^ There can be significant tax advantages to having a network of complex obscure subsidiaries, with benefits that accrue to shareholders. Clearly that’s not what Enron was doing, but having a complex network of subs is not a bad thing if done for the right reasons. One of my clients has more than 150 subs worldwide.
^ Yes.
And Brom:
Arthur Andersen was not complicit in the fraud. They were only charged with obstruction, and the conviction on those grounds was later overturned.
You can claim all you want they were complicit, but no court has ever agreed with that, nor have they ever even been charged with being complicit in the fraud. Did they purposefully avoid asking some questions to keep their consulting deals? Probably. But the idea that they helped Enron engage in fraudulent acts is unsubstantiated.
No firm is going to put their entire business on the line for $25M in fees. If AA knew the extent of the situation they woudl have severed ties.
There were some business school students who did a report on Enron before it crashed and sort of saw through the reality distortion field. My recollection is that they had looked at some indicators that can sometimes be indicative of problems, like changes in days sales outstanding and how accruals are behaving.
A sophisticated quantitative model can help identify these types of stocks. For instance, you could use a hierarchical logistical model to predict the probability of default. Throw in a bunch of financial indicators, categorical variables for ratings, output of a Merton model, and you’d probably get some pretty decent estimates.
^ Unless you have some pretty hard evidence, you’re putting your sack on the line by calling someone a fraud. If you’re wrong, no court is going to give a rats ass you have a quant model that indicates a high probability of anything. Any credible analyst would have reservations about doing so without seeing a smoking gun. Lawsuits, end of career… the consequences of being wrong are so much bigger than the rewards of being right. And that’s why we see so few call out frauds, it’s simply too risky.
^I respect that. I’m not particularly in favor of those value guys who will do that. You can still couch your argument in terms that everyone else uses. Say, we think it’s an underweight because of x and y instead of it’s a fraud because of z.
Companies already calculate the impact of such estimates. Analysts tend to think that they have found the real value after running some models and making adjustments but companies are smart. They already know how their figures would look on an adjusted basis.
Imo, the reason it took so much time to find out the fraud was because it was done by the top guys (ceo, chariman, cfo). It is very difficult to raise fingers at these people and you need to have very strong conviction behind your allegations.
In conclusion, I don’t think any analyst/accountant/CFA would have been able to find out the fraud. All you could have is suspicions and suspicions have zero value because the law follows “guilty beyond reasonable doubt” concept. And suspicions are in no way beyond reasonable doubt.
Geo you are suggesting that Arthur Anderson was not complicit in the Enron fraud and that no firm (of AA’s size) would put their entire business at risk for $25M revenues (actually $52 or which $25 was audit)…but respectively while these points are logical I think the circumstance can yield different conclusions…
Ultimately the quality control of an audit rests on its weakest link…and that happened to be the Houston office whose success was highly dependent on the Enron client and those revenues were very material to that office. Ever since AA has lost Accenture they strove to restore a consulting practice (far richer margins) and somewhere along the line the “auditors auditor” lost its way…further evidence of this this can be seen in their other audit misteps (Waste Management, Global Crossing, Haliburton, Dynegy, etc). And so I would suggest judgements are often made in a “micro” setting that prioritize individual practice and career goals and not so much the greater good of the organization (we have seen this time and again in the money management setting have we not)
Whether AA was complicit in the fraud I dont know (they certainly did not originate it or execute it directly) but just as certainly they failed to remain independent and objective and discharge their audit responsibilities. Believe me there was accounting management/staff at AA (and Enron) that knew that a number of their accounting practices stunk to high heaven but they were overruled by the ranking managers in their firms.
When AA failed felt very bad for the professionals that had chased the carrot for all those years, worked hard and did the right thing, and suddenly had the bottom fall out from under them through no fault of their own. But of course this happens across professions/industries and demonstrates how critical principled leadership is
M2M is used to this day in energy trading companies, and the tangled web of subsiduaries is a common tax strategy as well. Nothing there was enormously unusual. They were incompetetent but I’d suggest most auditors lack the knowledge and experience to fulfill their obligations to stakeholders. There wasn’t anything unusual, IMO and from my understanding, of AA’s behaviour at Enron.
Also keep in mind most audit reports specifically disclaim any responsibility for fraud. Auditors rely on management’s statements essientially regarding the sufficiency of internal controls. If you think auditors sit around their little audit room and look for fraud all day, you’re wrong. In fact, they don’t spend much time at all on the topic. Whether or not this is a flaw in the model is a good topic for discussion. No audit firm will take on that responsibility though industry wide because it’s too hard to detect fraud and to try to claim a company is fraud free carries too much liability.
Here is the 2000 annual report for Enron, for those interested:
It’s not possible that AA was unaware of the fraud – the key here is that the audit business doesn’t really care, it’s more of a toll booth. Lots of audit firms are willing to look the other way to avoid losing a lucrative client. Partners, after all, at audit firms are paid based on revenue generation, not fraud detection. Basically, the audit industry is broken and does very little at all to protect public shareholders. I put absolutely zero faith in audit opinions.
Your argument that no court found them guilty is flawed. The US Justice system has limited resources (particularly the SEC) and only goes after slam dunk cases. They hardly ever pursue even obvious cases against the Big 4 because they’re hard to win. The SEC would much rather pick on some lousy 5th tier auditor that doesn’t have the resources to fight back. This is an unfortunate reality.
Re: subsidiaries, there are some legit reasons for these such as overseas local firewalls for retail and hotel chains, but generally they are bad news. Most companies have no reason to open new subs in the Bahamas, Belize, Panama, Cypress, etc. It is an enormous red flag.
