This chapter will review selected testimony and concluding comments regarding Enron’s alleged management of earnings made during the Skilling–Lay trial (2006). First, we will briefly review the academic accounting literature and then summarize the concluding comments made by the US Attorneys.
It is important to note that the objective of this chapter is not to confirm the guilt or innocence of Skilling or Lay. That would require more legal expertise and information than the author possesses. The objective is much more limited. It is to suggest that frequently in the trial complex accounting issues were excessively simplified or incor- rectly analyzed in order to make a legal point not justified by the accounting evidence.
Earnings Management: Academic Literature
Ayerset al.(2006) find that (p. 651), “Consistent with earnings man- agement, results suggest that the association between discretionary accruals and earning intensifies around the profit benchmark”. The closer the actual results are to the target, the more likely the firm will use discretionary accruals to achieve the target. The authors cite 22 other papers that deal with earnings management.
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Ewert and Wagenhofer (2005) examine whether tightening accounting standards reduces earnings management. They find (p. 1113),
That real earnings management increases with tighter accounting standards is a subtle consequence of higher rel- evance of reported earnings, which increases the marginal benefit of earnings management.
The authors cite 21 papers of which 17 deal with earnings man- agement.
We could include the conclusions of numerous other published papers but we will restrict our discussion to the above two papers and reach the following conclusions:
1. The issue of earnings management has been extensively studied.
2. Earnings management is not rare but rather is very extensive.
3. The efforts of managers to influence the accounting earnings have not led to an extensive series of criminal court cases unless there is significant fraud.
The Indictment
Consider the following statement (p. 22 of the Indictment):
In fact, as Skilling knew Enron reaped huge profits in 2000 from energy trading in California and concealed hundred of millions of dollars of those earnings in undisclosed reserve accounts. As Skilling also knew, by late January 2001, California utilities owed EES hundreds of millions of dollars that EES could not collect, and Enron person- nel had concealed large reserves that Enron was forced to use to offset those uncollectible receivables within Enron Wholesale’s books.
On p. 23 of the Indictment we have:
EES was owed hundreds of millions of dollars in receiv- ables by California utilities that it could not collect and that Enron personnel were concealing within Enron Wholesale.
The first sentence says that Enron made hundred of millions of dollars, but hid these earnings in reserve accounts and thus under- stated earnings. This alleged hiding of earnings would most likely be achieved by debiting an expense account and crediting a reserve for uncollectibles. This would result in less earnings than if the entry was not made by recording the expense and the reserve. If this entry was not appropriate, earnings would be understated.
The second sentence starting with “As Skilling also knew …” that there were “hundreds of millions of dollars that EES could not col- lect …” This implies that Enron should have set up a large “reserve for uncollectibles” which the first sentence says that they did set up, but implies they should not have.
Together, the two sentences state that Enron’s accounting was more or less correct (we do not know what the exact numbers should have been).
On p. 23 of the Indictment, reference is again made to receivables that Enron could not collect “and that Enron personnel were con- cealing within Enron wholesale”. But setting up reserves for uncol- lectibles was appropriate, not a concealment. There might be faulty accounting for reserves by Enron, but the indictment does not clearly identify it.
The Concluding Comments of US Attorneys
Ms K. Ruemmler was a US Attorney in the Skilling–Lay trial. She established that “at Enron it was critically important for Enron to meet its earning targets” (p. 17714). If the targets were not met, “Stock price would go down”. Unfortunately for the prosecution, these state- ments and other similar statements, apply to nearly every company
listed in the New York Stock Exchange. Was there more pressure at Enron than at other companies? We do not know.
There is a quote (attributed to Skilling),
We have to try to get the P/E multiple up (p. 17715).
This is a standard goal of CEOs and not a crime.
