Book Extract: Emperor’s new clothes: Enron – the high-tide mark of unsustainable value

Market value assessments by investors are based on trust in:- opinions of expert commentators and business media; validity of value assessment and accounting assessment models; analyst calculations; regulatory agencies; auditors.

What happens when all these taken for granted systems fail and huge company, used to parading its value to global investors, is undone by one voice pointing out that, “the emperor has no clothes”? The financial collapse of the emperor – the global Enron company – in 2002 is the biggest scandal in United States corporate history.

Enron was fast-growing conglomerate which made its money from trading in futures in its various energy trading interests. business journalist precipitated the collapse in market confidence by publishing an article in Fortune magazine that reviewed the published accounts and asked the simple question – “how does Enron make its money?” The panic stricken response from leaders of the company gave the answer which pricked the hype about the company which had carried along investors, the business press, and also academic commentators whose judgement would normally be respected.

It threatens the reputations not just of the executives involved but also of highly respected politicians, accounting firms, investment analysts, media commentators, and business academics. It has unleashed series of investigations into misleading accounts, shoddy auditing, incompetence and fraud, which strike at the very heart of trust in the modern corporate system.

Business journals including The Economist have commented that international auditing procedures and protocols are seriously unreliable. This is exacerbated by the tolerance of major conflicts of interest within the auditing firms which invalidate the idea of absolute trust in the auditing procedures and protocols.

The need to value intangible assets
One of the factors with the Enron collapse was the stock trading at significant multiples to its tangible assets which compounded the various other irregularities. In this instance there was no adequate equivalent value in the particular intangible asset base to justify the over-inflated stock price. But as rule it is not abnormal for Knowledge Age companies to trade at significant multiples to their tangible assets because of the high valuation of their intangible assets. These intangibles include such things as brands, patents, licences, assignments and other forms of Intellectual Property. Brands are interesting in that valuing them on the balance sheet is still an emerging procedure surrounded by controversy since the problem is how to agree the formulas to be acceptable to auditing protocols.

But it goes much further than just valuing the potential in the future of leveraging documented IP. Tacit value may ultimately be more important and it resides in people’s minds, hearts, memories, and creative capacity. This value is based on the potential for the future – the breakthrough invention, or the ability to cut the right deal. How do you measure something both tacit and residing in the future? As an example information technology and knowledge management platforms have both tacit and explicit aspects, and offer the chance to create enormous future value by reshaping the very nature of the business.

In the case of bookseller like Amazon it is obviously the online commerce core platform which was considered by investors to be so valuable, as distinct from the usual intangible assets of large bricks and mortar bookseller. The online bookseller then becomes the online retailer of anything it chooses. Its next problem of creating intangible value is to acquire mastery of the logistics of getting the product from warehouses to ‘power of one’ customer’s home or office. Reputation is another intangible asset which is increasingly important in an age where trust has decreased and cynicism about corporate behaviour is high. But reputation is complex in that it is perceptual and thus only measurable by surveys and resultant behaviour. It also involves many different types of stakeholders who may hold very different perceptions – how do you weight them all meaningfully together? What if company is darling of the analysts but customers despise it, and the Governmental regulatory bodies are keen to pounce on its dubious behaviour in the marketplace?

New accounting
Even before Enron there was considerable debate within the accounting profession about the evolution of accounting to recognise more sophisticated notions of true cost, and true value. There are fierce debates about the measurement of value. Accounting rules have long been criticised for not addressing the issue of future value very well. The accusation is that accountants basically record historical value because their procedures do not measure the opportunity and risk of the future.

Accountancy also does not measure all the hidden environmental costs of company’s operations. ‘Full cost accounting’ answers this criticism and if it was implemented would provide the incentive for business to radically redesign processes to reduce resource usage and cost. The needs of business, government, and society to have more reliable accounting will force change on the naturally risk averse profession of accounting over the next 10 years, and from this will emerge some form of ‘new accounting’ which meets the needs of the Knowledge Age.

Triple bottom line reporting
The idea of corporations doing Triple Bottom Line (TBL) reporting has been pioneered by the London-based ‘Sustain Ability’ research consultancy. Many companies in sectors which had high environment profiles have been publishing Environmental Audits for some time. very few who have been influenced by the Business for Social Responsibility movement have also published Social Effect Audits. Obviously all public companies publish business results, both quarterly and annually. However the game changes when you consider trying to report on all three dimensions in one reporting format. The problems of definition abound, as do the problems of measurement. It is an intellectual puzzle of great pleasure to those who like brainteasers.

The complexity is based on the fact that policies and actions in each domain – social, economic, and environment are interdependent not separate. If you shut down your pig processing plant in Twin Forks, North Dakota, you may have put healthy amount of savings on your bottom line, reduced the pollution into the local river, but also wrecked the viability of the local farmers, workers, and tradespeople in the community who are now out of work.

The pioneers of TBL reporting have been the chemical, oil, and mining companies. But we believe that what is fringe practice right now will become mainstream within 10 years.

It is all about governance
As we have seen in the Enron situation there is real question about where does the ultimate moral and legal responsibility for shareholder value lie. Clearly it lies with the board of directors, no matter what the current legislation may be on director liability.

In addition, all the companies we have ever looked at that have stepped up to discuss the issues of long term sustainable shareholder value have done so at board level. Given the pressures on the CEO and senior team to perform today’s financials they must have clear direction from their board to also be expected to secure the long term sustainable value from their policies.

All these companies tell us that the key is to have rock solid Statement of Corporate Principles which the board has been involved in developing and which provide the framework of company performance accountability, as well as the basis for executive performance contracts. Porras and Collins’ study of successful companies in the USA came to the same conclusion.

The explicit set of Corporate Principles is what the company takes to the analysts, the institutio

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