports are the principal
means by which investors evaluate the company’s past
performance and future prospects, and a loss of trust effectively
turns away investor interest in the company.

“Deliberate,
impenetrable disclosures” raised red flags within some
investor circles, Dharan said. He pointed out a particular
problem with Enron’s third-quarter earnings release
that concealed $1 billion in expenses and losses in murky
language that reported pro forma earnings. While the headline
blared Enron’s favorable “recurring earnings,”
an investor would have to dig deeper in the release to learn
that the company actually lost $618 million during that
quarter. Thus, a net loss of $618 million was converted
to a “recurring net income” of $393 million by
conveniently labeling and excluding $1.01 billion of expenses
and losses as “nonrecurring,” Dharan said.

“My ongoing
research shows that the adoption of pro forma earnings reporting
is often a company’s desperate response to hide underlying
business problems from its investors,” Dharan said.
“[Pro forma earnings] may differ from one another in
the degree of deception, but the intent of all pro forma
earnings is the same — to direct investor attention
away from net income measured using generally accepted accounting
principles (GAAP earnings).”

In his testimony
to Congress, Dharan recommended that the Securities and
Exchange Commission, the New York Stock Exchange and Nasdaq
should adopt new rules that restrict the format and use
of pro forma earnings reporting. “All earnings communications
by companies should emphasize earnings as computed by generally
acceptable accounting standards,” Dharan said. “Companies
should be reminded by regulators and auditors that the use
of terms such as ‘one-time’ or ‘nonrecurring’
about past events in earnings communications implies certain
promises to investors about future performance and therefore
should not be used except in rare cases.”

Enron’s
use and manipulation of special purpose entities (SPEs)
accounting was yet another accounting trick that helped
the company hide bad investments and report false income,
Dharan said. “Many transactions with SPEs were timed
— or worse, illegally back-dated, just near the end
of quarters so that the income could be booked just in time
and in amounts needed to meet investor expectations,”
Dharan testified.

SPEs were formed
to hide debt, hide poor-performing assets, report gains
and losses when desired and to execute related party transactions
at desired prices. Accounting rules that permit these financial
effects of SPEs need to be re-examined, Dharan said, particularly
the rule that determines whether SPEs should be consolidated
or reported separately from the company that created it.

Unconsolidated
SPEs permitted Enron to report a transfer of assets to the
SPE as a sale. “Enron’s revenue recognition from
SPE transactions often depended on ‘mark-to-market’
accounting rules which gave Enron the ability to assign
arbitrary values to its energy and other business contracts,”
Dharan said.

— Maileen
Hamto is the assistant director of public relations at the
Jesse H. Jones Graduate School of Management.