Enron Fiasco Impact on Business Debt Recovery and Credit Risk Assessment

It’s been almost ten years since the Enron scandal was revealed in October 2001. Let’s not forget the impact this has had on business debt recovery and credit risk assessment. The following is a re-printed Creditworthy News clip from 6/26/02:


Business Debt Recovery - Enron Complex Houston and Enron Movie-flickr-wikicc Flickr Hey Ray and Wiki CCThe Enron fiasco has made everyone aware of the fact that companies do play games with their financial statements in order to adjust them to what they want.  In most cases, that means making the statement appear to be better than it actually is in order to help their stock price, obtain favorable loans or to just survive to fight another day.

I have always felt that the best way to determine the financial strength of a company was to review their financial statements.  We all know to be aware of scam artists and outright thieves, but until recently, I have not realized the degree some companies will go to manipulate their books for whatever purpose they have in mind.

One person who has spent time and energy researching this subject in order to find the companies who are manipulating their books is Howard Schilit of The Center For Financial Research and Analysis.  He has also written a book entitled Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports.

An example of what he has found is AOL time Warner.  In the mid-1990s, financial gimmickry enabled AOL to turn a big loss into a handsome profit.  He states that AOL spent money to attract customers and instead of expensing the cost, they converted it to an asset.

The SEC later sued AOL for improper accounting practices, and AOL paid a $3.5 million fine without admitting guilt.  The fine was small compared to the advantage AOL obtained.  By capitalizing the expense, AOL showed a profit in 6 of 8 quarters, instead of a loss it would otherwise have posted.  “They used this inflated stock to buy Netscape, CompuServe and later Time Warner,” said Schilit.

Schilit says that shenanigans are actions or omissions that distort the financial health of a company.  He goes on to identify the seven deadly sins of accounting:

  1. Recording revenue too soon
  2. Recording bogus revenue
  3. Boosting one-time gains
  4. Shifting current expenses
  5. Improperly recording liabilities
  6. Shifting revenue forward
  7. Shifting special charges

One example of recording revenue too soon is to include shipping goods before the sale is finalized.  An example of recording bogus revenue would be to record vendor refunds as revenue.  And AOL demonstrated how to shift current expenses to a later period.

The key to unlocking a clearer picture begins with careful assessment of financial data. Surprisingly, Mr Schilit advises financial sleuths against using the balance sheet, statement of operations, or statement of cash flow as a starting point.

Instead, investors and creditors should begin with the auditor’s report, proxy statements, footnotes to financial statements, the president’s letter, management discussions and other related filings. These documents will often reveal important clues in the form of opinions about the fairness of financial statements and overall health of the company.

It would be seem to be difficult for anyone to identify these shenanigans, but being aware of the possibilities is a good first step. If nothing else, it may cause you to dig a little deeper or to ask some questions you weren’t going to ask.

Conclusion: Sarbanes-Oxley came into force in July 2002 and introduced major changes and regulation of corporate financial practices. This is a step in the right direction, but do think this is enough? I would continue to ask the tough questions and dig deeper on the credit side in regards to your higher dollar, higher risk accounts.

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Merged Photo credits: Enron Complex Houston-Flickr by Alex via Wikimedia Commons and Enron Movie cover-by Hey Paul on Flickr.