What Nonprofits Can Learn from Enron

Nonprofit organizations need to understand the events at Enron (which, in 2002, was the largest bankruptcy in history at the time) in order to understand what Congress was trying to address regarding private corporations. Understanding why Sarbanes-Oxley (SOX) was passed can allow your organization to determine which concerns can be relevant to its financial reporting.

In the case of Enron, a handful of executives had paid themselves millions in bonuses and had profitably sold their own stock. Employees were prohibited from selling their Enron stock as its value plummeted because of a routine blackout period. During congressional investigations, it came to light that billions of dollars in losses had been kept off the books by hiding them in flimsy partnerships for which the chief financial officer (CFO) received huge commissions for forming. Amazingly, the board of directors had approved both the partnership transactions and the commissions to CFO Andrew Fastow (who later had to return the money and got five years in prison).

Major credit-reporting agencies failed to identify the events leading up to the collapse of Enron. Moody's Investors Service, Standard & Poor's Corporation, and Fitch Rating Services all gave Enron good credit ratings a mere two and a half months prior to Enron's filing for Chapter 11 bankruptcy.

The following omens that foreshadowed Enron's implosion are also present today in many nonprofit organizations:

• Successive resignations of key management: On August 14, 2001, Enron CEO Jeff Skilling resigned after being in the position only six months. On October 16, 2001, coinciding with a huge restatement of third-quarter earnings, Enron announced that its CFO, Andrew Fastow, would also be replaced. SOX now requires corporations to report changes in management within four days after they occur.

Many nonprofits have equally tumultuous turnover. For this reason, Senator Charles Grassley demanded an investigation into the abrupt departure of the Red Cross CEO after a scandal involving the distribution of funds designated for 9/11 relief.

• Inaccurate and unreliable financial statements: On October 16, 2001, Enron announced third-quarter earnings that reflected an unexpected $544,000 earnings change and a $1.2-million change in stockholders' equity (the value of the stockholders' interest in the company). On November 8, 2001, Enron further announced that it needed to restate its financial statements for the first and second quarters of 2001 and for the four years prior, 1997 through 2000. The grand total of overstated income was $586 million. This disaster was attributed largely to the fact that the financial statements were audited by accounting firms that were downright chummy with the management that they were supposed to be auditing.

Many nonprofits aren't required to have audited financial statements, and no rules regulate the independence of their auditors when they do.

• Off-balance-sheet transactions to hide losses: A big factor in Enron's eventual collapse was the use of so-called special purpose entities, which were separate companies set up to hide Enron losses. This arrangement ensured that the losses didn't see the light of day on Enron's books. Instead, the losses showed up on the statements of the special purpose entities.

Nonprofits are vulnerable to similar types of manipulation because organizations often have multiple separately balanced funds for different programs. Improperly allocating program funds caused the Red Cross to earn a rebuke from Senator Grassley after funds earmarked for 9/11 were shifted to other programs.

• Lack of clear document destruction policies: On January 10, 2002, Enron's audit firm, Arthur Andersen, admitted to Congress that it had destroyed or shredded an undisclosed number of documents related to Enron's use of special purpose entities to hide losses and related matters. At the time, no one within Andersen questioned or took steps to stop the shredding.

Nonprofits often rely on volunteer administrative staff or staff members who are paid less than the going rate. Without document-retention policies to guide these volunteers and staff members, valuable information can inadvertently be lost or easily obscured.