Re: fraud, not really. There are at least a dozen, probably two dozen, current public company frauds that I can name right now without even trying. Do I have absolute 100% proof? No, but I don’t need it, if there’s enough smoke it’s basically guaranteed to be a fire. Legit boards of legit public companies go to great lengths to make sure there isn’t even the appearance of wrong doing. I’d be willing to bet my entire net worth that there are at least 100 public company frauds operating in the US capital markets right now today.
This, 100%
Geo I could not disagree more strongly, with respect, to you thoughts on the characterization of Enron complexity, thoughts on auditor qualifications, and expectations concerning audit reliability.
Much complexity was built into the Enron environment that had no business basis with the sole role of obfuscating the actual financial standing of the firm.
It is true that auditors disclaim responsibility for detecting all fraud - simply not possible and certainly cost prohibitive to define this as an objective for a large corporation - but they are required to use sufficient work/procedure so as to detect fraud that rises to the level of causing a material mistatement in the financial statements.
Yeah, they have a duty too, but the guys doing the work aren’t qualified to figure that out. Why do you think these things keep happening?
I would suggest that its a bit extreme to put zero faith in audit opinions, that the industry is broken and does very little to protect shareholders. Of course there are a number of cases where it was shown that audit firms looked the other way and those cases are celebrated, sensationally large cases that would suggest the whole industry is broken.
But I reject that idea, quietly and typically audit firms are successful in keeping firms within the boundaries despite and are pretty adept at staying out of the headlines as a result. Also most cases are filed against audit firms after significant economic declines and often a triggered by Monday morning quarterbacking where the investors fortunes have been effected by events after the financial statement date that may alter assumptions reasonably made at the time - the deep pockets of audit firms make them a favorite target.
Anyway there is no profession/industry with a perfect track record but on balance the world does place a significant amount of trust in them and we are spending lot of money on the activity if as you are suggesting it yields little value.
GEO I don’t know what basis you have to discern auditor qualification and capability…I can’t recall the last time and auditor ran into trouble because they were unaware of an audit issue or over there head relative to the clients business. The often have as keen an understanding of the business as management themselves.
Like and discipline there are the better and lesser among them.
Anyway I have said my piece in this fascinating piece of american malfeasance! Respect all opinions and appreciate the dialogue.
You’re welcome to your personal views but this one’s not really up for debate.
If you look at the stock market, approximately 50% of public companies are under $2B of cap – it might even be higher than that. Of these 5,000 or so companies, some shockingly high percentage are not using Big 4 – that’s because of the cost – something like 50-70% are using non-big 4 firms. For a small revenue company, that’s fine, but $2B is a lot of cap, and most $500mm+ companies have real businesses with real revenue.
Now, of these, let’s say 3,000 companies not using the Big 4, some really large portion of those aren’t even using top 50 auditors. Think about that for a minute. Why would a supposedly legit public company choose a lousy auditor, or in some cases, an auditor with multiple PCAOB offenses? There’s no reason to do that, ever, unless of course you want an auditor who is complicit to the fraud or too incompetent to spot it.
That doesn’t mean all of these companies are frauds, but some actually material portion of them are.
If your premise is that Big 4 do a good job on large, blue chip companies, okay I won’t disagree there. But in general, looking across all 10,000 public companies, the audit opinion doesn’t mean much.
You’re welcome to your personal views but this one’s not really up for debate.
If you look at the stock market, approximately 50% of public companies are under $2B of cap – it might even be higher than that. Of these 5,000 or so companies, some shockingly high percentage are not using Big 4 – that’s because of the cost – something like 50-70% are using non-big 4 firms. For a small revenue company, that’s fine, but $2B is a lot of cap, and most $500mm+ companies have real businesses with real revenue.
Now, of these, let’s say 3,000 companies not using the Big 4, some really large portion of those aren’t even using top 50 auditors. Think about that for a minute. Why would a supposedly legit public company choose a lousy auditor, or in some cases, an auditor with multiple PCAOB offenses? There’s no reason to do that, ever, unless of course you want an auditor who is complicit to the fraud or too incompetent to spot it.
That doesn’t mean all of these companies are frauds, but some actually material portion of them are.
If your premise is that Big 4 do a good job on large, blue chip companies, okay I won’t disagree there. But in general, looking across all 10,000 public companies, the audit opinion doesn’t mean much.
@Bromion - you’re assuming that all non-Big 4 auditors are not capable of doing a quality audit. Academic research has suggested that “in situation where a Mid-tier auditor is potentially viable, Big 4 clients could utilize a Mid-tier firm without adversely affecting audit quality.” In other words, small auditors are just as good as Big 4.
However, “still, the results suggest that Big 4 clients have a lower ex ante cost of equity capital which is likely related to the insurance considerations - rather than the audit quality - associated with having a Big 4 auditor.”
So really, it seems that the only reason to have a Big 4 auditor is to lower cost of capital, thereby artificially boosting stock prices at shareholder expense. And of course, management gets to keep their artificially inflated stock options or stock grants.
I know many non-big 4 are not capable of doing public accounting work, it’s not just an assumption. If you have a public company with an auditor that has zero other public company clients, or which is using an auditor that has been tied to numerous prior frauds, and is doing weird things like opening up unnecessary offshore subsidiaries, that is probably a fraud.
Someone using Crowe Horwath can easily be legit, no red flags there. If they’re using Li and Company, you better watch your back because there is a very high probability it’s not legit.
These firms know there is fraud and look the other way. The probability of fooling an audit firm is very low unless they are extremely extremely incompetent / negligent or the company being audited is extremely complex. GE could probably easily commit fraud and the best auditors in the world would have a hard time untangling it. But GE is the exception.