How Enron Jumped the GAAP

By John D. Rossi III

Generally 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.

Though 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.

As 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.

A major 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.

Most 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.

Unlike 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.

Companies 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.

Information 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.

Enron 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.

Much 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 volume.

Just 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.

As 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.

Given 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.

If 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.

John D. Rossi III is assistant professor of accounting and director of the Personal Financial Planning certificate program at Moravian.

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