A finance officer tells the Enron Board in December of 2000 that the EES business is worth $15 a share. In January 2001, Skilling tells investors that EES (retail business) will be worth $23 a share (p. 17718). Ms Ruemmler states (p. 17719), “That $23 a share is the motive for why EES failed”. This, of course, makes little sense. Maybe the transcript is wrong, but EES did not fail because Skilling said it was worth $23 a share.
Ms Ruemmler states, “you can convict Mr Lay and Mr Skilling of conspiracy to commit securities fraud and Mr Skilling of all of the counts relating to EES …”
It would appear that one could be critical of the execution of EES’s function (pp. 17721–17722). But that does not mean that the business of delivering electricity did not have value.
Ruemmler reports a meeting with Skilling, Delainey, and others to discuss a reorganization with accounting consequences. Skilling states, “What do you want to do?” (p. 17727) and Delainey concludes that this was an order, “Get in line”. It is too large a leap to go from Skilling’s “What do you want to do?” to “Get in line”.
Ms Ruemmler established that “Meeting the consensus estimate”
(p. 17761) was a widespread practice. Enron was not unique having this objective. On p. 17762,
the investing public was never told that Enron could pull a penny here, pull a penny there, for purposes of meeting the consensus estimate … because it’s fraud.
Maybe it was fraud, or maybe there were other explanations for adjustment of the income statements.
Ms Rieker “talking about managing that consensus estimate, get- ting the analysts where they need to be. …” This is not fraud if it
is rather working to have the analysts’ estimates be reasonable and achievable.
Ms Ruemmler says (p. 17765) “That’s fraud”. Meeting the $0.31 estimate is not a fraud. The method used to achieve the $0.31 could be fraud, but p. 17765 and other pages of her concluding comments do not tell how the $0.31 was achieved. “Mr Skilling wanted to beat The Streetby two cents instead of one” (p. 17768). But did he direct anyone to do something that was criminal?
“How could the numbers be coming in hot?” (p. 17769). The answer is that the numbers could be hot or cold or something in between. We do not know until we see them and analyze them.
On pages 17772–17773, there is a discussion about the use of accounting reserves. There are situations where not using reserves is faulty accounting. Consider a $100,000,000 accounts receivable but there is a significant probability that the entire amount will not be collected. A reserve for uncollectible should be established. But the exact amount of uncollectibles is an estimate. Ms Ruemmler states (p. 17773) “how do you know that the reserve actually reflect the true financial results of the company?” The fact is that the “true financial results” are not known even after the fact, but only estimates are known. To hope for truth in accounting is being excessively optimistic.
Can accounting for reserves be misused? Yes. Did Enron misuse reserve accounting? Yes, if the entries to the reserve accounts were used solely to achieve earnings objectives. The statement by Skillings (p. 17776) “You have a billion dollars or so in reserves as a head start”. Does not clearly indicate fraud.
LJM is a conflict of interest problem (p. 17778). It is not accounting fraud. How much time did Skilling spend on LJM? (p. 17779). Skilling says very little. Ms Ruemmler says he spent a lot. If he had spent a lot of time, we would hope LJM would have been folded before it started to operate.
Conclusions
One of the classic method to manipulate earnings is to use reserve accounts. However, a reserve for uncollectibles (or allowance for
uncollectibles) is a generally accepted use of reserves. The reserves can turn out to be too large or too small and still be good honest account- ing at the time they are created. Instead of uncollectibles a reserve account can be used to estimate any ill-defined expense and liability.
Because the actual amount is different than the estimate, does not mean that there is fraud.
Accounting is an art and not an exact science. The use of a reserve account should be carefully controlled and analyzed, but a differ- ence between the original estimate and the final amount deemed to be appropriate does not, by itself, prove that fraud has been committed.
References
Ayers, BC, J Jiang and PE Yeung (2006). Discretionary accruals and earnings management: An analysis of pseudo earnings targets. The Accounting Review, May 617–652.
Ewert R and A Wagenhofer (2005). Economic effects of tightening account- ing standards to restrict earnings management.The Accounting Review, October 1101–1124.
