October 2002

In GAAP We Trust

By D. Christopher Ohly

Part 2 (Part 1 appeared in August 2002)

Transparency in corporate financial statements is essential for an investor’s assessment of risk and trust in stocks. Transparency depends upon the rules that are chosen and applied. Even a casual study of Enron’s financial dealings shows the degree to which GAAP and GAAS rely on judgment.

The December 2000 financial statements in Enron’s Form 10-K disclosed that “[in] 2000 and 1999, Enron entered into transactions with limited partnerships (the Related Party) whose general partner’s managing member is a senior officer of Enron. The limited partners of the Related Party are unrelated to Enron.” The 10-K advised that, “in 2000, Enron entered into transactions with the Related Party to hedge certain merchant investments and other assets,” and that “from time to time, Enron has entered into various administrative service, management, construction, supply, and operating agreements with its unconsolidated equity affiliates.” The 10-K states that “management believes that the terms of the transactions with the Related Party were reasonable compared to those which could have been negotiated with unrelated third parties.”

Various parts of the annual report reveal scant additional details, but nowhere in the financial statements and related disclosures is there a meaningful description of the transactions that have become the source of public comment. While the document mentions the entities JEDI and JEDI II, and lists SE Raptor L.P. as one of the limited partnership interests possessed by Enron at the end of December 2000, nowhere does the 10-K mention LJM, LJM2, or Chewco, and it gives virtually no information about the precise relationship of any of those entities, named or unnamed, to Enron. With disclosures as limited as these, it would have been difficult for either investors or analysts to raise significant questions about any of these off-book transactions. But accounting principles appear to require nothing more.

GAAS contains guidance for auditors about related party transactions, in SFAS 57, Related Parties. Although the standard appears to follow the principle-based approach some proclaim as a solution for the accounting standards crisis, on closer view SFAS 57 is so broad and ambiguous as to leave an accountant with few bright lines and ample room for judgment. The standard provides a definition of related parties that includes “entities for which investments are accounted for by the equity method by the enterprise.” The definition more generally states the following:

Another party is also a related party if it can significantly influence the management or operating policies of the transacting parties or if it has an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

SFAS 57 exemplifies GAAP and GAAS. The standard does not, on its face, require that transactions with “related parties” be treated differently. Nor does the standard mandate any specific disclosures in financial statement footnotes or otherwise. The standard requires only a good faith assessment of whether a particular business deal can be treated as an arm’s-length transaction. Enron management represented its belief that the terms of Enron’s transactions with related parties were “reasonable compared to those which could have been negotiated with unrelated third parties,” which in essence is an assurance that Enron’s dealings with related parties could be treated as arm’s-length transactions. Presumably, the auditors, after reviewing all of the relevant facts and circumstances, concurred. Under GAAP and GAAS, no more would seem to be required.

This conclusion is reinforced by the discussions of accounting for special purpose entities (SPE) such as JEDI, Chewco, Raptor, and LJM. After considering rules on SPEs for more than a decade, FASB finally issued an exposure draft on June 28, 2002. Normal rules of consolidation require that a financial statement reflect the activity of an affiliated entity when its parent owns 50% or more of its equity. Apparently, however, under practice established more than a decade ago, a different standard may apply to SPEs like those employed by Enron. Under those rules, a company can keep the assets and liabilities of an SPE off its consolidated financial statements as long as “outsiders” invest a mere 3% of the SPE’s initial capital and “control” its activities. The parent company can own the remaining 97% without requiring accounting consolidation of the financial activities, assets, or liabilities of the SPE with those of the parent. As noted in the article “Accounting Failures Aren’t New, Just More Frequent,” in the January 28, 2002, Business Week:

In 1990, accounting firms asked the SEC to endorse the 3% rule that had become a common, though unofficial, practice in the ’80s. The SEC
didn’t like the idea, but it didn’t stomp on it, either. It asked the FASB to set tighter rules to force consolidation of entities that were effectively controlled by companies. FASB drafted two overhauls of the rules but never finished the job, and the SEC is still waiting.

As Joseph Berardino, Andersen’s then–CEO managing partner, said last December, “The profession has been debating how to account for SPEs for many years. It’s time to rethink the rules.”

The notion of control inherent in these accounting practices for SPEs may well be the same as the notion of control evident in SFAS 57. Although this definition is not entirely clear, it would explain the lack of consolidation of financial activities, assets, and liabilities of Enron’s related parties with those of Enron itself.

In retrospect, the level of disclosure in Enron’s financial statements was not sufficient to enable even sophisticated investors to detect the peril in which Enron had placed itself and its shareholders by using Enron’s shares as currency to support these audited transactions.

Because the economic activities of public corporations are so diverse, and the accounting issues they generate are so numerous, GAAP is necessarily broad and some judgment will always be required. The failure of Enron’s financial statements to divulge even basic information about sophisticated and very large transactions, however, demonstrates how accounting judgment can be stretched so thin as to leave investors largely uninformed.

Enron’s financial statements are nearly opaque. Transparency in audited financial statements like Enron’s could be achieved by requiring that all transactions with related parties be disclosed in sufficient detail to enable a prudent investor to comprehend their economic impact on a corporation’s financial statements. Alternately, such transparency could be achieved by requiring consolidation of any entity in which a parent corporation owns more than some fixed percentage, whether or not the parent exercises control or created the affiliate for a special purpose.

Transparency can be achieved by simplification of accounting rules, and creation of brighter lines that require less judgment on the part of auditors. The elimination of pooling in favor of purchase accounting is an example of such simplification. Eventually, all businesses will adapt to this simplification and adjust their economic behavior to conform to the new standard. The balance sheets of all corporations would eventually appear different as a result, but they would in at least some small way be more readily understood and more readily comparable. The benefit of simplifying accounting rules and creating brighter lines will be evident in the clarity of corporate financial statements and the associated disclosures they contain.

Financial complexity may have made it easy for corporations to play financial games. Financial simplification, through revision of basic accounting standards, is a part of the remedy for “Enronitis” and part of what is needed to provide the American investing public what it needs to evaluate risk, compare risk levels among investments, and arbitrate the worth of one corporation’s stock with that of another.

No amount of legislation, no additional regulation, no revision of accounting or auditing standards, can ever prevent fraud by a determined corporate rogue. No legislation, no regulation, no accounting or auditing standards, can or should eliminate risk in the capital markets. Nevertheless, specific, directed, and prompt action can restore trust in reporting of financial results, whether propitious or calamitous. It can enable investors to engage in risk-taking activities with the assurance that risk assessments will be founded on an “efficient” market of accurate information.

The restoration of confidence in U.S. stock markets and the cure for the current accounting crisis lie in all of the steps envisioned in recent commentaries: Reform in auditor independence standards, “self-regulation with teeth,” mandatory rotation of auditors, a larger number of forensic audits, limitations on employment of an auditor by an audit client, and reform of corporate audit committees are all important. But changes in basic accounting standards should not be left for last: The process of review and revision should begin immediately, lest it take another 20 years and another Enron.

Our national currency no longer consists of government-issued dollars. It also consists of the collection of paper currencies issued by thousands of publicly franchised corporations. Our ability to rely on this new form of currency depends upon our ability to state, with assurance, that “In GAAP We Trust.”