NO TRUST—NO ENRON

Jonathan Karpoff reports on a particularly important, but often overlooked, aspect of the Enron debacle:

As we know, some of Enron’s reported profits in the late 1990s were pure accounting fiction. But the firm also had legitimate businesses and actual assets. Enron’s most important businesses involved buying and selling electricity and other forms of energy. [Using Enron as an intermediary, utilities that needed power bought energy from producers with surplus generating capacity.] Now when an electric utility contracts to buy electricity, the managers of the utility want to make darned sure that the seller will deliver the electrons exactly as agreed, at the contracted price. There is no room for fudging on this because the consequences of not having the electricity when consumers switch on their lights are dire. . . .

This means that the firms with whom Enron was trading electricity . . . had to trust Enron. And trust Enron they did, to the tune of billions of dollars of trades every year. But in October 2001, when Enron announced that its previous financial statements overstated the firm’s profits, it undermined such trust. As everyone recognizes, the announcement caused investors to lower their valuations of the firm. Less understood, however, was the more important impact of the announcement; by revealing some of its reported earnings to be a house of cards, Enron sabotaged its reputation. The effect was to undermine even its legitimate and (previously) profitable operations that relied on its trustworthiness.

This is why Enron melted down so fast. Its core businesses relied on the firm’s reputation. When that reputation was wounded, energy traders took their business elsewhere. . . .

Energy traders lost their faith in Enron, but what if no other company could be trusted to deliver on its commitments to provide electricity as contracted? In that case, energy traders would have nowhere to turn. As a direct result, energy producers with surplus generating capacity would be unable to sell their surplus power. As a consequence, their existing customers would have to pay higher prices. And utilities that did not have sufficient capacity to meet demand on their own would have to build more capacity, which would also mean higher prices for their consumers. So a general lack of trust in companies such as Enron would ultimately result in overinvestment in energy-generating capacity and higher energy prices for consumers.

Source: Jonathan M. Karpoff, “Regulation vs. Reputation in Preventing Corporate Fraud,” UW Business, Spring 2002, pp. 28–30

EXHIBIT 1–5
Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management

Practitioners of management accounting and financial management have an obligation to the public, their profession, the organization they serve, and themselves, to maintain the highest standards of ethical conduct. In recognition of this obligation, the Institute of Management Accountants has promulgated the following standards of ethical conduct for practitioners of management accounting and financial management. Adherence to these standards, both domestically and internationally, is integral to achieving the Objectives of Management Accounting. Practitioners of management accounting and financial management shall not commit acts contrary to these standards nor shall they condone the commission of such acts by others within their organizations.

Competence. Practitioners of management accounting and financial management have a responsibility to:

• Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills.
• Perform their professional duties in accordance with relevant laws, regulations, and technical standards.
• Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information.

Confidentiality. Practitioners of management accounting and financial management have a responsibility to:

• Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated to do so.
• Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their activities to assure the maintenance of that confidentiality.
• Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties.

Integrity. Practitioners of management accounting and financial management have a responsibility to:

• Avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict.
• Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically.
• Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions.
• Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives.
• Recognize and communicate professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.
• Communicate unfavorable as well as favorable information and professional judgments or opinions.
• Refrain from engaging in or supporting any activity that would discredit the profession.

Objectivity. Practitioners of management accounting and financial management have a responsibility to:

• Communicate information fairly and objectively.
• Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented.

Resolution of Ethical Conflict. In applying the standards of ethical conduct, practitioners of management accounting and financial management may encounter problems in identifying unethical behavior or in resolving an ethical conflict. When faced with significant ethical issues, practitioners of management accounting and financial management should follow the established policies of the organization bearing on the resolution of such conflict. If these policies do not resolve the ethical conflict, such practitioner should consider the following courses of action:

• Discuss such problems with the immediate superior except when it appears that the superior is involved, in which case the problem should be presented initially to the next higher managerial level. If a satisfactory resolution cannot be achieved when the problem is initially presented, submit the issues to the next higher managerial level.
• If the immediate superior is the chief executive officer, or equivalent, the acceptable reviewing authority may be a group such as the audit committee, executive committee, board of directors, board of trustees, or owners. Contact with levels above the immediate superior should be initiated only with the superior’s knowledge, assuming the superior is not involved. Except where legally prescribed, communication of such problems to authorities or individuals not employed or engaged by the organization is not considered appropriate.
• Clarify relevant ethical issues by confidential discussion with an objective advisor (e.g., IMA Ethics Counseling Service) to obtain a better understanding of possible courses of action.
• Consult your own attorney as to legal obligations and rights concerning the ethical conflict.
• If the ethical conflict still exists after exhausting all levels of internal review, there may be no other recourse on significant matters than to resign from the organization and to submit an informative memorandum to an appropriate representative of the organization. After resignation, depending on the nature of the ethical conflict, it may also be appropriate to notify other parties.

*Institute of Management Accountants, formerly National Association of Accountants, Statements on Management Accounting: Objectives of Management Accounting, Statement No. 1B, New York, NY, June 17, 1982 as revised in 1997.

LOSING THEIR BEARINGS

Some would argue that changes in the roles of the management accountant and the Chief Financial Officer have gone too far in recent years. Don Keough, a retired Coca-Cola executive, recalls that, “In my time, CFOs were basically tough, smart, and mean. Bringing good news wasn’t their function. They were the truth-tellers.” But that had changed by the late 1990s in some companies. Instead, CFOs became corporate spokesmen, guiding stock analysts in their quarterly earnings estimates—and then making sure that those earnings estimates were beaten using whatever was necessary, including accounting tricks and in some cases outright fraud. CFOs at companies like Enron who allegedly became entangled in such corrupt practices found themselves under arrest and in handcuffs. What is needed? Greater personal integrity and less emphasis on meeting quarterly earnings estimates.