United States of America v. Jeffrey K Skilling and Kenneth L Lay,Transcript of Proceedings Before the Honorable Sim Lake and a Jury.
United States of America v. Jeffrey K Skilling and Kenneth L Lay,Superseding Indictment,Cr. No. H-04-25 (S-2) United States District Court, Southern District of Texas, Houston Division.
Chapter 17
Mark to Market Accounting:
Feeding the Growth Requirement
Mark to market accounting was one factor that brought on the col- lapse of Enron. Consider the following thought of Fox (2003, p. 311):
As Enron showed, a company can become too focused on the short term, and one possible warning sign is an overre- liance on mark-to-market accounting, especially in illiquid markets where values are based on internal assumptions.
Why is it that the accounting profession (including the SEC) allowed Enron to get so far off track? Basically, the profession failed to consider and apply its own history.
The Mark to Market Issue
Until recently, accounting was based on the use of historical costs. An asset was recorded at its cost. The cost could be written down or be expensed but an increase in value was not recorded.
Theoreticians pointed out the failings of a cost-based accounting system. Take an investor who paid $50 a share for the widely traded common stock of a large corporation. Time passes and the stock goes up to $90 a share. Should the $40 stock price appreciation be reported as a gain? Transaction costs and tax effects should be considered but most reasonable people would agree that a gain has taken place.
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Now assume there are two investors and there is a cost-based accounting and no gain is recognized for accounting purposes unless there is a sale of the stock. But now assume one investor sells (with transaction costs equal to zero and no taxes). With the $90 of cash and a $40 gain, the investor now buys a share of stock. The stock is recorded at its $90 cost. The investor who does not sell has one share of stock with a cost of $40 and no gain. But the two shares of stock have the same value.
The consequence of the above cost-based accounting system is that the investor who wants a $40 gain cherry picks the portfolio by selling one share. The investor who does not want a gain in this accounting period does not sell. Obviously, a strict cost-based accounting, while well-defined, has major flaws.
The theoreticians pointed out that the crucial event in earning the
$40 was not sale of the stock but rather the change in price. By mark- ing the stock to market, the stock of all investors is recorded at $90 and a gain of $40 is recorded for all investors. This is superior to a system where the share may be recorded at $50 or $90 and a $40 gain may or may not be recorded.
Complexities
The above example is very persuasive about the merits of mark-to- market accounting. But now assume the investor owns a very large block of stock and the stock is not widely traded. While the cur- rent stock price can be read in the newspapers, the value that could be obtained for a large block of stock is not determined by the cur- rent market price. Estimating an effective market price for the share that represent a large percentage of the outstanding shares requires judgment.
Instead of an uncertain current price, there could be a problem estimating future prices as well as problems in discounting a future value estimate to obtain a present value equivalent.
In the case of Enron, traders would commit Enron to buy or sell natural gas many years in the future. If the contract was perfectly hedged, there still remained the problem of computing a present value.
Also, many of the Enron contracts were not perfectly hedged.
The History
Paton and Littleton (1940) were not discussing Enron’s specific accounting problems of 2001, but much of what they wrote before 1940 applies to the current accounting practices. First, they empha- sized the need for verifiable objective evidence (p. 18):
One of the important contributions made by professional auditing in its early development in Great Britain was the emphasis placed upon objective evidence to support recorded transactions. Recorded revenue was accepted as valid only on the basis of the objective evidence furnished by bona fide sales to independent parties; recorded expen- ditures were accepted as valid only on the basis of the objective evidence furnished by authentic business docu- ments related to the transaction. This evidence afforded the principal means by which the recorded facts could be verified. The dependability of the accounts was thus subject to the test of an examination of the origin of the transactions recorded.
