Powercut

What lessons can be learned from the Enron collapse and subsequent scandal?
Philip Whiteley reports

The biggest liquidation in corporate history; an impoverished pension fund;
a flurry of writs; a link to the US president; the whiff of scandal – the Enron
saga has it all.

It has some obvious lessons about the US pension system, accountancy and
regulation. But the lessons for personnel professionals and for the biases of
general management are far more profound and long-lasting. Bluntly, the
bean-counters have suffered a major defeat.

Last November the company admitted that it had overstated profits by $586m
over five years. The stock price plunged to a few cents, having been more than
$80 per share a year earlier. Many Enron employees, 60 per cent of whose
retirement fund was in Enron stock, were impoverished, and have launched legal
action.

The affair has now become a major international scandal, featuring the
resignation of chairman Kenneth Lay (a friend of President George W Bush), the
suicide of a director and a crisis of confidence for auditor Andersen,
(formerly Arthur Andersen).

Such headline-grabbing high drama tells only a fraction of the story,
however. The Enron collapse exposes deep-seated flaws in the assumptions of
accountancy and accountancy-based management. Enron’s failure cannot be brushed
aside by pointing to a few errors and shredded documents. The scale of the
collapse renders such an easy conclusion inadequate. It was all too easy for a
handful of executives to hoodwink investors and business journalists that their
collective valuation of the firm changed from $80bn to less than $400m in the
space of a few months, without anything fundamental having changed in the
organisation.

This points to some serious flaws in the way company performance is reported
and company potential analysed. For the personnel profession, however, these
problems can be seen as good news because the missing element is people’s
skills.

"What Enron has proved is that the balance sheet is a totally obsolete
form of control," says UK-based personnel consultant Paul Kearns. "It
should shake the accountancy profession down to its socks. It is not the first
time they have missed a major insolvency, yet no-one is pointing the
finger."

In the late 1990s and up to 2001, Enron was transformed from a gas pipeline
company to a massive energy and commodities group. It entered into a frenzy of
deal-making, buying companies all over the world as utility markets were
deregulated, while also introducing innovative web services. It also engaged in
partnerships and risky investments using equity in which the potential
liability was not recorded in the official accounts.

Indications that traditional accountancy has become anachronistic have been
around for years, but have been regarded as a curio in management circles. In
1997 Ernst & Young analysed some major companies and discovered that the
vast bulk of value was represented by intangible matters. Even at oil giant BP,
with its massive investments, intangible matters add up to 75 per cent of its
market value.

The minor amendment to throw in a guess at ‘goodwill’ is inadequate. In a
world where tangible matters only account for between 0.1 per cent and 25 per
cent of a company’s value, conventional accounting is of limited use. It can
only record what it is set up to record, which is increasingly no more than
tangential to the matters that make a company successful. Managerial practice
has not caught up, however; and most attention is still devoted to these now
quite minor matters. The obsession with financial records has become illogical.

Complicating the matter was the speculative boom in dotcom stocks in
1999-2000. The bursting of this speculative bubble appeared to weaken the case
for taking intangible matters seriously, as excitable investors ignored the
fundamentals completely and grossly over-valued intangible assets of companies
that turned out to be dud.

But this is to misread the case. In the absence of meaningful information on
company potential, the investors were guessing. They piled into all dotcoms,
including the bad ones; and then rushed out of them all, including the good
ones.

Leif Edvinsson, a pioneer of intellectual capital, who invented a method for
calibrating intangibles while at assurance group Skandia, comments: "What
we need is much more intelligence about these dimensions. For example if you as
an individual are investing in your competence upgrading, is that a loss or
something good? In the accounts it appears as a loss. It is the same with
research and development: is that a loss or a potential future? What happened
with Enron is that the potential future was not taken into consideration.

"It is in the interaction between people and research and development;
between people and customers and between people and processes that value
lies," Edvinsson told globalhr.

As Baruch Lev, another of the pioneers of intellectual management points
out, the fundamentals of accountancy practice are 500 years old, having been
invented by the Venetian mathematician Luca Pacioli. He developed double-entry
book-keeping to help tradesmen keep track of purchases and sales. The system
can only record historical transactions and the value of fixed assets.

Lev, professor of accounting and finance at New York University’s Leonard N
Stern School of Business, says there has been complete stagnation in reporting
systems. Some of the most important assets to a company – acquisition of
customers; research and development, training of staff – appear as costs.

He points out that when a drug passes its clinical tests, huge value is
created – but there is no transaction.

Edvinsson says the backward-looking, cost-based nature of accounting leads
to huge inaccuracies. In turn, this causes misallocation of resources by
investment institutions. "It is like saying, what is the cost of good or
bad weather? rather than looking at the weather forecast."

"Financial trading is done on derivatives; the shifting slopes of the
curves, which is a proxy of a proxy. You are betting on whether the enterprise
is a ship coming to harbour, rather than investigating what is on the ship or
who is at the helm. It is a very indirect assessment," says Edvinsson.

