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first_img Comments are closed. What lessons can be learned from the Enron collapse and subsequent scandal?Philip Whiteley reportsThe biggest liquidation in corporate history; an impoverished pension fund;a flurry of writs; a link to the US president; the whiff of scandal – the Enronsaga has it all. It has some obvious lessons about the US pension system, accountancy andregulation. But the lessons for personnel professionals and for the biases ofgeneral management are far more profound and long-lasting. Bluntly, thebean-counters have suffered a major defeat. Last November the company admitted that it had overstated profits by $586mover 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 whoseretirement fund was in Enron stock, were impoverished, and have launched legalaction. The affair has now become a major international scandal, featuring theresignation of chairman Kenneth Lay (a friend of President George W Bush), thesuicide 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 ofaccountancy and accountancy-based management. Enron’s failure cannot be brushedaside by pointing to a few errors and shredded documents. The scale of thecollapse renders such an easy conclusion inadequate. It was all too easy for ahandful of executives to hoodwink investors and business journalists that theircollective valuation of the firm changed from $80bn to less than $400m in thespace of a few months, without anything fundamental having changed in theorganisation. This points to some serious flaws in the way company performance is reportedand company potential analysed. For the personnel profession, however, theseproblems can be seen as good news because the missing element is people’sskills. “What Enron has proved is that the balance sheet is a totally obsoleteform of control,” says UK-based personnel consultant Paul Kearns. “Itshould shake the accountancy profession down to its socks. It is not the firsttime they have missed a major insolvency, yet no-one is pointing thefinger.” In the late 1990s and up to 2001, Enron was transformed from a gas pipelinecompany to a massive energy and commodities group. It entered into a frenzy ofdeal-making, buying companies all over the world as utility markets werederegulated, while also introducing innovative web services. It also engaged inpartnerships and risky investments using equity in which the potentialliability was not recorded in the official accounts.Indications that traditional accountancy has become anachronistic have beenaround for years, but have been regarded as a curio in management circles. In1997 Ernst & Young analysed some major companies and discovered that thevast 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 itsmarket value. The minor amendment to throw in a guess at ‘goodwill’ is inadequate. In aworld where tangible matters only account for between 0.1 per cent and 25 percent of a company’s value, conventional accounting is of limited use. It canonly record what it is set up to record, which is increasingly no more thantangential to the matters that make a company successful. Managerial practicehas not caught up, however; and most attention is still devoted to these nowquite minor matters. The obsession with financial records has become illogical.Complicating the matter was the speculative boom in dotcom stocks in1999-2000. The bursting of this speculative bubble appeared to weaken the casefor taking intangible matters seriously, as excitable investors ignored thefundamentals completely and grossly over-valued intangible assets of companiesthat turned out to be dud. But this is to misread the case. In the absence of meaningful information oncompany potential, the investors were guessing. They piled into all dotcoms,including the bad ones; and then rushed out of them all, including the goodones. Leif Edvinsson, a pioneer of intellectual capital, who invented a method forcalibrating intangibles while at assurance group Skandia, comments: “Whatwe need is much more intelligence about these dimensions. For example if you asan individual are investing in your competence upgrading, is that a loss orsomething good? In the accounts it appears as a loss. It is the same withresearch and development: is that a loss or a potential future? What happenedwith 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 valuelies,” Edvinsson told globalhr. As Baruch Lev, another of the pioneers of intellectual management pointsout, the fundamentals of accountancy practice are 500 years old, having beeninvented by the Venetian mathematician Luca Pacioli. He developed double-entrybook-keeping to help tradesmen keep track of purchases and sales. The systemcan only record historical transactions and the value of fixed assets. Lev, professor of accounting and finance at New York University’s Leonard NStern School of Business, says there has been complete stagnation in reportingsystems. Some of the most important assets to a company – acquisition ofcustomers; research and development, training of staff – appear as costs. He points out that when a drug passes its clinical tests, huge value iscreated – but there is no transaction. Edvinsson says the backward-looking, cost-based nature of accounting leadsto huge inaccuracies. In turn, this causes misallocation of resources byinvestment institutions. “It is like saying, what is the cost of good orbad weather? rather than looking at the weather forecast.” “Financial trading is done on derivatives; the shifting slopes of thecurves, which is a proxy of a proxy. You are betting on whether the enterpriseis a ship coming to harbour, rather than investigating what is on the ship orwho is at the helm. It is a very indirect assessment,” says Edvinsson. The convoluted language of the financial markets, and the plethora oftechniques used, disguise the fact that most investment is simply a form ofgambling, where the only information is historical and the tacit assumptionmade is that trends established in the past will continue. Hence the apparentlyimproving performance at Enron prompted more share purchases from investors whowere oblivious to the real state of the company. This leads to a problem with intangibles: the difference between the marketvalue and the book value ought to be the intellectual capital of theorganisation. But usually the investors are guessing at the intangibles andthey can get it horribly wrong, as with Enron and the dotcom speculativebubble. 