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: Phone:

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

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?

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?

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?

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.

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

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)

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.

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?

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