Sunday, February 25, 2007
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I made a hasty post on an email list that people seemed to really like. The discussion was Enron – again? – and getting it right as to whether or not the execs were merely following the rules or whether they were corrupt. They were corrupt. And the whole time the regulatory authorities were granting their blessings.

All said, what did Enron do wrong? Enron had many bizarre accounting techniques: too much to get into most of it, but……an interesting ploy that passed muster with the regulatory crowd was Enron’s crazed revenue recognition schemes. Most people hear the term “revenue recognition” often nowadays, due to the numerous accounting scandals, many of which were the result of irresponsible recognition schemes.

Revenues of the Enron sort are anything but typical, and in fact are extremely complex to understand and account for. There is something called “mark-to-market” — marking up/down your financial instruments to properly reflect the market price. The rule is two-fold: obviously, for proper recognition of profit & loss, and also, in the case of a securities dealer, to make sure margin requirements are being met.

Enron, because it eventually began to operate more like a hedge fund than a capital asset-based natural gas pipeline company, thus toyed with mark-to-market and began to recognize huge gains on hypothetical future contracts. Hypothetical future-value accounting can produce just about any result desired. Weather, paper, water, and bandwidth derivatives were thereby traded and booked as current earnings. OTC (over-the-counter, or, off exchange) derivatives are very sketchy when it comes to valuation, thus it was highly advantageous to partake in the trading of these derivatives for a company whose core business model had stealthily collapsed.

The SEC and Arthur Andersen knowingly let all of this slide. The principles of revenue recognition were supremingly and *knowingly* violated by Enron execs, and the ethical spirit of the accounting profession was whored out for the sake of making $$$$$. Enron defenders – including libertarians – often muse over the fact that some of what Enron did in regards to revenue recognition and ditching debt in its SPEs (Special Purpose Entities) was within the boundaries of the rules (as they hear it from others who purport to know). However, even those actions that were within the rules were professionally unethical and unquestionably violated fiduciary duties. An entire shareholder base was robbed for the sake of making Enron execs/management wealthy. Defrauding investors is indeed an accurate depiction of Enron as a whole.

To make a point regarding government approval, the PCAOB (Public Company Accounting Oversight Board), which was created by Sarbanes-Oxley, is staffed at the highest level by former Arthur Andersen partners who had to look for a job after they wiped out that company via their collective incompetence. Forget that the PCAOB is a “private, non-for-profit” corp, for it was created by Sarbanes-Oxley legislation (a federal law) for the expressed purpose of enforcing government compliance. Oversight is courtesy of the SEC and its board members are appointed by the, ahem, SEC. The current chairman is a former Fed governor. The CEI (Competitive Enterprise Institute) has argued that the PCAOB violates the Appointments Clause of the Constitution, and its case is lock-tight.

As to the Smartest Guys in the Room, it still remains the single best book on the Enron affair. It is well done and its authors – solid business writers – do a very respectable job of translating accounting and finance for the layman. The movie is also worth one’s time – I highly recommend either one, or both.

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