In a speech that should give all auditors pause, Andrew Fastow, former CFO of Enron, tells us that all the off-balance sheet transactions were reviewed and approved in advance by everybody.
Enron was one of the biggest in the host of business frauds after the turn of the century.
Half of Enron’s assets were off-balance sheet. According to the article, Former Enron CFO Andrew Fastow Confronts the Fraud Examiners, Mr. Fastow says those deals were intended to deceive:
Fastow admitted that his role was engaging in structured finance transactions that intentionally created a false appearance for Enron.
The goal was to create misleading financial statements.
Did he violate the accounting rules?
Did he break specific laws?
The transactions were reviewed and approved, yet still fraudulent
The attorneys reviewed the transactions and said they were okay.
The auditors reviewed the transactions and said they were okay.
The board reviewed the transactions and approved them.
Doesn’t get any better than that, huh?
Check out this explanation that everything was approved:
“All of you talk about controls and systems, and we thought about that too. I thought about that. What do you do if the rules are complex, vague or nonexistent? Well, you do four things, from where I was standing. You get management and board approvals, you get legal opinions, you get an accounting opinion from outside auditors to make sure it’s OK, and then you make disclosures in your financial statements. Here’s what’s not widely reported. We did that in every deal at Enron, and still it’s considered the largest accounting fraud in history. How can that be? You’re getting approvals for deals. The attorneys and accountants are telling you it’s OK. The board is approving it, and it’s still fraud.”
Did the auditors stop him? No.
They were part of the team. Mr. Fastow makes an accusation that the CPA firm helped engineer transactions. Check out this quote from the article above:
Fastow was asked how he was able to convince Arthur Andersen to sign off on the fraudulent transactions. “With Arthur Andersen, we didn’t get them to do it, they were part of the transaction team,” he responded. “The attorneys and the accountants worked with the team on a constant basis. When a deal was being structured that didn’t meet the rules, they and all the other people that were parts of the deal team would try to create new structures to fit within the rules or to fit within a broad interpretation of the rules. They were part of the team. They weren’t asking for approval. They were helping us structure the deal so it was approvable.”
I won’t go into the idea that the auditors should not be ‘part of the team’ or help engineer transactions to meet management’s goal. I’m assuming that anyone bothering to read this blog knows that doing so blows up your independence and is the short path to losing your license.
Apart from that and several other concerns, there’s a major part of Mr. Fastow’s story that should give pause to all accountants, auditors, attorneys, and board members.
Here’s the issue:
The accounting at Enron complied with relevant laws, SEC regulations, and accounting rules.
Everything was okay until the criminal investigations started and the indictments were issued. Jail time followed. All that for transactions that were reviewed and approved.
So are those its-legal-now-but-could-be-considered-fraud-later situations all gone?
Not from Mr. Fastow’s perspective.
Consider discount rates on pensions.
He suggests (and I am guessing his assertion is correct) that the discount rates used for pension plans today are so far out of line that they actually mislead investors. What’s the motivation to use an unreasonable discount rate? It improves the balance sheet, income statement, and disclosures. The question auditors should be asking themselves is how far do you have to push up the rate inside the “reasonable” range before you mislead investors?
He draws a parallel between what Enron did, which kept lots of assets and liabilities off the books, to what airlines do today by keeping all their airplanes off the books.
You can agree, disagree, or rip his ideas to shreds, but Mr. Fastow believes the accounting in play today is worse that what he did at Enron.
So what changed?
What caused the transition from Enron being named most innovative company in America by Fortune for six years and Mr. Fastow being named CFO of the year to Enron being the poster child for corporate fraud?
I suggest it is looking at those 3,500 off-balance sheet transactions in terms of substance instead of technical compliance with the fuzzy rules.
When law enforcement and regulatory staff, who were outside the closed decision-making loop, considered the substance instead of technical rules, they realized the intent was deception. With intent, which means criminal intent. Which the legal community defines as: Fraud.
How could that apply today?
Here is the scary question for auditors, corporate accountants, attorneys, and board members: Are there things you are doing that you think are okay and in compliance with the rules, but when looked at from an overall level, others would consider deceptive?
What things makes perfect sense to us but can be considered deceptive when looked at with a fresh perspective? Here’s a few questions to consider:
- What about that pension discount rate?
- What about skipping that “not really material” related party transaction?
- What about letting the client talk you out of that material adjustment?
- What about taking 500mg mebendazole pills which are readily available from multiple international vendors for $0.05 and booking a contribution with FMV of $10.54?
- What about that client that seems to push you around on audit scope?
What will others think when they step back from the technical accounting rules?
If you are an auditor, you might want to read the article at Accounting Today and think about Mr. Fastow’s comments.