08 April 2011

Corporate Accountability

Some thoughts toward what will eventually become chapter 8 of my book, Corporations and Accountability.
Sometimes the iffy accounting isn't the result of inflation, honest confusion, or simple self- deception.

Sometimes it is the consequence of blatant fraud -- a corporate management that in cold blood sets out to cheat investors by lying to them about the corporation's prospects.

Enron's use of "special purpose entities" that effectively turned their own stock into a company asset is an example of the blatant lying.

The fundamental equation of accounting is this: assets - liabilities = equity. That is also, not surprisingly, the format for a balance sheet.

What a company is worth to its stockholders consists of everything the company owns, minus everything it owes.

For a company to treat its own stock as one of its assets is in effect a matter of blatant double-counting. Suppose a company owns only a lot of furniture -- $7 million of furniture. Suppose it owes $6 million to various parties. Its equity is, then, $1 million. If it has one million owners with shares of equal value then one would expect the value of each share to be ... $1. Simple enough, right?

Actually, that's far too simple for a lot of reasons, and the shares if publicly traded will be worth whatever buyers agree to pay and sellers agree to receive. But in the very simple case described above, one would expect the market prices to cycle around $1.
To get to the point, though: suppose the company starts treating that $1 million equity as an asset. Aha! so it has now discovered that has assets of $8 million (because this accounting trickery doesn't affect the vaue of the furniture). Subtract $6 million from $8 million and you get ... $2 million. The effect (and most likely the point) is to trick the shareholders into thinking their shares are more valuable than they are.

Likewise, a company cannot use an increase in the value of its own equity to spruce up its income statement, wiuthout producing the same sort of nonsensical circularity.

But Enron found a way around this simple-seeming prohibition. It created special purpose entities (SPE), and supplied these off-book entities with Enron stock. Then it dealt with those entities in ways that spruced up both the balance sheet and the income statement.

The SPE's could be kept off-book, under accounting rules, so long as 3% of theiir equity belongs to someone who was neither Enron nor an Enron "related entity." The 3 percent figure may seem modest under the circumstances. But the point of it was that someone else has to be willing to put that their own investment at risk. (Recall that a defining feature of equity is that it is the residual bearer of risk.)

The ways in which Enron satisfied that 3% requirement were risible. A homosexual relationship with an executive doesn't make one a "related party" because Texas laws don't recognize such relationships, they reasoned.

Beyond such minor points, Enron sometimes entered into explicit side agreement with the parties contributing thaty 3% assuring them it would make good on any losses. So it wasn't really equity at all, and the circle is closed. [Eichenwald pp. 596-97 gives a dramatic scenario of Enron execs redicovering the crucial document, and realizing that they are 'toast'.] Early 2001, Carl Bass, a member of Artrhur Andersen's Professional Standards Group, objected to such practices by Enron and his superiors at AA removed him from that account.

When Skilling testified before Congress, in 2002, he tried to justify such trickery by saying in effect that it is no worse than what you, the Congress, have allowed and in fact encouraged as to the non-expensing of stock options.

Implicit in this, "because you have allowed us to deceive ourselves, now we are entitled to deceive others."

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Knowledge is warranted belief -- it is the body of belief that we build up because, while living in this world, we've developed good reasons for believing it. What we know, then, is what works -- and it is, necessarily, what has worked for us, each of us individually, as a first approximation. For my other blog, on the struggles for control in the corporate suites, see www.proxypartisans.blogspot.com.