Enron Jumped the GAAP
John D. Rossi III
Accepted Accounting Principles, which are taught in Moravian's accounting
classes, came about as a result of the 1929 stock market crash that
triggered the Great Depression. Accounting deception and fiscal
sleight-of-hand were believed to have been major causes of the crash
and subsequent business failures. The purpose of GAAP was to create
transparent, uniform, and independently verifiable financial statements
on which users could rely to make informed decisions.
the general public believes accounting follows a precise set of
rules, accounting is more of an art than an exact science. The outcome
of litigation against public accountants (such as the current prosecution
of Arthur Andersen over the Enron case) reminds us that many users
of financial information believe CPAs authenticate information and
attest to its absolute reliability. What the general public
does not understand is the complex and highly judgmental nature
of many assumptions that underlie financial statements. There is
an enormous expectations gap between reasonable assurance
as defined in the professional literature of CPAs and as assumed
by users, litigators, and the courts.
a financial reporting model, GAAP is not broken. But it is in need
of a major overhaul, including better disclosure and a change in
the current culture. It has been my experience that the majority
of CPAs are ethical and work very hard to help ensure quality financial
information. In terms of "audit failure," many of the
accounting problems with Enron fell within GAAP guidelines. Unfortunately,
many audit failures that resulted from clear violations of GAAP—those
associated with Waste Management, Lucent Technologies, Cendant,
and Sunbeam, to name a few—received far less media attention.
Any reforms must focus on the range of audit failures rather than
a single high-profile company that declared bankruptcy.
source of Enron's accounting irregularities can be linked
to more than 3,000 "special-purpose entities" (SPEs)
that Enron created to hide liabilities and risk from the balance
sheet. With creative names such as Chewco, Jedi, and Raptor, these
SPEs were structured according to existing GAAP rules and not consolidated
into the company's financial statements.
special-purpose entities have a legitimate business purpose: to
allow companies to shift risk from themselves to outside investors.
For example, a bank might pool an assortment of mortgages, credit-card
receivables, or auto loans into a portfolio, which it then sells
to an SPE (calling it, perhaps, Chase Auto Receivables IV Trust).
It is the trust that then issues debt and equity to pension funds
and mutual funds. The bank might pool $100 million of receivables
into the trust and then sell stock in it for $80 million. As customers
pay down their loans, investors receive the cash-flow: part principal,
part interest. Since the bank has reduced the risk of its $100 million
portfolio, it is required to remove that amount in assets from its
books. The $80 million of securities issued also is removed, because
the bank no longer owns the portfolio.
a bank, Enron issued a pool of loans and funded their trusts and
partnerships with their own equity and derivative agreements. When
Enron stock fell, the company was forced to continue to fund the
trust and partnerships with its only actual resource: additional
stock. Under existing GAAP rules, contingent liabilities such as
those resulting from guarantees to SPEs do not have to be recorded
(they are disclosed in the footnotes) unless the loss is both probable
and open to reasonable estimation. In the case of a bank SPE, the
bank has hundreds of loans outstanding; if someone misses a payment,
there are hundreds of others to cover the shortfall. It's
a more diversified cash-flow than that from Enron stock.
such as Enron use SPEs to move liabilities off their balance sheets.
(The technical term for this is "off balance-sheet risk.")
A reading of accounting standards related to SPEs (with Enron, this
included the partnerships, the arbitraging, and the off balance-sheet
debt) would show that Enron technically complied with GAAP. Its
main problem was lack of disclosure and, perhaps, a certain creativity
in assigning guarantees of debt behind its SPEs. And under GAAP,
the assets and liabilities of an SPE aren't included in company
consolidation reports if independent third-party investors contribute
at least 3% of the entities' total capital and exercise voting
control. By accepting part of the SPEs' total capitalization
from independent third parties, Enron not only was able to avoid
inscribing its liabilities on the books but also did not have to
eliminate intercompany sales, thereby inflating its revenues.
regarding the off balance-sheet risk associated with Enron was included
in the disclosure notes of its financial statements. Most experts
agree that Arthur Andersen should have insisted on more detailed
disclosures regarding off balance-sheet risk associated with the
SPEs. But I would be very interested to know how many of the analysts
that cover Enron bothered to read the disclosure notes. I am convinced
that we have a real problem with users of financial statements focusing
on a few key numbers and not taking the time to read the notes and
other disclosures, understand their implications, and make nformed
decisions. Because of the importance of disclosure notes, GAAP requires
that all financial statements contain these words: The accompanying
notes are an integral part of the financial statements.
was classified as the seventh-largest company in America based on
sales revenue, not assets or profits. Under existing GAAP, Enron
reported its revenues using the gross method (booking the transfer
price of energy trading contracts as sales revenue) rather than
the net method (booking sales revenue as the difference between
the transfer price and cost of acquisition). Looking up the 10-Q
for the quarter ending June 30, 2001 (the period before the scandal
broke), Enron reported revenues of $50 billion, cost of sales of
$48.1 billion, and net income of $ .4 billion (less than 1% of revenue).
All this is perfectly legal and, in the general sense, accountable.
of the problem is with GAAP for allowing revenue to be booked this
way. If analysts cannot learn to look below the revenue line, we'll
have many more Enrons. Recently another energy trading company,
Reliant Resources, got in trouble with the Securities and Exchange
Commission for questionable energy trading practices. Reliant allegedly
engaged in numerous energy trades to boost its revenues. The questionable
trades involve "round-trip" or "wash" trading,
by which energy companies trade with one another solely to boost
prior to the third-quarter financial statements that marked the
beginning of Enron's demise, of 16 analysts who covered it,
13 issued a strong buy recommendation and the remaining three a
common buy recommendation. None had a hold, sell, or strong sell
recommendation. Assuming that Enron had done nothing unethical,
it still would have been nearly impossible to analyze a company
with such a complexity of derivatives—a company that has essentially
morphed into a hedge fund. I don't remember any analyst saying
he couldn't understand the financial statements and therefore
was taking a neutral or no recommendation opinion.
a result of the Enron crisis and other audit failures, numerous
proposals are on the table to reform financial reporting. Unfortunately,
the majority of reforms are like the alcoholic who loved Scotch
and water and so promised his family that he'd reform—by
giving up water. Most of the proposals to deal with the Enron situation
are focused on the water rather than the Scotch: the financial statements
rather than the deals they describe.
the current culture of financial disclosure, failures such as Enron
will continue to occur, often with little warning. As a result of
what happened with Enron, the SEC has begun a formal inquiry into
the potential conflict that exists between research analysts and
investment bankers, who often are employed by the same firm. In
addition, the SEC is investigating whether securities analysts lied
to the public.
there is a silver lining to the Enron mess, it may be that the general
public has become more aware of commonly practiced techniques of
off balance-sheet financing through tools such as SPEs.
D. Rossi III is assistant professor of accounting and director of
the Personal Financial Planning certificate program at Moravian.