The convoluted language of the financial markets, and the plethora of
techniques used, disguise the fact that most investment is simply a form of
gambling, where the only information is historical and the tacit assumption
made is that trends established in the past will continue. Hence the apparently
improving performance at Enron prompted more share purchases from investors who
were oblivious to the real state of the company.

This leads to a problem with intangibles: the difference between the market
value and the book value ought to be the intellectual capital of the
organisation. But usually the investors are guessing at the intangibles and
they can get it horribly wrong, as with Enron and the dotcom speculative
bubble.

The mistakes are expensive for business and society, Edvinsson says:
"To give you a number: the value of that kind of betting is $1,500bn per
24 hours, mostly in guesswork. It is 50 times larger than the value of traded
goods."

More accurate historical reporting would help, but it would still be
historical. Chief executives, with performance targets and share options, have
massive incentives to improve the short-term appearance of results, even if
this does long-term damage to the earning potential of the organisation. Hence
the increasing desire for statements and measures on human capital,
intellectual capital, intangible assets – call it what you will.

Paul Kearns, a UK-based personnel consultant, makes the same critique of
conventional accounting as Edvinsson, though he argues against measuring human
capital, which he says runs the risk of becoming another form of bean-counting.
Instead, executives and investors have to apply subjective judgement about the
ability and potential of a company’s people, and accept that not everything can
be measured.

A few investors are switched on, he reports. "I was hired by the Royal
Bank of Scotland, which was doing a presentation to City analysts. Someone said
to them ‘Your profits are good, you’re doing well but it is not tomorrow we are
bothered about, but four or five years’ time, are you still going to be
delivering good results? What we can look at now to predict that is quality of
management: do you have a pipeline of good managers coming through that will
bring good people to the top?’

The chief executive went back to the company’s HR team and said he had no
answers. He needed some form of measurement that showed what the firm was doing
to get the right people in place. What it produced was a simple system
identifying good management potential and looking at the risk of particular
managers leaving and so on.

"The approach at the Royal Bank of Scotland is better than most
people’s answer. It said: ‘Here are the people we have identified as being our
future. This is how we are looking after them; this is how we can keep 75 per
cent of them for at least five years’. It starts to tell analysts something
about the future.

"There is also the strong argument that it is not just about
individuals, but the whole organisation. You can look at individuals [for
example in a drug company], do you have the top R&D people? Are they going
to stay – are you looking after them? Do you work well as an organisation?"

Concepts such as intellectual capital may not be the answer; but at least
they address the problem. Moreover intangibles are more than just a trendy
Swedish experiment. The US Financial Accounting Standards Board put forward a
proposal on the reporting of intangibles last year. A special report by the
board, Business and Financial Reporting, Challenges from the New Economy
concludes that improved business and financial reporting will require more
attention to intangibles, expanded and systematic use of non-financial metrics
and forward-looking information. From 1 January this year, it has required
companies to give annual updates on goodwill.

While new measures of intangible capital, or human capital, will be
developed, refined and used to varying degrees to supplement information from
conventional accounts, the conceptual challenge remains.

It is very difficult for traditional managers to shed the view that accounts
are factual and all else is opinion. Personnel professionals have a tremendous
opportunity to prove to their colleagues that rational decisions can only be
made in business by basing them on the skills and capacity of people and teams;
and that accounts give only very partial information.

"Of course people are sceptical, because you are dealing with years of
tradition," says Edvinsson. "But then people were once sceptical
about whether the earth was round."

How the "bottom line" can be divorced from reality

Personnel professionals are commonly
told by the finance community they are merely to deal with the "soft"
matters, while executives and accountants hold the keys to the "hard"
levers of business performance. Enron was the most dramatic example of the
opposite being the case. The HR profession concerns itself with people skills,
teamwork and motivation; with recruitment, succession planning and leadership
development – in short, with the real company and things that make a
difference. In contrast Enron’s executives, obsessed with accountancy and
deal-making, were living in a virtual reality. US Congress investigators
estimate Enron had a staggering 3,000 partnerships and subsidiaries, nearly 900
of which were offshore. Executives were using Enron stock to make risky
investments, keeping the risk off the balance sheet but giving the impression
of growth.

In the virtual reality these disciplines create, the
significance of numbers is hugely inflated and the significance of skills is
arbitrarily shrunk. No amount of accounting tricks would have fooled investors
of Enron if they had been geared to analysing the real company.

This all hands a powerful argument at the disposal of personnel
professionals, though it is one they rarely have the courage to deploy. Enron
will make it easier.

How can intangibles. Or
intellectual capital, be measured?

www.intellectualcapital.se,
an agency which Leif Edvinsson helped to set up, can carry out assessments of
the intangible assets of a company. It seeks to give an indicator, a relative
measure, of the strength of the following attributes:

– Business recipe

– Intellectual properties (such as patents)

– Processes

– Management and employee capability

– Networks, such as recruitment, competence and
R&D networks

– Branding

– Customers

Measures are determined by interviews
with staff, managers and customers, from internal and external data. The
process takes six to eight weeks, and also results in an overall intellectual
capital rating. Around 200 employers, mostly IT firms in Scandinavia, have had
their intellectual capital rated in this way.

Comments are closed.