Reconstructing financial reporting following the accounting fraud disclosure at Enron Energy Company

Reconstructing financial reporting following the accounting fraud disclosure at Enron Energy Company

Hotaling, Andrea

There have been apparent breakdowns in the financial reporting process as evidenced by the recent numerous restatements of financial results and legal actions brought against both companies and their auditors. In designing the appropriate corrective measures we need to keep in mind that the financial reporting process involves a variety of parties with differing responsibilities. This article points out some of the weaknesses in the current reporting standards illustrating that much of the divergence from actual economic reality is the responsibility of the standard setters. CPAs are often prohibited from deviating from the rigid standards as promulgated even if strict application of the standards results in misleading financial information.

In response to the public cry for action following the Enron bankruptcy and other recent business failures the US Congress has passed the Sarbanes-Oxley Act, which addresses a variety of abuses by management and auditors. Less attention has been focused upon the standard setting process and the standards themselves. Current U.S. reporting is very rule-based, emphasizing the uniformity of the application of accounting principles across firms so that similar transactions should receive similar accounting treatments. This improves the financial statement users’ ability to make informed judgments about financial performance and position. This means however, that the rules may actually dictate the form of a transaction in order to assure a specific accounting treatment. Many critics are calling for accountants to be more responsible for compliance with the spirit of accounting rules and less focused on helping their clients avoid the spirit of the rules while complying with the letter.

There are several reasons why accountants and auditors cannot be reasonably expected to comply with the “spirit” of many accounting rules as they are currently stated. Most importantly is the prohibition by the rule makers themselves, the FASB (Financial Accounting Standards Board). The FASB promulgates generally accepted accounting principles that are required to be followed and auditors then attest to that compliance. The FASB also has drafted concepts statements that are supposed to provide a conceptual framework under which new accounting rules are proposed and promulgated. CON 1 published in 1978 states that: “a Statement of Financial Accounting Concepts does not…. justify either changing existing generally accepted accounting and reporting practices or interpreting pronouncements …. based on personal interpretations of the objectives and concepts.” (FASB, 1978) In other words, accountants are strictly prohibited from exercising any judgment about whether an accounting rule presents the economic substance of a transaction or applying their own interpretation to an accounting situation based on the conceptual framework. They are limited to merely attesting to whether the rules were followed correctly.

There are many GAAP rules that permit or specifically require that information be presented in a manner that seems “unfair”, in the sense that it doesn’t correspond with the underlying economic reality of the business activity. Current GAAP requires that all Research & Development (R & D) expenditures (FASB, 1974) and most advertising costs (AICPA, 1993) shall be charged to expense when incurred. In today’s economy intellectual property and the rights inherent in intangible assets are an increasing portion of the value of a firm. This accounting rule requiring the immediate expensing of R & D expenses or advertising costs based on the premise that it is difficult to measure future economic benefits does not represent economic reality. Clearly many of these outlays result in valuable assets that will make significant contributions to stockholder value. Do we want auditors permitting the capitalization of these types of expenditures based on the judgment that they represent economic assets?

Some rules, such as those on stock option accounting, represent compromises made by the FASB due to industry and political pressure. The FASB concluded that the fair value method more properly reflected the economic cost of compensatory options but allowed companies to instead place a low or even a zero value on these options by permitting the intrinsic value method. (FASB, 1995) As this controversial topic moved through the FASB rule making process, there was actually a bill introduced in the Senate that would have prohibited the FASB from adopting a rule that required companies to report compensation expense for these stock option plans. In resolving this matter, the FASB yielded to political pressures. They acknowledged the theoretical superiority of the fair value approach but allowed companies to use the intrinsic value method providing that there is footnote disclosure of the pro-forma results using the fair value method.

The saga of the debate on stock option accounting illustrates two flaws in some of the current remedies. If Congressional pressure on standard setting can result in the adoption of a standard that accountants recognize as theoretically deficient how will giving more control over standard setting to any governmental agency improve the resulting standards? Also, the compromise of disclosing the “real” economic information via a pro-forma footnote creates confusion. Does additional disclosure in the footnotes offset the misrepresentation of information in the body of the financial statements?

Finally, there are instances where the standards impose an arbitrary “cutoff” for certain types of accounting treatment. The factors being measured are continuous factors, but the accounting treatment is dichotomous. The resulting distinction between the two accounting treatments is a rule, not a concept. Current GAAP regarding lease accounting and the treatment of special purpose entities (SPEs) provide examples of this rule-based accounting.

