In the early 1990s, the integration of ethical discussions and cases into the first-year accounting courses became a fashionable trend. A major effort was made by the American Accounting Association, which included workshops and the development of cases, to promote the integration of ethics into the accounting curriculum. Most major first-year accounting textbooks include text and cases on ethics. In spite of these efforts, the evidence is that very few schools have made use of these resources in their classes. A study my co-authors and I conducted of assignments in first-year accounting courses show that less than ten percent of faculty includes ethics cases in their syllabi.

     The bankruptcy of Enron in December 2001-the largest in the history of U.S. corporations and one of the most shocking-has served to reinforce the importance of not only good financial reporting but also the ethical application of accounting principles. It is time to reassess and renew efforts to introduce ethical considerations into the first-year accounting course. This is necessary for several reasons.

      First, ethics cases help students understand proper accounting. The cases also demonstrate to them the importance of knowing accounting because most ethics cases involve the proper or improper application of accounting principles. For example, most of the issues in the Enron scandal revolve around various partnerships, called special-purpose entities or SPEs, used by the company for moving assets and related debt off Enron's balance sheet, and increasing Enron's cash flow showing funds flowing through its books when assets were sold by the energy trader.¹ When each partnership or SPE was established, Enron's management would transfer assets (and any related debt) to the SPE at an appraised value above the net cost of the assets, recording a gain on the transfer. Understanding what this means is greater facilitated when one knows accounting. For example, assume that an asset that cost $600,000 (appraisal value, $750,000) and related debt of $250,000 are transferred to an SPE. This transaction was recorded on Enron's books as follows:
  

Investment in Special Purpose Entities	500,000
Debt	250,000
Assets	600,000
Gain	150,000

To record transfer of assets and related debt to partnership at asset appraisal value of $750,000 ($500,000 + $250,000) resulting in a gain of $150,000 ($500,000 - $600,000 + $250,000).

This transaction has the effect of increasing Enron's net assets by $150,000, decreasing its debt by $250,000, and increasing income by $150,000. Note that no cash is received in this transaction. Sometimes the transferred assets were used as collateral on loans to the SPEs, which was then used to buy the assets from Enron.

Second, since for the vast majority of students-eighty to ninety percent in many cases-the first-year accounting course will be their only exposure to financial reporting, first-year accounting is the place in the curriculum where it can be most effectively emphasized that good financial reporting is the responsibility of management. Ethics cases serve to highlight the fact that judgments made by management affect the financial statements. For example, the SPE partnerships used by Enron are not illegal and have in fact been in use by many companies for more than 20 years. However, Enron's management used them to a much greater extent than other companies. Enron had more than 3,500 of these partnerships (the next closest company had only 350), and management unethically benefited financially from the transactions.

Third, ethics cases illustrate the importance of drawing the line between acceptable accounting practice and fraudulent financial reporting. Basically, fraudulent financing reporting is management's deliberate misrepresentation of the financial statements. To avoid fraudulent financial reporting, the financial statements must meet three criteria:

1. Technical compliance: A transaction must be recorded in accordance with generally accepted
   accounting principles (GAAP).
2. Economic substance: The resulting financial statements must represent the economic substance
   of the event that has occurred.
3. Full disclosure and transparency: Sufficient full disclosure must be made so that the effects of
   the transaction are transparent to the reader of the financial statements.

The Enron incidence illustrates hat even though the first criterion may be met because the transaction is apparently recorded in technical compliance with GAAP, technical compliance alone is not sufficient for truthful accounting. The other two criteria are as important for good financial reporting. For example, the second criterion is not met because the transaction as recorded does not reflect the economic substance of the event that has occurred. This is true for three reasons. First, many of the assets Enron transferred to SPEs were not producing sufficient income to justify their cost as recorded on the balance sheet. They were assets for projects that never got off the ground such as a venture to deliver movies over a fiber-optic network on which Enron booked more then $100 million of gains. Under GAAP, their value would be judged to be impaired, and they would normally be written down, thus showing a loss, rather than a gain. In economic substance, these assets were not worth the amount at which they were being recorded.² Second, the partnership SPEs were 97 percent owned by Enron. Under GAAP, a 3 percent outside interest allows Enron to exclude the partnership assets and debt from its records. If the SPEs had been established as corporations, GAAP would consider the entities to be subsidiaries that Enron would have to consolidate into its financial statements. Thus, there would be no advantage to Enron if the SPEs were set up as corporations. Nevertheless, the SPEs, in economic substance, were under Enron's control. Third, in some cases, Enron actually loaned money to the outside investors so they could buy the 3 percent ownership. When this transaction was done, Enron would record a Receivable for the amount of the loan-thus, a receivable that was unlikely to be collected. In essence, Enron had a financial interest of 100 percent in the partnerships after this loan was made. Further, in an apparent conflict of interest, not only did some Enron executives have interests in companies that invested in the 3 percent ownership of the partnerships, they benefited financially from the partnership transactions in the form of commissions and other payments.

Finally, the third criterion was not met because the notes related to the SPE's in Enron's financial statements were written so obtusely that they were opaque rather than transparent to the reader. There was very little public disclosure of the hundreds, maybe even thousands, of Enron's partnerships. For example, one large partnership, called Crewco, that has become a focus of investigations, was created in 1997 but was not reported in SEC filings until November 2001.³ It was not disclosed that in a typical partnership, banks would loan up to 97 percent of capital needed by the partnership. The partnership was expected to repay the loan from cash generated by the assets it received from Enron. In the event the partnership could not repay the loan, which was often the case because the assets were under-performing, Enron pledged to make up any shortfall. To make up the shortfalls, Enron had pledged shares of its own stock, but as the market price of its shares declined, it had to make up the shortfalls in cash. It became a spiraling decline. As the shares declined, more cash was needed which caused the shares to decline more until Enron eventually had to declare bankruptcy.⁴ The lack of transparency in Enron's financial reporting made it difficult for investors to understand the implications of the partnerships.

Thus, we have to conclude that Enron's management participated in fraudulent financial reporting because, even though GAAP may have been technically followed, the recorded transactions did not reflect the substance of the economic events and the reporting did not constitute full disclosure or transparency. Gains were recorded that had little basis in reality and the partnership deals had little capacity to generate future cash flows. In fact, after Enron's management restated the company's financial statements for fiscal 2000 and the first nine months of 2001, Enron's cash flows from operations dropped from a positive $127 million in 2001 to a negative $753 million in 2001.

Fourth and perhaps most important, ethics cases demonstrate that accounting matters and plays a critical function in society. Accounting numbers affect human behavior especially when it affects compensation. This is true for all levels of employees and management, but was especially important in the Enron scandal where accounting was used to cover up transactions that were not in the best interest of the company but enriched top management. Because of the resulting bankruptcy, thousands of investors lost millions of dollars, Enron employees lost not only their jobs but in many cases also their retirement funds that were invested in the company's stock. Further, one of the most respected CPA firms failed as a result of the case, displacing more than 35,000 accountants and consultants worldwide. It is not too much to say that better accounting and auditing could have prevented this tragedy.

Endnotes

¹ Delroy Alexander, "Keener Focus on Enron Deals," Chicago Tribune, February 20, 2002.
² Holman W. Jenkins, Jr., "Enron for Beginners, The Wall Street Journal, January 23, 2002.
³ John R. Emshwiller, "Legal Liability for Enron Debacle May be Determined by 1997 Memo," The Wall Street Journal, February 5, 2002.
⁴ Emshwiller and Smith, op.cit.