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 per24 hours, mostly in guesswork. It is 50 times larger than the value of tradedgoods.” More accurate historical reporting would help, but it would still behistorical. Chief executives, with performance targets and share options, havemassive incentives to improve the short-term appearance of results, even ifthis does long-term damage to the earning potential of the organisation. Hencethe 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 ofconventional accounting as Edvinsson, though he argues against measuring humancapital, which he says runs the risk of becoming another form of bean-counting.Instead, executives and investors have to apply subjective judgement about theability and potential of a company’s people, and accept that not everything canbe measured. A few investors are switched on, he reports. “I was hired by the RoyalBank of Scotland, which was doing a presentation to City analysts. Someone saidto them ‘Your profits are good, you’re doing well but it is not tomorrow we arebothered about, but four or five years’ time, are you still going to bedelivering good results? What we can look at now to predict that is quality ofmanagement: do you have a pipeline of good managers coming through that willbring good people to the top?’ The chief executive went back to the company’s HR team and said he had noanswers. He needed some form of measurement that showed what the firm was doingto get the right people in place. What it produced was a simple systemidentifying good management potential and looking at the risk of particularmanagers leaving and so on. “The approach at the Royal Bank of Scotland is better than mostpeople’s answer. It said: ‘Here are the people we have identified as being ourfuture. This is how we are looking after them; this is how we can keep 75 percent of them for at least five years’. It starts to tell analysts somethingabout the future. “There is also the strong argument that it is not just aboutindividuals, but the whole organisation. You can look at individuals [forexample in a drug company], do you have the top R&D people? Are they goingto 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 leastthey address the problem. Moreover intangibles are more than just a trendySwedish experiment. The US Financial Accounting Standards Board put forward aproposal on the reporting of intangibles last year. A special report by theboard, Business and Financial Reporting, Challenges from the New Economyconcludes that improved business and financial reporting will require moreattention to intangibles, expanded and systematic use of non-financial metricsand forward-looking information. From 1 January this year, it has requiredcompanies to give annual updates on goodwill. While new measures of intangible capital, or human capital, will bedeveloped, refined and used to varying degrees to supplement information fromconventional accounts, the conceptual challenge remains. It is very difficult for traditional managers to shed the view that accountsare factual and all else is opinion. Personnel professionals have a tremendousopportunity to prove to their colleagues that rational decisions can only bemade 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 oftradition,” says Edvinsson. “But then people were once scepticalabout whether the earth was round.” How the “bottom line” can be divorced from realityPersonnel professionals are commonlytold 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 theopposite being the case. The HR profession concerns itself with people skills,teamwork and motivation; with recruitment, succession planning and leadershipdevelopment – in short, with the real company and things that make adifference. In contrast Enron’s executives, obsessed with accountancy anddeal-making, were living in a virtual reality. US Congress investigatorsestimate Enron had a staggering 3,000 partnerships and subsidiaries, nearly 900of which were offshore. Executives were using Enron stock to make riskyinvestments, keeping the risk off the balance sheet but giving the impressionof growth.In the virtual reality these disciplines create, thesignificance of numbers is hugely inflated and the significance of skills isarbitrarily shrunk. No amount of accounting tricks would have fooled investorsof Enron if they had been geared to analysing the real company.This all hands a powerful argument at the disposal of personnelprofessionals, though it is one they rarely have the courage to deploy. Enronwill make it easier.How can intangibles. Orintellectual capital, be measured?www.intellectualcapital.se,an agency which Leif Edvinsson helped to set up, can carry out assessments ofthe intangible assets of a company. It seeks to give an indicator, a relativemeasure, of the strength of the following attributes:– Business recipe– Intellectual properties (such as patents)– Processes– Management and employee capability– Networks, such as recruitment, competence andR&D networks– Branding– CustomersMeasures are determined by interviewswith staff, managers and customers, from internal and external data. Theprocess takes six to eight weeks, and also results in an overall intellectualcapital rating. Around 200 employers, mostly IT firms in Scandinavia, have hadtheir intellectual capital rated in this way. PowercutOn 1 Mar 2002 in Personnel Today Previous Article Next Article Related posts:No related photos.last_img