In establishing lease accounting rules, the FASB concluded that if the lease transfers the risks and rewards of ownership from the lessor to the lessee, it is a capital lease requiring inclusion in the financial statements of the lessee. If the risks and rewards remain with the lessor, the lease is an operating lease, requiring merely footnote disclosure of future obligations. Leases that cover a large percentage of the asset’s economic life or involve payments that approximate those that would be required if the asset had been purchased, seem to involve the transfer of much of the risks and rewards of ownership, but fall short of complete transfer. The FASB resolved these cases by settling upon some arbitrary numeric cutoffs relating to lease term and the fair value of lease payments. (FASB, 1976) In a dissenting opinion to FASB 13 several Board members recognized that the lease accounting rules were a compromise that did not reflect the economic substance of the transaction. In their view “regardless of whether substantially all the benefits and risks of ownership are transferred, a lease, in transferring for its term the right to use property, gives rise to the acquisition of an asset and the incurrence of an obligation by the lessee”(FASB, 1976). These cut-offs provide the auditor with a means of distinguishing between capital and operating leases. Can we reasonably fault the auditor for” certifying financial statements that while complying with the rules do not reflect economic substance when even members of the FASB have acknowledged the disconnect between reporting and reality? Can we even criticize them for advising their clients how to structure lease transactions to meet the operating lease classification criteria?

A second example of the complex rule-based accounting that has evolved in response to current business practices is the treatment of special purpose entities (SPEs). If we consider the use of the organizational vehicle of an SPE to accomplish a complex lease transaction we see another example of an arbitrary cutoff that allows technical compliance with the rules while perhaps masking the economic reality of the situation.

An airline company that needs to lease a fleet of jets or an energy company that needs to construct a pipeline might decide to establish a special purpose entity to acquire or develop those assets with the sole function of leasing them to the company. The assets themselves serve as collateral for the financing. The charter establishing the entity limits its activities to those defined by the sponsors so even if the company has no equity interest in the SPE it does have effective control over the activities of the SPE. Additionally, even if the sponsoring company is not legally responsible for the debt of the SPE there might in fact be an implied guarantee of the SPE debt by the sponsor company.

According to the guidelines outlined by the Emerging Issues Task Force (the quick response branch of the FASB) in EITF 90-15 a lessee company can avoid having to consolidate a special purpose entity by simply failing any one of three specified criteria. Even if an SPE was created for the sole purpose of acquiring and leasing a specific asset to the lessee company, and even if the lessee company guarantees its debt, the SPE is be viewed as independent of the lessee so long as there are unrelated owners who contribute at least 3% of the total capital of the SPE and that equity remains at risk for the entire duration of the lease (EITF, 1991). The assets in the SPE are not subject to possible claims by the creditors of the lessee company resulting in a greater degree of protection for the financing institution, and the lessee company limits its risk to the amount that it has invested in the SPE. (This is providing that the lessee has not guaranteed the debt of the SPE) If the lease between the SPE and the company is properly drafted to qualify as an operating lease, the asset and corresponding debt burden will remain “off balance sheet” under the lease criteria as well. Therefore the activities of the SPE will not show up anywhere in the financial statements of the lessee. There will simply be a footnote disclosure of future cash payments required under the operating lease agreement.

Does this separate legal structure hide important information from the shareholders of the lessee company? If the cash payments from the lessee will be the sole source of revenue for the special purpose entity and the sole cash stream that the financing institution is looking to for repayment can it make sense that the legal form of the structure overrides what in substance seems to be an asset acquisition? Certainly, it would seem that the financing institution is looking at the financial capacity of the lessee company as well as the liquidation value of the asset in making its financing decision.

We have a set of criteria established by the accounting authorities that define a “qualifying special purpose entity”. According to these rules, companies only need to have 3% of the SPE’s equity from independent sources to avoid consolidation. If the letter of the rule has been satisfied, can we expect the auditors to overrule the EITF? Analysts and government regulators who are critical of the current definition of qualifying SPEs have suggested that the “substantive residual equity” investment should be pegged at 10% rather than the current 3%. Would it really have made any significant difference if there were 10% outside equity? The basic economics of the transaction would be unaffected and the relationship between the SPE and the lessee company would be substantively the same.

