In the case of Enron, it appears that the Board didn't exercise its responsibilities, ask the right questions or was misled by management, or all three.

Management

Corporate management has an obligation to shareholders to maximize the value of the shareholder's stock. Although this is not inconsistent with making a significant amount of money for management, Enron's management appears to have lost sight of its fiduciary duty in a rush to maximize its own profits, rather than those of the company. It may be that the compensation system in which large stock options were granted to managers throughout the company created too great a focus on short-term corporate goals and earnings instead of the longer term good of the company.

In any case, management appears to have deliberately structured Enron's affairs to create false impressions of financial growth and strength, to have misled employees, investors and the general public as to its financial affairs, to have created an internal culture of aggressive behavior and avarice in the name of economic efficiency and the advance of the free market and to have aggressively utilized the political system, including campaign finance, to advocate for the elimination of regulation and to attempt to influence legislation and regulation. Ironically, as advocates for free markets, Enron management was happy to have regulation applied to others, so long as Enron stood to gain from the regulation.

If there is to be blame assigned in this situation, it is clearly first and foremost with management because its philosophy of unbridled competition created the environment in which there were incentives to manipulate information and deceive the public.

The Auditors

A recent cartoon in Newsweek showed a Jeff Skilling character in a Nixonian pose proclaiming, "I am not an accountant!" Accountants and auditors in general, and the old and prestigious firm of Arthur Andersen in particular, have come in for significant criticism in the Enron affair. It is not even clear at this point that the Enron situation involved an audit failure, although the firm has been indicted for its role in destruction of documents. In any case, given that U. S. traded companies have approximately 17,000 audits per year done and the very few situations in which audit failures have occurred, it is not fair to tar all auditors or the auditing process with the same brush.

The core values of the auditing profession are objectivity, integrity, continuing education and lifelong learning, staying attuned to broad business issues and competence. Most CPA's are successful in adhering to those values. Nevertheless, the economic environment of the late twentieth century contains within it some conflicts and "incentives" for problem behavior on the part of auditors.

First, auditors are hired by the organizations which they audit. If the auditing firm wishes to retain the business, it will attempt to satisfy its client's financial statement needs and desires. This does not mean that auditors will simply (1) accept all of the positions taken by management or (2) try to help management "cook the books". By far the majority of auditors carefully consider the financial statements being audited and will not sign off on positions that they do not feel "fairly present" the financial position of the client. But there is a dynamic tension which exists.

Second, auditing firms perform a number of other services for most clients; tax return preparation, review and planning, merger and acquisition planning, and a variety of financial and non-financial consulting. In some cases, the non-audit work exceeds the audit work in dollar volume. Some firms view an audit as a means of obtaining access to consulting work, so they view the audit as a "loss leader". In addition, the normal competitive process acts to place a lid on the amount of fees that can be charged for an audit. In many cases, clients view the audit as a commodity which should be contracted out to the lowest bidder. These factors can lead to a tendency to try to do the audit in less time than it perhaps should take, with the increased possibility of audit failure. Again, based on the small number of audit failures that take place in the U.S. each year, this tendency has not gotten out of hand, but it does exist.

Enron's situation appears to be far more complex than most. The transactions into which it entered were myriad, large, and complicated. For whatever reason, the auditors concluded that some of them had not been reported appropriately the first time and that resulted in Enron restating its earnings to a much lower figure, which added significantly to the crisis in confidence that led to Enron's bankruptcy. To the outsider it appears that (1) the Enron auditors accepted (and perhaps fostered) the financial structures put in place by management, (2) created the appearance (at minimum) (and perhaps the fact) of inappropriate destruction of documents, (3) may have been more focused on their own business model to the exclusion of a focus on the public trust which they are licensed to protect and (4) perhaps relied too much on management representations as to the facts surrounding the financing structures created rather than proving out the facts for themselves. It will take some time for all of the facts to come out.

The Regulators

There are a variety of regulators in this saga. The Securities and Exchange Commission (SEC) was created by Congress in the 1930's to oversee the stock exchanges and to mandate appropriate financial disclosure by corporations listed on those exchanges. The Financial Accounting Standards Board (FASB) is a privately funded standards setting body which creates Generally Accepted Accounting Principles (GAAP), the bedrock upon which corporate accounting and disclosure is based. Finally, there are the state boards of accountancy, the state agencies that license and regulate CPA's. All of them have a part to play.

The SEC may have the most important part, at least with respect to publicly traded corporations. The SEC can mandate behavior by corporations, stock exchanges, and CPA's with respect to the work they do for publicly traded entities. Over the past several years, Arthur Leavitt, the former chairman of the SEC, worked to limit the amount of consulting CPA's could do for clients which they also audited. He was unsuccessful in that attempt due, in part, to extensive lobbying on the part of CPA firms who believed that their consulting efforts were part of an overall service that could be efficiently delivered to clients without impairing their independence. In light of the Enron situation, all of the "big five" auditing firms (the five largest auditing firms which audit the majority of publicly traded companies) have stated that they will limit the consulting which they do for companies which they audit.

