My Views on Enron's Case

(July 23, 2002)

This was breaking news in wall street as at July 23:

They found that Citibank and JP Morgan had sold some financial products to Enron that enabled Enron hide its loans as commodity trades. This would reduce Enron's taxes and alter its balance sheet reports! Citibank's shares have dropped 14% as at now while JP Morgan has dropped 11.4%. The immediate fear was whether these 2 companies have broken the law, making them suffer huge punishment losses or go bankrupt as well. The next worry was about who else have bought these financial products - whether these products hid loans of other firms as well. The final concern was which other banks or financial institutions have offered similar financial products, whether these financial products would bring losses to these financial institutions.

This is my analysis. I think in general, the entire issue has changed beyond where it started from. It started from a plain and simple case that (1) Enron went bankrupt. The entire story is just that. However this led people into thinking about why Enron's financial problems were not visible earlier in the balance sheet. Thus the next issue came about: (2) Andersen seemed to have helped Enron hid financial information via various accounting methods. This in turn led to the issue about business moral values. If an auditing firm does/could not prevent its client from hiding financial problems, what can the market trust? Now this issue branched in 2 directions: (a) to find more firms who have hidden financial problems; (b) to find out how they hid their problems. The (a) direction has brought a lot of fear into the stock market. Slowly they found Worldcom, the Medco, etc, and probably more are coming. The (b) direction is new, now they found at least one kind of financial product, sold by well reputated financial institutions, that could be used by companies to tuck away financial problems from their balance sheets!

No wonder the stock market is in chaos. In the boom period (90s), businesses have advanced so quickly that business practices and reporting changed significantly. With the growth of multi-national and multi-subsidiary companies, it would not be surprising that old accounting guidelines become ever more ambiguous, giving rise to more "loopholes" in financial reporting. To cope with this increasing sophistication, auditing firms and consultant agencies came up with new practices. However there were not enough time to rigorously counter-check these practices. As long as these new practices do not contradict the old guidelines in the sense of the word, they were quickly adopted. These new practices generated demands for new financial products, which the banks also quickly came in to provide the market. This went on for 10 years. Now finally everybody began to look back and ask whether what they have done was truly legal.

There are 2 problems now: (i) the legal system did not progress as fast as the changing business practices during those boom years. (ii) the trustworthiness of the entire current business practices is thrown into question. Problem (ii) occurs because the re-examination comes too abruptly, it could have been easier if the re-examination was gradual during the past 10 years.

Thus a better way of out of the current situation now, is to add a third direction to the development: (3) a review committee to update on acceptable business practices. As more and more faults ("faults" according to the old standards) are discovered, and the market loses more and more confidence, we should also upgrade on the old standards to decide on what "faults" in the old sense are now acceptable in the modern sense. We should not leave till all the "faults" are discovered, then upgrade on the old standards. Doing so would cause an unnecessary market crash during the lowest point. Instead, doing both (2) and (3) at the same time could enable some firms to escape the misunderstanding and be able to get on with their businesses.

Standards change. Now is the time for greater innovation. Perhaps the good old balance sheet method has met its limitations with the present sophistication. Perhaps it is time for a new method, while in the interim, we simply augment the balance sheet method with some additional reports (on hidden assets?). There is no need to tear down the entire old accounting system overnight, a system which has faithfully served us for centuries. As we point more fingers and find more culprits, let's work on an alternative perspective that could help us adapt to present reality more painlessly.

Your comments are welcome.