January 30, 2002
ENRON'S MANY STRANDS: THE ACCOUNTING
ENRON'S MANY STRANDS: THE ACCOUNTING; Fuzzy Rules Of Accounting And Enron
By FLOYD NORRIS and KURT EICHENWALD
Enron collapsed after reporting strong profits for years, a fact that might be seen as proof that the profits were illusory.
But even some accountants who are extremely critical of Enron's accounting now say that accounting rules -- including one that was influenced by Enron when it was being written -- give at least a veneer of acceptability to some of the most widely questioned Enron accounting practices.
''It's conceivable that they complied with the rules,'' said Douglas Carmichael, a professor of accountancy at BaruchCollege. ''Absent a smoking-gun e-mail or something similar, it is an issue of trying to attack the reasonableness of the assumptions they made.''
The Enron case highlights a weakness in the system that exists to encourage companies to fairly describe their financial health: when accounting rules are written very specifically, clever accountants find ways to get around them. When, as in this case, they are written far more generally, proper accounting can be overly reliant on the good faith of companies and auditors in applying the rules.
As a result, the evidence that the Justice Department and the Securities and Exchange Commission would need to bring fraud charges would be documents showing that accountants made estimates they knew to be unreasonable. To find such evidence, investigators would review internal memorandums and e-mail messages. But some of those appear to have been destroyed by employees of Enron and its former auditor, Arthur Andersen.
The rule in question concerned trading in the energy business. When Enron's energy services division agreed to supply power to a company at a fixed price, it made optimistic projections that energy prices would fall enough in the future to guarantee Enron a healthy profit. It was then able to report that profit as soon as it signed the contract -- long before it was clear whether its optimistic assumptions would prove to be accurate.
''It looked like a license to print money,'' said Glenn Dickson, a former manager in the energy services unit.
The decision that energy trading could be accounted for in the way that Enron used was made by the Emerging Issues Task Force, a group under the oversight of the Financial Accounting Standards Board, the principal accounting rule maker in this country. It did so in 1999, after meeting with Enron, which was viewed as the leading company in energy trading.
Timothy S. Lucas, the director of research at the F.A.S.B. and the nonvoting chairman of the task force, said Enron's role was to provide information, not to serve as a consultant. He said that, as he recalled, Enron had already begun using accounting similar to the accounting the task force wound up endorsing.
In retrospect, Mr. Lucas said, the task force may have erred by not requiring more disclosures about the accounting used, particularly in long-term transactions.
''There are suggestions for good information that we could add to the disclosure that we simply did not think of,'' he said, adding that such disclosures would now be considered.
The accounting rule in question required Enron to ''mark to market'' the value of its energy trades. Where there was an active market, as with stocks or publicly traded bonds, that is relatively easy to do and difficult to manipulate. But where there is no such market, companies were allowed by the rules to use their own models to estimate fair value, and to treat that as the market value.
The mark-to-market technique was used to report profits in some Enron businesses. When its energy services unit signed a power-supply contract with a company, it would structure the deal to bring it under those accounting rules. It would then project electricity and natural gas prices for the full term of the deal, which could last as long as 10 years, according to former Enron officials.
Many of the contracts covered companies in states that had not yet deregulated their power markets. In those cases, Enron forecast when the states would deregulate those markets and then projected what prices would be under the currently nonexistent deregulated market.
Then, based on its projections, Enron would calculate its total profit over the life of the contract. After discounting that figure to account for the risk its customer would default and the fact that it would not receive most payments for years, Enron would book the profit immediately.
Mr. Lucas said it had not occurred to him that anyone would use models to try to forecast energy prices for 10 years, and then use those models to report profits, but that the rule had not placed a limit on such trades. He noted that any trade that required assumptions for such a long time would appear to be very risky.
A former Enron official has told associates that Arthur Andersen, Enron's auditor, took a number of issues related to Enron's accounting to the task force. That official said Andersen accountants viewed the company's structuring of financial instruments to be on the cutting edge.
Andersen has a seat on the task force, as do each of the four other large accounting firms. The other members among the 13 on the task force are 4 representatives of smaller accounting firms and 4 executives from large companies. One industry seat is now vacant, after an executive from General Electric left. The others are held by officials of J. P. Morgan, Exxon Mobil and Dow Chemical.
The task force does not disclose who suggests topics, so it is not possible to be certain which Enron issues were considered. But it appears that one such issue came in 2000, when the task force addressed the question of what should be done about what appeared to be the application of widely varying approaches by energy traders to determine how much contracts were worth. The task force refused to specify how valuations should be made, leaving companies free to use methods they deemed best.