Expecting the CPAs to look beyond the rules to the substance of a transaction is prohibited by the current accounting regulations. Responsibility to have the rules conform to economic reality must lie with the rule makers if accountants are not allowed to depart from GAAP. The two examples of capital leases and SPEs illustrate the difficulty of assigning responsibility for the failure of financial reporting or for designing a system that will prevent future accounting misunderstandings. In both of these complex areas the letter of the rules may be followed but a common sense approach to the issues of risks, rewards, and control seems to require a different result.

With many parties involved in the design, preparation, and oversight of the financial reporting process the quality of reporting is dependent on the quality throughout the chain. Clearly the remedy for financial reporting needs to be targeted to the weaknesses in the system that give rise to the problems.

* If the problem is simply that the rules were not followed, resulting in misleading disclosures, the solution might be to increase the oversight of the CPAs. This might also indicate a need to further explore and limit the relationship between audit services and consulting services to ensure that the CPAs are indeed independent in making accounting judgments.

* If the letter of the rules was followed, but the disclosures were misleading either because there was a bad rule or because the “spirit” of the rule was not followed, the resolution is more complex. One possibility would be instead of holding the CPA responsible for compliance with the rules; we could allow them to disregard the rules if they felt that the resulting financial reporting was misleading. This solution is probably not optimal, nor likely, because then the preparation of financial information becomes subjective and the results will vary widely depending on which accountant is rendering the judgment. One of the primary benefits of a highly structured and rule-based accounting system is the comparability that results between companies and between periods for a reporting entity. Another possibility would be to follow the suggestion of adding a qualitative judgment to the auditor’s opinion where the auditors could more clearly state the risks associated with just barely passing the “rules.” Do accountants in this litigious climate however, want to take on the added risk of saying they are doing more than just attesting to the compliance with the rules?

* We could change the organization and oversight of the rule making bodies. We can improve the present system by continuing to hold the CPA responsible for the application of GAAP but put more pressure on the GAAP makers (FASB, SEC, AICPA) to insure that strict application of the rules will result in fair presentation and disclosures that are not misleading. It is imperative that the rule making bodies be truly independent and free of political and industry pressure in their task of timely and economically sound rule making.

The recent intense scrutiny of the accounting profession in the wake of the Enron collapse provides a unique opportunity and challenge to the profession. The role of accounting information in our economy and the role of accountants in presenting that information are normally topics of limited interest to the general population. Now many parties, including Congress, local politicians, government regulators, the disgruntled employees, the investors, the financial press, and even the President are calling for additional regulation or oversight of the profession and financial reporting. Business people and investors alike are eagerly reading explanations of what went wrong at Enron and descriptions of possible accounting misrepresentations or omissions at other companies. The opportunity we are presented with is this eager audience, much broader and more concerned than ever before. The challenges are many, education of this audience about the role of the accountant or auditor in applying GAAP; careful reflection on the application of GAAP to the complex organizational and financing structures that have developed in recent years; and thorough review of the standard setting, regulatory and enforcement processes inherent in the current system. We need to clarify the problems before the proposed solutions can be evaluated.

References

AICPA (1993), “Reporting on Advertising Costs,” Statement of Position 93-7. New York: AICPA.

EITF (1991), “Impact of Nonsubstantive Lessors, Residual Value Guarantees, and Other Provisions in Leasing Transactions,” Emerging Issues Task Force Statement 90-15. Norwalk, Conn.: EITF.

FASB (1974), “Accounting for Research And Development Costs” Statement of Financial Accounting Standards No. 2. Stamford, Conn.: FASB.

FASB (1975),””Reporting Gains and Losses from Extinguishment of Debt,” Statement of Financial Accounting Standards No. 4. Stamford, Conn.: FASB.

FASB (1976), “Accounting for Leases,” Statement of Financial Accounting Standards No. 13. Stamford, Conn.: FASB.

FASB (1978), “Objectives of Financial Reporting by Business Enterprises,” Statement of Financial Accounting Concepts No. 1. Stamford, Conn.: FASB.

FASB (1995), “Accounting for Stock Based Compensation,” Statement of Financial Accounting Standards No. 123

Andrea Hotaling

Siena College

Jeffrey Lippitt

Ithaca College

Copyright International Journal of Management Dec 2003

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