Commentary: Five Ways to Avoid More Enrons

If financial statements aren't made more credible, there is little hope of restoring investor confidence

After months of growing concern about accounting issues at Enron Corp. (ENE ) and other companies, the national debate reached a fever pitch on Feb. 2 when an investigative committee of Enron's board released its findings. The 211-page report outlined in numbing detail the pervasive accounting missteps and obfuscation that hid losses and debts, enriched insiders, and inflated earnings by almost $1 billion. The next day, Enron's former auditor, Arthur Andersen, announced that it had brought in former Federal Reserve Chairman Paul A. Volcker to help it clean up its practices.

In the days since, congressional hearings have highlighted the myriad ways Enron cooked its books. Securities & Exchange Commission Chairman Harvey L. Pitt has reiterated his calls for better accounting. Stocks such as Tyco International Inc. (TYC ) and Computer Associates International Inc. (CA ) continued to get hammered for problematic bookkeeping. "Very fundamentally, our whole system of capitalism depends on investor confidence in the financial results of operations," says Robert S. (Steve) Miller Jr., CEO of Bethlehem Steel Corp. (BS ) and the man who was brought in to clean up Waste Management Inc. (WMI ) after its accounting blowup in 1997. "I think that confidence has been brought into question."

Lost amid the table-pounding, however, is the fact that, long after the last Enron executive has pleaded the Fifth, investors will still be relying on the same corporate reports that utterly failed them at Enron. Unless a serious effort is made to make those statements clearer, there is little chance of restoring shareholder confidence. Doing so will be particularly tricky today, when the complexity of business is increasingly turning accounting into an art of estimation and judgment. To make those judgments credible, auditors and managers need to work hard to restore faith in their basic integrity. In the meantime, better rules would certainly help. Here's where to start.

Bring hidden liabilities back onto the balance sheet

It was the disclosure of billions in off-balance-sheet debt tucked away in "special purpose entities" (SPEs) that first brought Enron's problems to the fore. It now looks as if many of Enron's hundred-odd SPEs, entities created to hide potential losses or debt from public view, were not handled properly. But even the use of legitimate SPEs has been a source of debate for close to 30 years. The Financial Accounting Standards Board hopes they will finally have rules in place by the end of the year, but today the group remains conflicted about how to solve the thorny issues SPEs bring up. "I can describe SPEs that definitely should be consolidated" onto their sponsor's balance sheet, says Tim Lucas, FASB's director of research. "And I can describe SPEs that definitely should not. The problem is, I don't often see either. Most often, they're in the gray area."

Guiding accountants through that gray area isn't easy. But clearly the current rules--which allow companies to remove SPEs from their balance sheets if they can find an investor willing to kick in just 3% of an SPE's capital--are not acceptable to investors. Upping that to a higher fixed percentage, however, is not the best answer, argues New York University accounting professor Baruch Lev. To Lev, the solution is to focus on the "essence of the economics of the contract as opposed to specific rules, which seem objective but are really incredibly easy to manipulate." In other words, instead of complying with the letter of the law, he wants auditors to delve deeper into these deals and dig out their true ramifications. Who really controls the SPE? Could the liabilities come back to the company attempting to get them off the books? If so, they should be consolidated--no matter how much outsiders own.

Highlight the things that matter

Recent pronouncements by the SEC and FASB have attempted to clarify which events and data are important enough to be considered "material." This was another area where simple convention provided too much wiggle room: Anything less than 5% or 10% of earnings or assets was generally considered "immaterial" to overall performance and thus could be left out of the statements. But recently, the SEC made it clear that the issue must be addressed "qualitatively as well as quantitatively," says Bear, Stearns & Co. accounting expert Pat McConnell.

Yet on Feb. 4, many were amazed by revelations that industrial conglomerate Tyco had made hundreds of acquisitions totaling $8 billion over the past three years. Because each purchase was quite small, its impact was considered immaterial. Tyco did disclose the aggregate spent on the deals but did not detail them. "Any one acquisition, if you looked at it in isolation, might not be material, but what you need to look at is the entire course of action," says Lehman Brothers Inc. accounting guru Robert Willens. Auditors should demand that companies report even the smallest transaction if it is important.

List the risks and assumptions built into the numbers

This is something SEC Chairman Pitt has been hot to do. Pitt wants disclosure of the "three, four, or five" critical accounting principles at every company. Although they may involve ambiguity and judgment, the principles are vital to a company's financial status. So far, Pitt hasn't provided much detail on how businesses would accomplish this goal. As the Enron scandal showed, corporate guesstimates can play a big part in corporate earnings: Managers there estimated what the future demand for their products would be and derived current earnings based on those guesses. This is one step beyond "mark to market" accounting, whereby financial instruments are valued based on current worth. David F. Hawkins, a Harvard Business School professor and Merrill Lynch & Co. accounting consultant, calls it "mark to model" and says it's "a big black box for investors right now." He would like to see more information about the assumptions inherent in these calculations in a footnote to the financials.

Standardize operating income

The mushrooming of so-called pro forma operating earnings, calculated according to each company's whim, was an issue even before Enron's collapse. To get more uniformity, Standard & Poor's has put out a proposal for what should be included and excluded in these operating-earnings calculations. Last fall, FASB put the topic on its agenda, although very little progress has been made to date. Setting up a universal formula is just the first step, though. Companies also must provide enough detail to show what they added and subtracted from GAAP net income to get to their pro formas.

Provide aid in figuring free-cash flow

To many investors, this is the real bottom line. How much cash, net of interest, and other obligations will a company generate in the future? Today, analysts make this calculation themselves, largely by extrapolating from past results. But some are now calling for additional information to make the calculation easier. "The real question is, how do you predict the future, and who's best able to do that?" says Ed Nusbaum, CEO of accounting firm Grant Thornton LLP. Companies currently are reticent to provide too much information about the future for fear of being sued, Nusbaum says, but investors are calling for more such data in the section of the annual report entitled "management discussion and analysis."

What investors want from financial statements is a clear picture of corporate performance. Instead, they are often left to guess at information that companies should readily provide.

By Nanette Byrnes

With Michael Arndt in Chicago and Susan Scherreik in New York

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