Issues Arising from the Demise of Enron: Anticipating Regulatory Fallout

1. Issues Arising from the Demise of Enron:Anticipating Regulatory Fallout Assoc. Prof. Julie Cotter Department of Accounting University of Southern Queensland Toowoomba Based on presentation prepared by: Professor Stephen Taylor University of Technology, Sydney May 2002 Contact Details: Email: cotter@usq.edu.au Phone: 07 4631 2916

2. OVERVIEW • Why do companies fail? • How do regulators react to failure? • How does regulation work? • Accounting ‘issues’ at Enron • Changes to auditing • Other ‘Independent’ monitors • Impact on accounting and disclosure rules • Regulatory fallout - some conclusions

3. 1. Why Do Companies Fail? • Simple fact: Companies fail due to poor management decisions, sometimes in combination with an economic downturn. • Fraud can be the cause of failure, but often follows an initial decline. • “Audit failure” where fraud is involved. • Things that don’t cause corporate failure • accounting standards • disclosure rules • corporate governance requirements • auditing • Is it reasonable to “attack” accountants and auditors following corporate failures • Involving fraud? • Not involving fraud? • How about “aggressive accounting?” • Relatedly, how useful is corporate failure as a basis for policy formulation?

4. 2. How Do Regulators React to Failure? • Enron is a political issue, a crisis that needs to be managed • Politicians respond to “public opinion” (ie. voters) • What do the (public) regulators see? • huge sudden collapse • “average” employee loses retirement funds • corporate insiders making large personal gains • Who let this happen? • The real bad guys are Enron insiders, but others are open to blame • Not stopped by auditors • Not stopped by independent board members/audit committee • Why didn’t security analysts see it? • Accounting rule makers too slow? • Were politicians looking after the public interest? • So, is it a surprise that more regulation is likely?

5. 3. How Does Regulation Work? • Initial aim is to protect the public interest • Propelled by political motivations • Maintaining confidence in capital markets • Regulation can be ‘captured’ by powerful individuals or groups • Enron influential in energy regulation • AASB captured by accounting profession • What can we expect to see as a result of Enron? • Action needs to be seen as sufficient to satisfy the voting public • Emphasis likely to be on: • More/tighter regulation of derivatives markets, auditing and audit committees, accounting and disclosure standards • However, some may also use Enron case to push existing agendas, eg. • Harvey Pitt (SEC) wants “forward looking” accounting. • Will new regulations be ‘captured’? • Will innovation be used to circumvent the increase in regulation?

6. 4. Accounting ‘Issues’ at Enron • Enron not subject to the same detailed disclosure regulations as financial institutions. • The way that trades were accounted for made revenues appear much higher than they really were. • Debt and losses hidden in special purpose entities (SPEs) • Additional debt hidden through disguising loans as financial hedges (prepaid swaps). • Both forms of off-balance-sheet financing • All allowed under current US GAAP • Overall effect was to enable true extent of debt to be hidden and make the company look much bigger, more solvent and more profitable than it really was. Illusion of a credible counterparty.

7. 5. Changes to Auditing • What is an audit? Is there an expectation gap? • Why are we so obsessed with independence? • easy to see • large fees • consulting services • Very few audits fail - but the cost of failure is perceived to be high • Audit failure is seen as rampant • US: Sunbeam, Waste Management, Cendant • Australian: HIH, Harris Scarfe, OneTel • Some “solutions”: • new self regulation • ban consulting to audit clients • mandatory rotation of auditors • impose more “forensic accounting” • limit staff moves from auditor to client • reform (in Australia, require) audit committees

8. 6. Non-executive Directors as Independent Monitors • Current emphasis on audit Committees • Australia lags the US • US focus on independence and expertise of members • How is ‘independent’ defined? • Ramsay Report • JPAA (Joint Committee of Public Accounts and Audit)

9. 7. Impact on Accounting and Disclosure Rules • Accountants are under fire because • standard setting seems too slow • a disconnect between accounting model and today’s business models • Is mark-to-market the answer? • How about more footnote disclosures? • A simple fact: the accounting model works pretty well, and is, for the most part, conservative • US vs. Aust. approach to accounting regulations • US approach is to write detailed, “Bright line” standards - they point to the “escape mechanism” • UK/Australian/IASB approach is to establish the “principles”. • Standards aim at the “underlying economics” • Standard setters avoid “exceptions”: say goodbye to hedge accounting? • This relies on judgment. Does this work better? Probably not, if the “judge” is not truly impartial.

10. 6. Impact on Accounting and Disclosure Rules(continued) • US (FASB) reaction is to write more standards (eg special purpose entities). Is this a case of “closing the stable door…”? • Emphasis on continuous disclosure will increase (US has relied more on periodic reporting than Australia does) • US standards setting will be less independent of government • Australia’s (AASB) commitment to international convergence may save us from overzealous political intervention • Or will we succumb to pressure and follow the US approach? • Is the problem the standards or the way they are applied?

11. 7. Regulatory Fallout: Some Conclusions • Accountants are under pressure • More so in the US than Australia • Auditors under even more pressure • government regulation? • less consulting? • Emphasis on good corporate governance is increasing • Increased audit committee requirements • Corporates have been seen as “outside” the net of financial market regulators - this is less likely in the future • Overall, more regulation