This post is for
Walter. It’s for all those times he wrote posts with medical stuff in them. I had come to him for funny, and he made me read big words. What follows is a brief explanation of a few rudimentary accounting principles (Accounting 101 and 102), a fairly brief explanation of exactly what Enron did that was so bad, and what I want to do with all this fancy ehdumucation. Fair warning, this is like 5 pages long; you may just want to stop reading now, in fact.
You all remember Enron, right? Buncha no good crooks. Jerks, they were. What did they do again? It’s funny, but a lot of people just know that they did something wrong and cost a bunch of people money. I’m going to try and offer a very small glimpse here into some of the shenanigans that Enron pulled that was so bad.
But first, I actually have to delve into some very basic accounting. Don’t worry, I won’t go any farther than Accounting 101, and maybe a little 102.
First thing, for those who don’t know, Accounting is the practice of record the financial state of a company. You have to record what a company has, what a company owes, and who owns it. This is done, at its very core, through one equation. A firm’s assets are equal to the sum of its liabilities and its equity. Assets are anything the firm owns, from cash to equipment to stocks of other companies. Liabilities are things the company owes other people. Equity is the portion of the company that is owned by somebody else (stocks and retained earnings, mostly). The stock accounts represent the investment in the company by people who paid money to own part of the firm. Retained Earnings is the additional capital that stockholders did not pay in the past, but have claim to. Whenever a firm has net income at the end of a period, that net income is closed to increase the Retained Earnings account. So, as a company profits, its retained earnings go up, and therefore the implied value of the stock goes up. Of course, if the transactions and occurrences aren’t properly accounted for, then the retained earnings account is incorrect. Using some truly BS accounting tricks, Enron managed to post income when there was none, thus overstating its Retained Earnings account, and therefore making it appear to investors that the company was rising in value when in fact it was rapidly going out of business.
So you have that basic equation: A = L + E
These various totals are altered whenever a transaction occurs. We record these transactions with “journal entries”. For example, suppose you own a coffee shop, and you sell $500 worth of coffee in a day.
Cash . . . 500
. . . . . Sales . . . 500
The Cash account is part of Assets. The Sales is part “revenue” which is part of “net income” which is closed to retained earnings at the end of the period. So in this case, an asset increases, and Equity increases. At the end of every business period (standard is one year, but there’s flexibility in different industries) you have to release a financial statements of all of your asset, liability, and equity accounts. Assets must equal liabilities plus equity.
In EVERY journal entry, the debits (the number on the left) must be equal to credits (the number on the right). Normally, assets have a debit balance (debits make them go up, credits make them go down) and liability and equity accounts have a credit balance (vice versa). Therefore, expenses are debits and revenues are credits. In the above example, we have a debit to cash (an asset is increasing) and a credit to sales (a revenue account). On our income statement, “net income” will be the total of all our gains, losses, revenues, and expenses. Hopefully, the credit balances (revenues and gains) will be higher than the debit balances (expenses and losses). This will result in a credit balance on our income statement, also referred to as net income. That credit balance will be transferred to Retained Earnings. If the expenses and losses outweigh the gains and revenues, then we have a debit balance, which is a net loss. This also gets carried to Retained Earnings, and reduces that account.
To clarify, expenses occur when we spend money to make money. Paying our employees, buying inventory, paying rent, etc. Likewise, revenues occur as we do business, such as selling coffee. Gains and losses occur when we make money through unusual means. If we get sued and have to pay a settlement, that’s considered a loss. If our company invests in some stocks and then sells them back for more than we paid, that’s a gain (note that it’s only a gain because we’re a coffee shop, not an investment dealer. If we bought and sold stocks professionally as part of our business plan, it would be income).
When a company records expenses, it is required to record those expenses in the period that the related benefit occurred. For example, the electricity bill for 2008 must be expensed in 2008, no matter when it gets paid. The usual way of dealing with this is that there is a debit entry for the expense, and if we didn’t pay it yet, there is a credit entry for something like Utilities Payable. This is called the Recognition Principle, and it is required. In this example, the debits match the credits, and the increase in liabilities (Utilities Payable) is offset by the decrease in Owner’s Equity (the expense will reduce net income, which will reduce Retained Earnings, which is an equity account) so that the A = L + E equation is satisfied. The liability is increased just as the Equity is decreased.
This Recognition principle comes into play in a lot of ways, but the example I’ll focus on now is Fixed Assets, particularly equipment. Suppose our coffee shop buys a big industrial natural gas roaster. You do not get to record an expense for the cost of that roaster, because you haven’t earned the revenue yet. The roaster is going to be used for years, after all. So, that expense has to be spaced out over all of those years. You will first record a credit to cash or Accounts payable (depending on whether you bought it for cash or on credit) and you will record a debit to Equipment – Roaster. Equipment is an asset, so the A in the accounting equation is increased. This is offset either by a decrease in another asset (cash) or an increase in liabilities (A/P). If you bought in on credit, then when you pay the bill later (probably periodically) then you will credit cash and debit A/P (debit reduced A/P, since it’s a liability account, and credit reduces cash, since it’s an asset). You still don’t get to record the expense.