The FASB has been criticized for not more quickly developing accounting principles to effectively deal with some of the increasing complexities of modern business. When those principles have been promulgated, often they are attacked as being too much a set of rules rather than over-arching standards. Rules, it is argued, are easier for management to avoid, using the argument that management can do anything it wishes in a particular area if there isn't a rule to prevent it.

State boards of accountancy have done a reasonably good job of monitoring the work of CPA's in general, particularly given the relative obscurity and poverty in which they labor. However it is much more difficult for them to deal with large cases of alleged wrongdoing by auditors due to the lack of funding and staff with which most are constrained. Very often, in those cases, the board of accountancy must wait until some other agency, such as the SEC has done its investigation before taking action against individual CPA licensees. The phrase, "Justice delayed is justice denied" comes to mind.

The Analysts

Most stock analysts work for larger organizations such as banks and brokerage firms that sell stocks and do investment consulting for corporations. Although the analysts claim that their employers do not pressure them to provide favorable reports on companies that are working with other parts of the employer organizations, it is clear that many analysts did not issue "sell" recommendations regarding Enron until well after numerous indicators of serious problems were available to the general public. It appears that they may have allowed themselves to be influenced by their investment banker or stock broker employers into not being sufficiently skeptical of the information given to them by management. It also appears to an outsider that they did not dig into the data sufficiently to have seen the issues that existed.

What were the proximate causes?

Enron grew very rapidly and tried to finance much of its growth with debt. One of the indicators of corporate health is the "debt to equity" ratio that a company maintains. The higher this ratio, the more of a concern a lender or investor may have about the ability of the company to service its debt. Companies have developed various ways of moving some of their debt "off balance sheet". Some of these methods are commonly used. For example, a company may sell an asset to an outside third party, such as a bank, and then lease the asset back. If properly structured, the asset and the debt disappear from the balance sheet and the company simply records a lease expense each year that it uses the property. The continuing lease obligation is recorded as a footnote in the financial statements so that the reader has a full picture of the company's non-debt obligations.

Enron used a technique called a special purpose entity (SPE). The accounting rules allow a company (Enron) to enter into a partnership with other, independent, parties and record Enron's share of the income of that partnership as its own income without recording the assets and liabilities of the partnership as its own. If the SPE buys and operates a large power plant, for example, the debt incurred to buy the power plant will not appear on Enron's books, but Enron will record its share of the income produced by the partnership. Thus debt is "hidden" off the balance sheet.

In Enron's case, it appears that some of the partnerships were improperly structured. The rules provide that the independent third parties must own at least 3% of the equity of the SPE in to be treated as a valid SPE. In the case of at least one of the partnerships, it is not clear whether the third parties were even independent. In fact, it appears that they were either Enron employees, or persons related to Enron employees.

Even assuming that the SPE's were independent, their ownership level was diluted by Enron loaning the funds to the third parties to enable them to make their equity investment.

In addition, the revenues which Enron was reporting in connection with their energy trading activities reflected the underlying revenues involved in the contracts, not the commission income earned by Enron. This is equivalent to a stock brokerage firm reporting revenues of $100 on the sale of one share of a $100 stock, rather than the $5 commission that the brokerage actually earned on the sale.

As these types of issues were disclosed and it became apparent that Enron had significantly less earnings and revenue than originally reported, the trust of the marketplace was lost. The loss of trust led to reductions in stock price which triggered covenants in some of Enron's loan documents and it was forced into bankruptcy.

What can the average investor do?

Enron isn't the first time that corporate management has betrayed its trust and mismanaged a business to the point of failure, and it won't be the last. The landscape is littered with various corporate train wrecks such as those that created the savings and loan crisis of the 1980's, for example, so it pays to be vigilant.

Most of us don't have access to the kind of information that Warren Buffett recommends be requested by the audit committee of the board of directors of a publicly held company. We have to rely on published data, but there is a substantial amount of that. Magazines such as The Economist, Business Week, Fortune and Forbes and newspapers such as The Wall Street Journal, The Financial Times, and USA Today (yes, it has a good business section) provide a wealth of information on general economic conditions and articles and statistics on specific companies. Information on companies is also available on the web at sites such as www.bigcharts.com and www.quicken.com to name just two. These web sites contain links to access information such as SEC filings if greater research is desired.

But there are red flags to watch for, also. Alfred Rappaport recently set out some of them in a Wall Street Journal article. Here are some of his red flags, along with some of mine. Does the company's business model seem credible?