Accounting Fraud – Its repercussions

Enron, WorldCom, Lehman Brothers, Arthur Anderson. Who would have thought that these companies will be companies of the past, something that future generations would read in history lessons. But the truth is that we lost these companies, and all in just a few years.

Before its demise in late 2001, Enron was an electricity and natural gas giant. It was known all over the world and was hugely successful; at least on paper (with $101 billion in what they claimed to be revenues). It was popular with the press, with Fortune magazine naming the company for six consecutive years as the “America’s Most Innovative Company”. When the bubble burst and the truth was revealed, it wasn’t a pretty picture. The company had duped everyone to believe they were a successful company.

The so called success was being sustained only by creative accounting or in simpler terms accounting fraud. The company had established a number of limited liability special purpose entities, some of them offshore and moved a huge amount of debt and losses to these entities. These entities were not rolled into the financials of the parent company, so the company looked far healthier than what it truly was. But in August 2001, when Daniel Scotto the first analyst to publicly disclose Enron’s financial flaws came out with his report “All Stressed up and no place to go”, the truth started to unfold and by end of 2001 the company filed for bankruptcy. It was the end of a giant!

Enron’s demise had two big impacts on the accounting industry, first was that this scandal made the government take more notice of accounting fraud and thus began the idea of Sarbanes Oxley and the second was that along with Enron, the accounting community lost one of the big 5 (at that time) accounting firms, Arthur Anderson, the audit firm of Enron.

But apart from the impact on accounting industry, the collapse of any big corporation has a ripple effect. There is a big list of affected parties in a situation like this. The employees, the customers, the suppliers, the creditors, the investors and the total market. Each party feels the heat, even though some may feel it more than other.

The employees, they not only lose their job, (at the time of the revelation of Enron’s fraud, the company employed 22,000 people) and hence their current source of income but they also lose their future source of income in the form of losses on their 401Ks. In case of Enron, most of the 401K investments were almost wiped out as more than 60% of the assets held in the company’s 401(K) retirement plan consisted of Enron shares. The share price dropped from over $90 to just pennies at the time the fraud was unraveling. So basically 60% of the asset base was completely wiped off. The rest 40% was affected as well, because when such behemoths are lost the market sentiment goes down, the entire market takes a hit. So the employees lose their safety net for the future with no source of income for the present.

When big companies fail, they tend to have a bigger impact on the market as a whole. The investors become wary of the whole market. The mentality becomes of wait and watch; no one wants to do any more investments because they think if things like this can happen to such big companies what is to say smaller organizations won’t get wiped out! And after being hit with big losses due to investment in the lost giant, very few people rise out of it and start investing again.

Customers lose too. They lose their source of supply, and in cases where there are fewer suppliers, the customers are faced with the dilemma of who to choose. With fewer suppliers in the market, the law of economics would kick in- the suppliers would have an upper hand in setting up prices and there is a chance of deteriorating service as fewer suppliers have to meet the demand of more customers. Which raises the question, would customers get the supply they need; now that the demand supply equilibrium needs to be readjusted.

The suppliers suffer. They are able to recover a smaller portion of their outstanding bills and will have to write off a big portion; thereby affecting their margins. Some smaller suppliers might very well be wiped out if they have a very few client base and their biggest client files for bankruptcy.

Other creditors like the utilities, the equipment and space providers, other service providers also lose on their outstanding bills. Banks that work on investment as well as commercial banking for such clients get burnt too. In case of Enron Citigroup and J.P. Morgan Chase took a big blow.

Is it possible to stop such activities and save corporations from being wiped out? Sarbanes Oxley and now Dodd-Frank Acts are trying to do just that. Will they be successful? They will be helping in laying down the rules and regulations and the penalties. But it will take a holistic approach to solve this situation. The auditors need to be much more involved, the employees need to raise their voice is they see something fishy, investors should not just look at the main financial indicators and stock price but try to read between the line, the analysts tracking the companies should be more thorough in scrubbing the numbers and last but not the least, the executives should realize that greed is good but too much of it can land them in prison!

Kenneth Lay, Jeff Skilling, Andrew Fastow; the accounting community will not forget these names. These names will go down in the accounting history as the executives who schemed the investors into believing what was not even close to the truth.