Financial statements should be read with a critical eye, and readers should question not just the information included in the statements, but also the accounting standards used to prepare the statements. Informed decisions include assessing the quality of the information provided not just the information itself.
Being responsible to ensure quality, I work hard to maintain my professional skepticism. According to Auditing Standards professional skepticism "is an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence". In simple terms: asking the hard questions.
One way that I maintain my professional skepticism is by reading about audit and business failures. One of my recent books, "The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron" by Bethany Mclean and Peter Elkind, is about the failure of Enron, the dissolution of Arthur Anderson (at the time one of the big international accounting firms), and the failure of the U.S. Generally Accepted Accounting Principles (GAAP).
Enron didn't start breaking accounting principles until relatively late in its life. For most of the company's history, it used aggressive, but acceptable, accounting practices. These practices included using mark to market accounting to record assets at their fair value based on current market prices. This treatment allowed the company to immediately recognize the profits in a twenty year natural gas delivery contract instead of over twenty years on delivery of the natural gas to the customer.
Other acceptable practices included the use of special purpose entities (SPE) which are legal entities that fulfill narrow or temporary objectives of a company. For example, a group of companies could have a payroll service company whose sole purpose is to process and pay employees of the group.
Enron's slide to destruction was partially driven by its use of acceptable accounting practices which pushed for early recognition of revenue to increase the company's publicly reported earnings and drive up its share price. Options on Enron's shares were part of its management compensation package. The company started to break accounting rules when it tried to maintain the momentum caused by its aggressive accounting practices.
The idea that acceptable accounting practices helped push Enron over the edge was one of the contributing factors to the introduction of the Sarbanes Oxley Act. It was created to reform public company accounting to protect investors. In addition to Sarbanes Oxley, U.S. GAAP and GAAP in other countries was changed.
These modifications included altering the accounting treatment of special purpose entities (SPEs), called variable interest entities (VIEs) in Canada. Enron used SPEs to aggressively move debt off its balance and recognize revenue early from the sales of assets. The combination of less debt and higher revenues helped Enron increase its share price.
Accounting Standards for Private Enterprises
Up until 2015, Accounting Standards for Private Enterprises (ASPE) included explicit accounting guidelines and language discussing the treatment of VIEs – "AcG-15 Consolidation of variable interest entities." The guideline and any mention of VIEs has recently been removed and replaced with an expanded definition of a subsidiary (a VIE is a special type of subsidiary). Companies are required to report under these new accounting standards in any financial statements with years ending on or after January 1, 2016.
The new standards are rigorous and are expected to result in the recognition of a greater number of subsidiaries in consolidated financial statements. Financial statements should be stronger from the change in standards. If financial statements are now stronger, why does removing any discussion of variable interest entities matter?
Lest we forget
Enron's bankruptcy rocked the financial world in 2001 and while it has since been eclipsed by more spectacular failures such as the bankruptcy of Lehman Brothers, or the bailout of AIG, its lessons are important. Previously, when I came across VIEs or SPEs I remembered Enron's use of these entities to hide debt and it drove me to ask: does the company have a legitimate business purpose for the entity?
The changes in ASPE integrate the concept of VIEs, but have removed the name variable interest entity, which shows that the world has moved on from Enron. If the language doesn't include the name VIE, entities made famous by the collapse of Enron, will Enron's lessons be forgotten?
The Impact of Accounting Standards
Accounting standards can have both expected and unexpected consequences to your operations. We are happy to discuss accounting standards and their implications with you, including helping you assess any possible issues with the upcoming change in standards for the treatment of subsidiaries under Accounting Standards for Private Enterprises.