Source: Jeremy Kahn, “The Chief Freaked Out Officer,” Fortune, December 9, 2002, pp. 197–202.

TAKING A CHAINSAW TO ETHICS

“Chainsaw” Al Dunlap earned a reputation as a no-nonsense executive specializing in turning around struggling companies. He is known to have proudly declared: “If you want a friend, buy a dog. I’ve got two.” The dark side of his tactics came to light after the debacle at Sunbeam, which he took over as CEO and then left in disgrace two years later. For a while, Dunlap was able to show consistent improvements in quarterly earnings at Sunbeam, but only later did his methods for achieving this record come to light. John A. Byrne describes what happened:

By the fourth quarter, as it became more difficult to meet the numbers, a new and rather menacing management technique was invented. It was called “tasking.” Kersh [Sunbeam’s CFO] and Dunlap would gather the top executives in the boardroom and ask each to run through the numbers for their businesses. If one area was lagging, someone else would be asked to make up the difference so Dunlap’s forecasts to Wall Street would be met.

“They would say, ‘I don’t care what your plan was. I don’t care what you delivered last month,” recalls Dixon Thayer, head of international sales. “We are going to task you with this number.’ Russ [Kersh] would give you a revenue and profit number and say, . . . Your life depends on hitting that number.’ These numbers got to be so outrageous they were ridiculous.”

In an effort to hang on to their jobs and their options, some Sunbeam managers began all sorts of game playing. Commissions were withheld from independent sales reps. Bills went unpaid. . . . As Sunbeam moved toward the holiday season, its struggle to make its numbers became more desperate. . . . [T]he company offered retailers major discounts to buy grills nearly six months before they were needed. The retailers did not have to pay for the grills or accept delivery of them for six months.

In the often esoteric interpretations that are made in accounting, Kersh was rarely conservative or bashful about his creative competence during his tenure as Sunbeam’s CFO. In a self-congratulatory tone, he would point to his chest and boast to fellow executives that he was “the biggest profit center” the company had. . . . At meetings, executives recalled, Dunlap would say: “If it weren’t for Russ and the accounting team, we’d be nowhere.” Several executives heard Dunlap shout to subordinates: “Make the [?@!] number. And Russ, you cover it with your ditty bag.”

Deirdra DenDanto, then 26, a recently hired member of the company’s internal audit department, challenged the company’s questionable practices from the start, but there was little follow-up to her recommendations. She finally resigned after unsuccessfully attempting to send a warning memo to the board of directors. A few months later, the accounting ploys Dunlap had been using to bolster earnings came unraveled, leading to a dramatic boardroom ouster. The company’s losses in that year totaled almost $1 billion and its stock crashed to $6, from an earlier price of $53. The company and its employees still suffer from the aftermath.

Source: John A. Byrne, “Chainsaw: He Anointed Himself America’s Best CEO. But Al Dunlap Drove Sunbeam into the Ground,” Business Week, October 18, 1999, pp. 128–149.

WHERE WOULD YOU LIKE TO WORK?

Nearly all executives claim that their companies maintain high ethical standards; however, not all executives walk the talk. Employees usually know when top executives are saying one thing and doing another and they also know that these attitudes spill over into other areas. Working in companies where top managers pay little attention to their own ethical rules can be extremely unpleasant. Several thousand employees in many different organizations were asked if they would recommend their company to prospective employees. Overall, 66% said that they would. Among those employees who believed that their top management strives to live by the company’s stated ethical standards, the number of recommenders jumped to 81%. But among those who believed top management did not follow the company’s stated ethical standards, the number was just 21%.

Source: Jeffrey L. Seglin, “Good for Goodness’ Sake,” CFO, October 2002, pp. 75–78.

CAPITALISM AND GREED

Capitalism is often associated with ruthless, self-centered behavior, but is that a bum rap? Researchers have run many variations of the following experiment. Two randomly selected players who do not know each other are placed in different rooms. The individuals cannot see or hear each other and are never introduced to each other. The first player is given $100 and told to split the money any way he or she chooses with the second player. The first player could propose a $100/$0 split, a $80/$20 split, a $50/$50 split, or any other combination that adds up to $100. However, under the rules of the experiment, the second player is allowed to refuse the offer and in that case, neither player gets anything. The game is played only once for each pair of players.

What would a greedy person do? A greedy and ruthless first player would reason that the second player would accept a very low offer of perhaps $10 since $10 is better than nothing. However, in repeated experiments of this sort, people cast as player one were usually far more generous than this and people cast as player two often rejected small offers, even though that left them with nothing. Even more interestingly, responses differed across cultures. When the experiment was run with farmers from Hamilton, Missouri, player one offered on average $48—very close to a 50/50 split. In contrast, the average offer by player one among the Quichua Indians in Peru was only $25. The Quichua Indians subsist in a slash-and-burn agricultural society with little trading, whereas farmers from Hamilton, Missouri, live in a fully developed capitalist market economy. This experiment has been repeated in many communities around the world and the consistent result is that greed (i.e., a low average offer by player one) is associated with nonmarket, precapitalist societies, and in general, the more developed the local economy, the closer the offer by player one is to a 50/50 split.

It is not clear what is the cause and what is the effect. Do markets make people act less greedily or is suppression of greed a prerequisite to a fully developed market economy? At any rate, ruthless greed seems to be much more a hallmark of people who live in undeveloped, precapitalist societies than of those who live in fully developed market economies.

Source: David Wessel, “Capital: The Civilizing Effect of the Market,” The Wall Street Journal, January 24, 2002, p. A1.