TOPICS > Economy

Background: Vouching for Veracity

August 14, 2002 at 12:00 AM EDT
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PAUL SOLMAN: Today’s deadline is in the spirit of spectacles like the recent arrest of WorldCom executives — to make CEOs and CFOs think twice about playing games with their companies company’s financials.

From now on, the CEOs and CFOs of America’s 942 largest publicly traded firms, those with more than $1.2 billion in revenues, must sign statements reviewed with their audit committees, that to the best of their knowledge their current financial report is neither untrue nor misleading.

Penalties could be as high as 20 years in prison. And the number of firms required to make statements could get a lot larger. The idea is that future WorldComs won’t, for example, inflate their profits, if prison is the price. That the next Enron won’t camouflage its debts with off balance sheet partnerships, if top executives can’t use the excuse that they simply didn’t know the numbers — as ex-Enron CEOs Jeffrey Skilling and Ken Lay both have.

What numbers? Well, the key financial statements in the quarterly and annual reports of publicly traded companies. The balance sheet and the income statement.

PAUL SOLMAN: So first let’s take a look at a balance sheet. Enron’s — with Harvard Business School accounting professor, Paul Healy.

PAUL HEALY: The balance sheet shows the firm’s assets, resources that it owns, it shows its obligations to creditors and banks, called liabilities, and it shows the residual, what’s left over for shareholders.

PAUL SOLMAN: And it’s a balance sheet because what the company owns has to balance where the money came from.

PAUL HEALY: Correct.

PAUL SOLMAN: The difference between what a firm owns and what it owes, is called shareholders equity. What you or I might call our net worth.

And to pump up your net worth, or shareholders equity, you just show a greater difference between your assets than liabilities. So what Enron did was lower its liabilities by whisking some of them off the balance sheet entirely.

PAUL HEALY: In the case of Enron, the key question that arose was whether all of its debts and obligations were properly recorded under its liabilities.

PAUL SOLMAN: But plenty of debt here on the balance sheet.

PAUL HEALY: There’s lots of debt. The question is whether all of it was showing up.

Enron had arranged for complex off-balance sheet partnerships — which it owned — so subsume a large part of the debts so we don’t see it showing up on the balance sheet.

PAUL SOLMAN: So it’s companies that Enron effectively owned, they take on debts off the balance sheet, don’t show up here at all.

PAUL HELAY: That’s right.

PAUL SOLMAN: We first illustrated these so-called partnerships in January. In a piece on Enron we called “Accounting Alchemy”:

PAUL SOLMAN: Now the key to this scam was perhaps Enron’s main alchemical tactic — the use of its so-called related party companies, like Raptor or Braveheart, companies created and ones almost entirely by Enron, subsidiaries, really, some of them run by its chief financial officer. Yet when it suited Enron’s interests, these related parties were treated as independent arms-length businesses.

PAUL SOLMAN: With nary a mention of them in Enron’s annual reports to keep the debt from prying eyes.

PAUL SOLMAN: Now, while Enron did this in exotic ways, other companies did it much more simply.

Krishna Palepu, the head of Harvard’s accounting department, had one such example: A fast food chain that also seems to have played fast and loose with its balance sheet in the early 90s.

KRISHNA PALEPU: Like Enron, Boston Markets, which was Boston Chicken at the time, had its own off-balance sheet financing, and the way they did it was by creating a lot of franchises to open stores, and these franchises are supposed to be independent parties.

However, they gave them a guarantee that should they lose money, they will be willing to buy them out. And many franchises when they lost money went and borrowed a lot of money to cover up their losses and ultimately Boston Chicken shareholders had to repay all these loans even they knew all these loans were liabilities, because they were not on the books.

PAUL SOLMAN: Is that why they went bankrupt?

KRISHNA PALEPU: Yes, because they had all owes obligations they had to meet and didn’t have enough cash flow to pay those obligations, so they had to clean up their act, close down a lot of stores, and they are just now emerging with a new name and much fewer stores.

PAUL SOLMAN: The new rules aim to head off collapses like Boston Markets and Enrons by making CEOs and CFOs accountable for their balance sheets.

PAUL SOLMAN: And for their income statements as well: The report that shows the firm’s income, and all the expenses that have to be deducted from it before you get down to the all important bottom line. A firm’s reported profit, or loss.

PAUL HEALY: The second major financial statement is the income statement, or statement of operations.

PAUL SOLMAN: Here we have one for Qwest…the telecom…

PAUL HEALY: It shows revenues, cost and bottom line.

PAUL SOLMAN: But the bottom line is a loss, so they were acknowledging they were losing money.

PAUL HEALY: The problem is the loss is greater than they were reporting. And the reason is included in their revenues, the revenues from long term contracts, where they’re showing the full amount of the contract revenues here in their income statement, and they haven’t received cash from their customers yet, they haven’t provided the service, so we don’t know whether they’re ever going to get paid for these.

PAUL SOLMAN: In other words, while Qwest’s annual reports were typical of the genre — devoting most of their pages to image — when it came to the numbers, they were inflated in the hype and in the fine print of the financials themselves.

So shaky long-term rental contracts that were not even generating any cash in the current year were reported as revenues, and Qwest claimed the entire amount of the contract. The revenues on the income statement were thus overstated. And so the bottom line showed a much smaller loss than Qwest in fact incurred.

PAUL SOLMAN: Again, the new rules use accountability and fear to try to nip such flummery in the bud, and thus prevent boom bust collapses such as the one recently seen as our final example, WorldCom, where they monkeyed not with the revenues on their income statement, but with the expenses.

WorldCom’s annual report, posted on its Web site, emphasized its high tech hopes, telecom cable running right across its pages — from up high in the sky, to way down in the ground.

Its numbers were similarly hopeful. Indeed, WorldCom never even used the lines it paid to rent, and then claimed that since it hadn’t used them, the lines must have been a long-term investment.

So you might say that to keep profits high, it buried its expenses, and when WorldCom had to restate the investment as a one-year cost, its stockholders wound up swimming with the fishes.

PAUL SOLMAN: So then how could WorldCom have in good conscience done this?

PAUL HEALY: They didn’t do it in good conscience. It was almost surely fraud.

PAUL SOLMAN: Whether it was fraud or not remains something for the legal system to decide. But the point of the regulations whose deadline was today is to make it tougher for top executives to say they didn’t really know the numbers.