Preventing Another Enron – Red Dirt Liberty Report

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Enron code of ethics

After 12 years of incarceration, Jeff Skilling, former CEO of one of the best icons of corporate fraud ever, has returned to the streets of freedom. He served time for many counts brought against him by government officials in what was likely one of the worst orchestrated schemes of corporate fraud in history.

Skilling sat atop a company called Enron, which began its life as a boring energy company with slow growth and was transformed into what appeared to be a company of innovation that would transform the world. At least, that’s the sort of thing that investors were led to believe. The company even helped to form entirely new markets that had not previously existed – futures on weather, and trade on electric power.

A formerly stodgy and unimpressive utility company enjoyed a meteoric rise as it appeared to be bringing in profits by the megaton. And, investors went crazy for it. That is, until it was discovered that leadership had orchestrated complicated schemes that hid many of the company’s expenses and inflated reported profits that simply were not there. The company collapsed, thousands lost their jobs, and investors and creditors lost billions. It became the very picture, for many, of corporate greed and everything that is wrong with corporate regulation.

Without addressing Skilling specifically and what he really was or was not guilty of doing, and whether his sentence represents justice, I think the more important issue is how to prevent such massive scams that have this sort of major impact across entire markets. Was this a case where regulators did not step in soon enough? Should those that are tasked with safeguarding the public from this sort of fraud have detected it earlier or even prevented it? Has enough been done to prevent this sort of thing going forward?

Enron is one of many cases of extremely large-scale fraud at the hands of greedy corporate captains who didn’t care about how their crimes affected others. Past measures did not stop the fraud, and although there has not recently been anything on the scale of the Enron fraud, it is likely only a matter of time before another Enron has devastating consequences. There are many things in place to try and prevent this sort of fraud, but are they enough?

To some extent, it is not reasonable to believe that all fraud can be eliminated and detected prior to it happening. Investors and creditors need to do their best job in determining and accepting whatever risks they have. While the nature of deceit keeps some of these risks hidden, investors and creditors should always assume a risk for fraud. Not that they are responsible for it, but that if they do not assume it, they are not shielded to at least some extent from devastation.

When it comes to the job of regulators, I believe corporate regulation is one of the few areas where the government recognizes some need for private regulation. Financial institutions all have some amount of a combination of both government and private group regulation. Organizations like the SEC are manned by people who work within the industry and are advised by private accounting firms with some government oversight. Insurance companies contribute to funds that are used to bail out competitors should they become insolvent and work symbiotically with government officials. We don’t have much transparency with the federal banking system, but we do know that there are private elements of regulation there as well. So, corporate regulation, at least in terms of public corporations, is really one of the very few areas where the markets actually work with government to try and help police themselves, at least to a small degree.

Born out of this sort of regulatory system is an odd system of accounting. Every public corporation is required to keep two sets of books. One for investor and creditor reporting, and one for taxing authorities. Accountants spend many years in training to understand everything that goes into both complicated systems. In fact, it usually takes several experts that work in different areas of expertise in accounting to put the full picture together. These systems lead to a lot of confusion in the general public about trying to discern what represents a good investment. The systems offer a lot of wiggle room in how they can report earnings and losses, because accounting does not represent how much money a company is actually moving, but rather it resents a system for reporting numbers that loosely represent theoretical earnings or losses.

There is broadly a misunderstanding that what people think of as their personal profits is not the same as what corporations are required to report as their profits. Here’s an example: Let’s say you have a company selling gadgets that has purchased 10 gadgets at $100 each for a total of $1,000. The fictional company sells 3 gadgets for $200 each for a total sales of $600. Now, the way we handle our personal finances, we would think of ourselves as having lost $400, because that’s how much cash we are short. However, the fictional company would be required to report a profit of $300. Unless investors are savvy enough to dig deeper into a cash flow statement (which is only sort of adequate), they wouldn’t know this.

A statement of cash flow is also required to be reported along with earning reports that are required on most corporations on a quarterly basis. However, even that doesn’t really describe the full picture. And, it is not cash that is reported as a mainstay of what you see when you look at things like earnings per share that are widely reported. But, it is actually buried deep in the required financial statements. Scenarios get really complicated when you also add in the handling of capital expenditures that are placed on amortization schedules (an expense now is actually reported later), and the reporting of when sales and liabilities occur (as they are paid or as they are accrued).

The best way to keep corporate fraudsters form hiding information about earnings is to simplify financial reporting. It’s absurd to use two systems of accounting. It’s ridiculously expensive, and it is unnecessary. It only comes about because the government wants to collect its money and manipulate outcomes. It’s another way government can manipulate the economy. There should be only one system of accepted reporting that applies in every market in the world, and that system should be as simplified as possible for the average person.

In this case, it really isn’t necessary for an accounting system to be dictated by government, but rather it would be wiser to allow the markets themselves to solidify a system of reporting. The markets can create their own regulators who can be tasked with a system that not only prevents fraud but makes things more transparent to investors. Those systems of accounting should be more focused on cash flows rather than on arbitrary ideas about theoretical accounting mechanisms. Accounting for corporations should more closely mirror the way that people think about their personal finances. It’s easy to manipulate fictional accounting ideas about theoretical earnings, but more difficult to play games with actual cash flows. In other words, we don’t want to follow a series of made up numbers. We want to follow actual hard cash moving through the company.

We aren’t going to stop all the Enrons. Smart conmen and hustlers will always find some way to deceive. But, we can improve our regulatory systems through privatization of them, and through insisting the accounting systems be more open and transparent, as well as simplified. Accounting shouldn’t be something that theorists enjoy in systems of moving and reporting numbers. Accounting should be about following the real money. That is what eliminates many of the ways the Jeff Skillings of the world can hide and manipulate profits and losses. More government oversight isn’t the answer here. More oversight by the people most involved in the markets is the real answer.

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Danny Chabino

Danny Chabino has a background in operating small businesses. He has been involved in managing and/or owning the operations of multiple retail establishments, a sub-prime lending company, a small insurance company, a small telemarketing venture, and insurance consulting. In addition to these activities, he also has spent many years managing investments in stocks and stock options as a successful trader. He is the married parent of two adult children, living as a proud lifelong Oklahoman and a part-time redneck. Danny writes for the enjoyment and pleasure of sharing ideas and for the love of writing itself. His opinions skew libertarian, but he enjoys hearing open debate and listening to or reading of opposing ideas. As an odd confession, he personally detests politics, but enjoys writing about political ideals and philosophies.