Mark-to-market accounting for long-term transactions presents company management “with a temptation to be overly aggressive that is too great for them to ignore,” a leading short seller, credited with spotting Enron’s problems early on, told a congressional committee last Wednesday.

“Earnings can be created out of thin air,” said James S. Chanos, president and founder of Kynikos Associates Ltd. in New York City. Then if the future projects don’t yield those profits, and results have to be adjusted downward, management is under pressure to do new and bigger deals to offset the earlier ones. “It’s a treadmill that’s hard to get off of.”

The rules were, in part, to blame, but Enron’s fall was caused by a “flawed business strategy that led to colossal investment mistakes in virtually every new area that the company tried to enter,” Bala G. Dharan Ph.D., CPA and professor in the Graduate School of Management at Rice University, told the House Energy and Commerce Committee. The bad business decisions led to the attempts to hide the losses with accounting tricks. “The failure of Enron points to an unparalleled breakdown at every level of the usual system of checks that investors, lenders and employees rely on…,” and constitutes “one of the largest securities frauds in history.”

Other expert witnesses offered suggestions for reform of financial accounting and the auditing profession. After the stock market crash in 1929 and huge public losses resulted from the failure of many banks, Congress put in place rules to make the banking system transparent and accountable, a former Securities and Exchange Commission (SEC) commissioner said. Now, when most earnings and savings have migrated from banks to money market funds and stocks, increasing failures by those entities are very disturbing. “The public confidence has once again been badly shaken. There must be a shift by lawmakers to fashioning protections for those investments,” Bevis Longstreth told the committee.

Enron’s strategy of an “asset-less” company meant it “was virtually devoid of any boundary system that defined the perimeter of what is an acceptable and unacceptable investment idea for managers to pursue,” Dharan said. “Since any business investment basically involves some risk position, this strategy is not really a strategy at all but an invitation to do anything one pleases. Enron’s top management essentially gave its managers a blank order to ‘just do it,’ to do any ‘deal origination’ that generated a desired return.”

Chanos said his first questions about Enron in October 2000 were prompted by the company’s mark-to-market accounting. In November of 2000 he began shorting the stock when he noted that despite gains on sales, the company’s return on capital was “a paltry 7%.” For every dollar in outside capital Enron earned 7 cents. “For a trading company that is abysmally low,” Chanos said, given that the cost of capital was probably in excess of 7%. “Enron wasn’t really earning any money at all,” despite its financial reports to the contrary.

Dharan also noted that in Enron’s third quarter 2000 earnings release it started using recurring earnings, “often a company’s desperate response to hide underlying business problems.” The internal Enron report released last week shows “that this was also the time when the senior management started worrying about the declining value of many of their merchant investments.”

The Rice University professor said the SEC “should recognize all pro forma disclosures for what they really are — a charade. They may differ from one another in the degree of deception, but the intent of all pro forma earnings is the same — to direct investor attention away from net income measured using generally accepted accounting principles, i.e., GAAP earnings.”

As a short seller looking for companies whose stock prices can be expected to decline, Chanos said he uses “rigorous financial analysis,” looking for three things: “materially overstated earnings, a flawed business plan or outright fraud.”

Chanos said he spotted “cryptic notes” in Enron’s 1999 10K and its 10Qs regarding transactions with special entities, which apparently had been created to trade with the parent company and were run by Enron executives. In addition “there was a large amount of insider selling,” which coupled with the other concerns raised red flags. He also found it strange that in late 2000 Enron was boasting of a huge untapped market in broadband capacity trading that could add $20 to $30 to the value of Enron stock, “when we already were shorting telecom stocks. Enron seemed oblivious. It still saw a bull market for itself.”

In January of 2001, Chanos gathered other analysts from the main Wall Street investment firms and told them of his concerns with Enron. While most of them conceded that Enron was “a black box” and there was no way to really analyze its financial statements, they continued to recommend that investors buy the stock. Chanos noted that most of them “were hopelessly conflicted” because the investment side of their business either provided services to Enron or wanted to.

Another warning sign came in early February 2001, during the California energy crisis, when reports started coming in that Enron was invoking contract clauses to drop out of deals it had made, telling its customers and suppliers to deal with each other. “Despite being paid a middleman fee, they were telling companies ‘this is your problem, not ours.’ They backed out of their counterparty risk and their credibility began to crumble. They refused to recognize a loss; they could never admit to losing a trade,” Chanos added.

As commodity prices began to drop, there were rumors Enron had been caught long in the power market, Chanos said. “The bears came out of hibernation. Trading operations always do better in a bull market.”