It is not possible to know how much, if at all, Enron would have been restrained from its aggressive accounting had the task force chosen to enact more detailed rules. But Mr. Carmichael, the Baruch professor, said that an enforcement case would be easier to make had the regulators ''set some kind of parameters on the ability to use an internal model.''
Absent such clarifying rules, he said, ''you would expect an auditor to come in and challenge the assumptions made.'' He said the investigation ''is likely to delve into whether the assumptions were reasonable and to what extent did Arthur Andersen challenge the reasonableness of the assumptions.'' Internal Andersen memorandums could be crucial to making a case against the auditor.
Edward W. Trott, who in 1998 was a member of the task force representing KPMG, a large accounting firm, and who since 1999 has been a member of the F.A.S.B., said in an interview that he believed that the right decisions were made on how to account for energy trading.
But, he added, ''if you're telling me that somebody who wants to game the system can do it, you probably have a lot of evidence to support that.''
The accounting for energy services is not the only area in which Enron engaged in accounting that used rules in surprising ways.
In one transaction involving a joint venture with Blockbuster, Enron reported large profits even though the venture never attracted more than a few customers.
''They were extremely clever,'' said Paul Brown, the chairman of the accounting department at New YorkUniversity.
In the Enron-Blockbuster deal, the two companies set up a pilot project, streaming videos to a few dozen apartments in Portland, Ore., from servers set up in the basement of the building. With that tiny beginning, Enron opened up a partnership, called Braveheart, which raised more than $115 million from a bank in exchange for a promise of most of the earnings from the Blockbuster deal for years.
Enron asserted that there was a market in broadband, and that its transaction amounted to one involving the transfer of financial assets. That meant it could report the transaction on a mark-to-market basis, similar to the way it accounted for the energy trades. It applied its undisclosed model to calculate how much revenue it could report from the transaction, and reported more than $110 million. Former executives say accountants at Arthur Andersen approved the accounting.
''Nobody in the division could comprehend how they got Andersen to sign off on that,'' one former senior executive in the broadband division said. ''It just didn't make any sense. When we heard what they did, everybody's mouths just hung open. We weren't doing business on any scale even close to those numbers.''
The Wall Street Journal has reported that the bank that put up the money had a guarantee from Enron that it would not lose money. From the bank's point of view, that may have made the transaction look like a loan, but Enron says the accounting came under an F.A.S.B. rule covering the securitization of assets. Under that rule, accountants say, Enron could still treat the transaction as a sale, while reducing the profit to reflect the value of its guarantee.
An Enron spokesman said the company believed that it had complied with applicable accounting rules. ''I'm sure all of these past transactions will be investigated by lots of people,'' he said. ''Why don't we just wait and see what the appropriate authorities decide?''
An auditor at one large firm not involved in the Enron case said it was common for auditors to face creative ways to use accounting rules. ''These issues can become very complex and very fact-specific,'' he said. ''You have a lot of sharp pencils on Wall Street cooking up transactions to achieve a specific result. Oftentimes, they understand the accounting rules as well as or better than we do.''
Or, as Mr. Brown, the N.Y.U. professor, put it: ''It's the old adage of a F.A.S.B. rule. It takes four years to write it, and it takes four minutes for an astute investment banker to get around it.''
Chart: ''A Complicated Partnership With Debilitating Results'' Investigators are examining some of the deals that improved Enron's balance sheet but were not part of its financial statements. Here is one in which Enron used a partnership to increase its short-term earnings. 1. Enron signed a multiyear deal with Blockbuster to provide videos over Enron's broadband network. Enron hoped to make millions of dollars off the deal. 2. Enron created a partnership called Braveheart whose purpose was to get someone to advance Enron the money it expected to make on the deal with Blockbuster. To capitalize Braveheart, a small amount of money came from outside investors and Enron lent the partnership some stock. 3. An outside investment bank gave Braveheart $115 million in return for a promise that most of the earnings from the Blockbuster deal would go directly to the bank. If the earnings were not enough for the bank to recoup its investment, Enron promised that it would repay the bank. 4. Enron recorded $110 million of the money invested in Braveheart as profit. Enron did not count all $115 million because, under an accounting rule, it had to estimate the value of its guarantee to pay back the bank and reduce its revenue by that amount. PROBLEM: Blockbuster backed out of the contract, leaving Enron responsible for repaying the bank. (pg. C6)
Assignment:
- Once you have read the article over, take some time to reflect on how important and powerful accountants and accounting in general can be in our world today. Take time to write a paragraph (100-250 words) about this subject.
- In groups of two, find one more example from the news of an accounting scandal – use keywords such as “creative accounting” and “cooked books”. Search around Google and the Google News service to find an article (it can be from any country and any time period). Print a copy of the article and attach a one paragraph assignment on the mechanics of how the scandal was perpetrated and how much money was lost/at stake.