[A-List] Enron: regulatory crisis

["Keaney Michael" <Michael.Keaney@xxxxxx>]

Five Ways to Avoid More Enrons
Business Week; New York; February 18, 2002; Nanette Byrnes;With Michael
Arndt in Chicago and Susan Scherreik in New York;

Sub Title:  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.
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. and Computer Associates International
Inc. 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. and the man who was
brought in to clean up Waste Management Inc. 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.


The Spreading Contagion

Questions of accounting at Enron and other companies helped send the
market reeling

Jan. 2, 2002: 1154.67 (price of the S&P 500 Index)

Jan. 9: 1155.14
The Justice Dept. confirms it is investigating Enron

Jan. 15: 1146.19
Andersen fires its lead auditor on the Enron account amid revelations of
extensive document shredding

Jan. 22: 1119.31
Tyco begins what will eventually be a 45% drop after announcing plans to
split up, renewing worries about its mergers

Jan. 28: 1133.06
Proxy shows Tyco paid $20 million to board member and his favorite
charity for work on Tyco's largest acquisition ever, the purchase of CIT

Feb. 4: 1094.44
Enron special committee report condemning accounting irregularities,
together with Tyco debt refinancing, help send market down 2.5% in a day

Feb. 6: 1083.51

Data: Bloomberg Financial Markets, BusinessWeek


Michael Keaney
Mercuria Business School
Martinlaaksontie 36
01620 Vantaa
Finland

michael.keaney@xxxxxx