The resignation of CEO Jeff Skilling in August 2001 was a huge red flag on the company’s financial condition. “There’s no louder alarm bell than the abrupt resignation of a chief executive, no matter what explanation is given. We increased our short position,” Chanos said.

“No one should depend on Wall Street advisors. There are too many conflicts of interest. Outside auditors are archaeologists” who are no good at detecting current problems, Chanos said, noting that not one major financial fraud in the last 10 years had been detected by auditors. Rather short sellers or financial journalists have uncovered the problems.

Short sellers, without those ties and with their emphasis on negative reports, are generally considered “un-American or unpatriotic” by the rest of Wall Street, Chanos said. The unfolding of the Enron story is one of the few times “we get to wear the white hats.”

To ensure that investors get a true picture of the companies they are backing, Dharan said, government should “mandate a fuller, more complete presentation of financial statements in the earnings news releases,” including balance sheets.

In addition, the notorious “three percent” rule, allowing companies to leave special purpose entities (SPE) off the consolidated financial statements as long as outside parties have at least a 3% interest, should be eliminated. It should be replaced with a more strictly defined “economic control” criterion, Dharan said. “We should emphasize economic control rather than rely on some legal definition of ownership or on an arbitrary percentage ownership. Economic control should be assumed unless management can prove lack of control.”

While most of the witnesses before the House committee agreed that mark-to-market (MTM) accounting was a valuable tool, it can and has been abused. “Enron sought and obtained exemptions from regulators to allow it report regular long-term contracts to supply energy at fixed prices as merchant investments, rather than regulated contracts, and obtained permission from accounting standards-setters to value them using MTM accounting,” Dharan said.

Without MTM, Enron would be required to recognize no revenue at the time the contract is signed and report revenues and related costs only in future years for actual amounts of energy supplied in each year. However, MTM accounting permits Enron to estimate the net present value of all future estimated revenues and costs from the contract and report this net amount as income in the year in which the supply contract is signed.

While the use of MTM accounting where future values are known, using published futures prices, is valid, a major problem with using it for long-term private contracts is that the valuation requires a company “to forecast or assume values for several dozen variables and for several years into the future,” Dharan said. For example, the revenue forecasts may depend on assumptions about the exact timing of energy deregulation in various local markets, as well as 20 years of forecasts for demand for electricity, actions of other competitors, price elasticity, cost of gas, interest rates, and so on.”

Dharan suggested MTM rules should be modified to require that all gains calculated using the MTM method for assets and contracts that do not have a ready market value should be reported only in “Other Comprehensive Income” in the balance sheet, rather than the income statement, until the company can meet some high “confidence level” about the realization of revenue for cash flows that are projected into future years.

Baruch Lev, professor of accounting and finance at the Stern School of Business at New York University, and a respected leader in accounting circles, suggested the whole system of financial statements “is an outmoded, completely useless information system,” which fails to recognize intangible assets and unexecuted liabilities. He recommended a top-down rewrite of the rules. “We have to move from very narrow financial reporting to broad comprehensive disclosure, including alliances, joint ventures, obligations undertaken, and intangible assets.”

Lev suggested auditors be selected by shareholders every five years, using the same system used for proxy voting. This would “break the axis between managers and auditors.” The shareholders, not the company management, are the clients of the auditors, and therefore should choose them. Currently a company’s audit report “is a useless piece of paper,” cooked up by management in collusion with the auditors.

Lev, noting that SEC investigations can take two years, also suggested that a regulatory enforcement body be set up to quickly investigate and release results on all failures, including any restatements of earnings. Funding for this body should not come from the companies or the accounting firms; it could be funded with a penny charge on every 100 shares of stock traded, which recently would have yielded a $70 million budget.

Also, the rules of insider trading should be revised to require insider trades be reported no later than the day following the trade, he said.

Auditors came in for criticism. Former SEC Commissioner Longstreth, of Debevoise & Plimpton, who had been one of a recent panel reporting on audit effectiveness, outlined “two notorious fictions.” One is the claim that auditors are not affected by the income from consulting services for audit clients. “Non-auditing services generate 73% of the total fees paid to an auditor by audit clients.”

The second notorious fiction is that auditors have the ability and motivation to regulate themselves voluntarily. “Nothing short of legislative reform” can correct the system, Longstreth said, advocating a prohibition on auditing and consulting services for the same client, and an effective system of self-regulation for the profession including creation of a governmental agency with clear powers to write rules and conduct enforcement and disciplinary proceedings.

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