Evidence Proving Fraud May Turn Out to Be Elusive
January 30, 2002
THE ACCOUNTING
By FLOYD NORRIS and KURT EICHENWALD
nron (news/quote) 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 Baruch College. "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
(news/quote) left. The others are held by officials of J. P. Morgan, Exxon Mobil
(news/quote) and Dow Chemical (news/quote).
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 York University.
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."
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