Now, you must record that expense over the life of the roaster. There are numerous ways to do it, and they can be very complicated in their own right, but let’s assume we use the really simple “straight line” method. Let’s assume we determine that our roaster will have a “useful life” of 5 years. Well then, each year, we record 1/5 of the cost of the roaster as an expense. However, the Equipment account must always show the roaster at its historic cost, until we sell or scrap it. Even though the asset has, presumably, decreased in value (depreciation), we must record it at its historic cost. So what we will do is create an account called Accumulated Depreciation – Roaster. We will credit this account and debit Depreciation Expense. Accumulated Depreciation is called a contra-asset account. It is an account that exists to offset the asset it is linked to (the roaster). Increases to a contra asset account are credits, and factoring a credit into our total assets will decrease the balance.
Now, let’s assume we sell that roaster to the coffee shop across the street. When we do that, we will debit our cash account (or accounts receivable, which is also an asset) for the selling price, and we will credit the equipment account for the original price of the equipment. We will also debit the Accumulated Depreciation – Roaster account. Now the balance in all of these accounts is zero, but the journal entry does not have equal debits and credits. The difference between debits and credits is going to be balanced by either a gain or a loss. The entry would look like this:
Cash . . . . . . . . . . . . . . . . . . . . . . 80,000
Accumulated Depreciation . . . 40,000
. . . . . Equipment . . . . . . . . . . . . . . . . . . . . 100,000
. . . . . Gain . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
So we have a $20,000 gain. Yay. Note that while it is ultimately closed to our Net Income, this gain is NOT income. Income must be part of our normal operations. It has to be called a gain, because it is irregular. We don’t sell roasters for a living, we sell coffee. When potential investors see our income statements, they will see that this 20,000 was an irregular activity; if it was called income, then an investor might reasonably expect such a gain to be recurring.
However, it does let us show on our income statement a nice 20,000 gain. But what if we OWN the coffee shop down the street? Did we really make any money? We sold the roaster to ourselves!
If you own enough of a company to exert significant influence over its financial decisions, there are rules about how you disclose intercompany transactions. Otherwise, if a company didn’t want to publish a net loss for the period, they could start a company, grant that company a line of credit and sell it a bunch of inventory. This would result in a debit to Accounts Payable and a credit to revenues, but the asset you’re recording (accounts payable) would be fake because the company you own isn’t going to pay it, and the revenues would therefore be fake as well, because you recorded those revenues to reflect an increase in assets.
This is what Enron did, but there was one very important difference: I have done everything I could in the above example to make it as simple as possible; Enron did everything they could to make it as complicated as possible. They wouldn’t just sell their products to a company they owned. In fact, they couldn’t because publicly traded companies are required to release special consolidated financial statements where they go back and reverse all the entries related to that sale, retroactively apply new depreciation entries, and a LOT more (to give you some reference, my Advanced Accounting Theory professor has spent almost a month on how to do consolidation entries for equipment sales alone).
So Enron started a company, which started a company which started a company. This continued about twenty times, until they only needed about $20,000 of non-company capital to start a company that Enron could sell things to and record income (in Enron’s case, it wasn’t selling equipment, but financial products). That $20,000 couldn’t come from any company employee or from the family thereof. No spouses, and the law is touchy about girlfriends that have been living with you for X amount of time. But gay marriage was illegal even in the very liberal state of New York, and so the gay lover of one of the company’s higher-ups (he couldn’t be considered family in any sense of the word, since the law abjectly denies the possibility of these two being family) ponied up that cash. Now, it turns out this was all still very, very illegal, but nobody could follow that money trail and prove it. This is how it went on for years with nobody catching on. Enron had to fall apart and all its investors had to lose every dime before anybody stepped in, and even in retrospect trying to follow the actual series of transactions that they used to put it all together is more complicated than trying to solve a Rubics cube with your feet.
Now, in response to the collapse Enron and WorldCom, a lovely little bill called Sarbanes-Oxley got passed. SOX did a couple of neat things, but perhaps the most useful was this: the management of a publicly traded company now must review the financial statements of the firm, and sign a statement saying that they have read and understood them. See, before this, any CEO could just shrug his shoulders and say “I’m a businessman, I never studied accounting. I had no idea this stuff was going on.” Up until this point, it was only required that every year, publicly traded companies hire professional auditors from outside the firm to review the financial statements and issue an opinion as to whether or not the financial statements are accurate and in accordance with all the rules. Now, those auditors have more responsibilities, and more authority. They are now also required to perform an audit of the internal controls a company uses to make sure that any fraud and errors that would materially impact the financial statements are either prevented or detected. Basically, auditors have a bigger job, and more authority. They’re anal. They’re picky. They work 70 hour weeks and they’re perpetually cranky. They don’t work for your company, and it’s not their job to make sure you company succeeds financially. Their only job is to decide whether or not you fucked up when you made all those complicated journal entries. And let me assure you, you fucked up. You always fucked up. Perfect financial statements are like perfect governments- they simply don’t happen, no matter how hard everyone works, how smart anyone is, or how much you all tried your very very best to do a good job. The only question is how many mistakes the auditors find, whether they’re big enough to be a real problem and whether you can correct them before the auditors issue their opinion. If you can’t get a passing grade from the auditor, banks won’t let you borrow their money. Investors won’t buy your stocks. Other companies make fun of you and throw rocks.
So yeah, I plan to become an auditor.