Most importantly, they stress the necessity of having objective evi- dence (p. 19):
‘Objective’ used here relates to the expression of facts without distortion from personal bias. It is in contrast to ‘subjective,’ a word which suggests that the personal equation — state of mind, wish, intent to deceive — may affect the result. ‘Objective evidence’ therefore is evidence which is impersonal and external to the person most con- cerned, in contrast with that person’s unsupported opin- ion or desire.
The requirement for objective evidence is not absolute, thus we have (pp. 19–20):
It is in connection with this subsequent treatment that the concept of objective determination must submit to some
variation, for ‘objectively determined’ is not a gauge that registers positive or negative and nothing more. The evi- dence supporting a given treatment may be completely objective, convincingly objective, doubtfully objective, or clearly unobjective.
It is clear that the Enron mark to market accounting practices were
“clearly unobjective”. Traders estimated future prices to a large extent based on the income outcome that was desired.
A Mark to Market Rule Target
In the spirit of Paton and Littleton (1940), let us consider some rules for mark to market accounting.
At one extreme, there are reliable current market prices for today (no time discounting). This is analogous to the common stock example for one share of stock. There is reliable objective evidence. In fact, we will call this the equivalent to certainty situation. When we have an equivalent to certainty situation, the mark to market accounting is not only acceptable, but it should be the required accounting method.
Now, let us consider the other extreme where there is a large amount of uncertainty. Assume that Ford Motor Company has just completed construction of an engine manufacturing plant at a cost of $200,000,000. The net present value of the plant at the time of construction was $700,000,000 (the total gross present value was
$900,000,000). Should the plant be written up from $200,000,000 to $900,000,000?
The current practice for a manufacturing plant is for the plant’s owner not to mark it up for future estimated cash flow. Even if there were a surge in property values so that the plant had an estimated value larger than $200,000,000 (the cost), this upsurge would not be recorded.
However, if the auto industry in the US were restructured and the estimated value of the plant was reduced to $30,000,000 (its value as a shopping mall), there could be a write down in value to $30,000,000.
Why was the plant not written up to $900,000,000 when that was its estimated present value? The $900,000,000 was highly uncer- tain and based on subjective estimates of value. With that degree of
uncertainty, to report $700,000,000 of income because someone (or some group) thinks that in the future cash flows will be earned, would be to reduce significantly the usefulness of the firm’s income statement.
We are now ready for a conclusion. Mark to market accounting should only be used when the information is objective and is applica- ble to the value estimate. When there is a large amount of uncertainty and the value calculation is based on subjective inputs from people who might well have a bias (a reason for preferring one account- ing outcome over other accounting outcomes), then mark to market accounting is much less useful. If the amount of uncertainty is large, then it is possible that mark to market accounting is not a useful technique. The mark to market accounting may be useful for a cor- poration’s internal use when it is not useful for external purposes (especially as the primary reporting device).
Let us consider the Enron situation where the firm signs a contract to deliver a quantity of natural gas each year at a given price for 20 years. Given today’s natural gas price, the differential between the price to be received and the cost of buying the gas is $1,000,000 to be netted immediately.
To book the $1,000,000 as income is reasonable. There will be 19 additional net receipts or net outlays. To book $20,000,000 as income today is not reasonable. To book the present value of $1,000,000 a year for 20 years (say the present value is $9,365,000) is not neces- sarily correct. The correct discount rate might not be 0.10 and the amount each year might not be $1,000,000. In fact, the amount for one or more years might not be positive, they might be negative. Unless we know more than is assumed above, the recognition of the incomes of 2–20 years should not be published as known facts.
So far, we have stressed the difficulty of estimating the value of the contract for each year and choosing the correct discount rate, but there is also the bias (conscious or unconscious) of the person (or persons) doing the calculations. In the absence of the objective evidence required by Paton and Littleton, we cannot rely on the value estimates and the effects on income. Unfortunately, much of the inputs going into Enron’s earnings numbers were based on estimates made by managers with something to gain or lose as the result of the income measures.