Convicted felon Andy Fastow, the infamous chief financial officer of Enron Corp., ironically said accounting and auditing rules need to be changed to help prevent corporate fraud.
“I think it’s very important for the PCAOB to consider the distinction between ‘accurate reality’ and ‘accurate’ according to the rules. Companies are very adept, and I am one of the poster boys for this unfortunately at exploiting the rules to make the numbers intentionally inaccurate in a reality sense,” Fastow said during a meeting of the board’s Investor Advisory Group (IAG) on March 9, 2023.
“This is an entire type of fraud that I don’t think is focused on. We are very focused on finding the intentional fraudulent entry, as opposed to the fraud that occurs by exploiting loopholes for the ambiguity and complexity in the rules, which is more the Enron story than the former,” he said. “So, I encourage you when you use words like fair, words like accurate related to the financial statements that you create a distinction between reality and according to the rules.”
He shared his views during a panel discussion on fraud. This session was organized by the IAG, which invited Fastow and other experts to speak.
Fastow served prison time for his role in hiding the energy company’s massive losses two decades ago, which prompted Congress to pass Sarbanes-Oxley in 2002 to prevent large accounting frauds. At the time Enron collapsed, it was the largest bankruptcy in the United States.
And his remarks come as the PCAOB has a mid-term standard-setting project on fraud. Some say that sometime Wall Street analysts are the ones to first detect fraud, and they believe auditors ought to do a better job of identifying them to better help investors.
Former SEC Chief Accountant Lynn Turner and a member of IAG emphasized that Sarbanes-Oxley uses the word “accurate” financial information, but a term “which I think maybe all too often auditors try to walk away from that and try to say well, the numbers are within” the range of acceptability.
“When I was one of the founders and running Glass Lewis and we were doing financial research, what I found was the auditors really don’t understand at times the information that’s available” to analysts, and some “were not even aware of the information that Wall Street used …to analyze companies, which I found to be astounding.”
He said that firms say they are doing data mining, but in his view, it is data mining of company databases, not information that Wall Street analysts would often use.
“And as a result, they’re just missing a great opportunity to, I think, learn some invaluable information during the course of the audit,” Turner said.
Gray Areas
To elaborate his views on fraud, Fastow provided an example of gray areas that companies will exploit to their advantage. He is not discussing a type of fraud that occurs when companies are simply recording the wrong numbers intentionally.
“When this occurs, very often the government enforcement agencies will make the case look as if the company has simply been committing black or white fraud, putting in the wrong numbers,” Fastow said.
“But in reality, many of these cases where you have a fraud especially in large companies occur because these companies are exploiting the accounting rules, accounting assumptions, and they’re using structured finance in order to make their financial statements look healthier than they really are,” Fastow explained. “I would emphasize again the importance of creating a distinction in the minds of auditors between what is accurate according to the rules and what is accurate in reality.”
Fastow believes that often auditors use a standard that the company is following the rules, not really looking at financial reality.
“There’s an entire industry of bankers and accountants and attorneys who do nothing except to help these large companies exploit these rules,” he said.
Then he gave a simple example of how financial statements, while perfectly in compliance with the rules, could be completely divorced from reality.
In 2014, the average price of oil was $95 per barrel. For most of the year, the price was $110, but it dropped to $50 at the end of the year. The rule at the time told companies exactly what number to use when they calculate their economically recoverable reserves. The company takes the price of oil on the first day of each of the 12 preceding months and average it, or $95. But the price was $50 at year end. So the price was $50 when every oil and gas company released its financial statement.
“I can say with a high degree of certainty that at that point in time, none of those oil and gas companies had 95 on their 10-year forward price curve any longer,” he said. “All of them followed the rule. They used 95. All of them massively overstated their economically recoverable reserves, which is perhaps the most important metric that Wall Street looks at when they evaluate independent oil and gas companies.”
He is often invited to give talks to a group of business people, and he said he did a case study on this situation. At first, he does not tell them what the rule is and shows them what the companies have done or what a company has done using $95 to value their reserves.
“Everyone unanimously always says it is unethical. It is materially misleading, and they would not do it,” he said. “Then I showed them the rule. Almost everyone says it’s okay that the company did it. The mindset among people is so long as you’re following the rules, it doesn’t matter if the financial statements are misleading. It doesn’t matter if they’re divorced from reality.”
Thus, he encouraged the PCAOB to consider that issue as it works to revise standards because there are people “like me” unfortunately that will exploit every one of those situations.
Wrong Incentives
Charles Niemeier, former founding member of the PCAOB, said solving the issue of fraud is bigger than just auditing standards. When looking at the reasons why auditors did not find fraud, it was often not because auditors failed to comply with auditing standards.
Moreover, this is a complex problem. After the fact, it may be easy to say it was clearly fraud. But in the real world, it is not so clear cut, he said.
“And most auditors when you do the autopsies of these cases, many times the auditors identify the area which turned out to be fraud as a high risk area,” said Niemeier, who is a senior counsel at Williams & Connolly LLP.
Regulators can look into the standards and try to improve the situation. But one of the biggest problems is that auditors are paid by the company. Sarbanes-Oxley tried to put a buffer by making audit committees of the company to oversee their auditors. But not all audit committees are created equal.
The “challenge becomes greater when you’re dealing with areas and the accounting standards where company has discretion,” Niemeier said. “Andy has identified the gray area there that he knows well. The use of fair value. We all like the idea of having a presentation of what values are. But fair value, especially level three becomes very difficult for an auditor to address; it becomes often what management wants it to be. And it’s one of the reasons why in good times, everything looks good and in recessions, things look bad because just like a light switch, that value disappears. But how does the auditor address that when the accounting standards actually allow flexibility. That’s true for impairments, the way impairments work. There’s a number of areas where this level of discretion makes it very difficult for auditors to do their job.”
This does not mean that auditors should not do their best job, but he believes there should be a larger discussion that includes the SEC, the FASB, auditors and the investing community.
This article originally appeared in the March 22, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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