Accounting Issues and Enron: What is Likely to Happen?

Once a comparatively simple pipeline company, Enron transformed itself, over the past few years, into the nation’s largest merchant energy company. Two years ago, as we all now know, Enron’s then chief financial officer set up and ran two limited partnerships that operated as structured financing vehicles and paid the CFO millions in fees. When questioned about the arrangement, Kenneth Lay, Enron then-Chairman and Chief Executive Officer, said in an interview early last year that, “Almost all big companies have related party transactions.”

True enough. But typically, related party transactions are dealings with partly owned affiliates or a contract with a firm tied to one of the company’s outside directors. It is rare for a company to deliberately place a top executive in a position where he would have directly conflicting fiduciary responsibilities.

Enron eventually revealed other partnerships, including some which allowed Enron to bring in outside equity and to borrow large sums of money for asset purchases without that debt showing up on Enron’s balance sheet. Given interlocking executive management, debt levels and assets the issue is whether or not these partnerships should have been folded into Enron’s financial statements and whether or not the disclosure that occurred was adequate. By the end of November 2001, Enron and its subsidiaries had filed for protection in bankruptcy, the largest company in American history to do so. By mid-December no fewer than six separate Congressional committees and three Federal agencies announced hearings into the debacle.

The creation of special purpose entities (SPE’s) for off-balance-sheet financing is very common, not at all new and perfectly legal. The most common example is the securitization of receivables, a practice which routinely uses SPE’s and which has been part of the financial services and auto industries for years. Accounting standards are quite clear on how SPE’s should be treated.

Another common practice receiving scrutiny is that of marking to market. While an outright rule is not yet in place, the Financial Accounting Standards Board (“FASB”) has suggested that marking assets to market is a generally accepted accounting principle. Marking to market is designed to combat previous practice wherein companies would sell appreciated assets for gains and would simultaneously hold depreciated assets, even though they sat on the balance sheet at a higher historical cost. Mark-to-market accounting, however, requires valuation, a subjective exercise at best, and often creates increased earnings volatility.

Another issue is that of disclosure. Twenty-five years ago there were only a few clarifying notes in financial statements. Today, there are 40 or 50 notes. However, they are frequently so full of legalese or accounting double talk that they are useless to the average investor. The Securities and Exchange Commission (“SEC”) needs to insist on clear and adequate disclosure with a clear focus on the users of financial statements.

The FASB must insist that conflicts of interest be resolved to the benefit of the investor. Securities analysts need to dig independently for signs of eroding earnings quality and must demand independence from the priorities of their employers. Corporate managements and Boards of Directors need to ensure that their financial statements are complete, that audits are truly independent, that disclosure is adequate and that they understand what the statements actually convey.

As Senator Lieberman said in the Government Affairs Committee hearings recently, “The status quo is not an option.”

The most disturbing aspect of the Enron disaster is the degree to which it has damaged investor confidence. With good reason, investors now mistrust most management representations and even look askance at audited financial statements. While a questioning and analytical attitude is desirable, investors of late have taken a “sell first, ask questions later” point of view, which has exacerbated market volatility and unduly punished some fine companies.

Oakwood clients held no Enron assets ever, neither bonds nor stock. But because of the Enron situation clients are exposed to more than the usual degree of market fluctuation right now. We recall the 1970’s when National Student Marketing and Equity Funding occurred at the same time as the economy was moving into recession. There were Congressional panels, blue ribbon committees, years worth of hearings and reams of findings and recommendations. From it all, the FASB was created as an independent private sector accounting standards setter. Not much else ultimately occurred. We expect the same will be true this time.

Complex companies will very likely continue to receive scrutiny. This is as it should be and undue complexities will continue to be reflected in companies by tighter credit standards and in common stocks by lower multiples. While it is better than it ever has been, the financial reporting system in this country can still stand improvement. Ultimately, the quality of corporate earnings goes directly to the credibility of American business.