Accounting Alchemy

JIM LEHRER:

The kind of magic behind the rise and fall of Enron. Our economics correspondent Paul Solman of WGBH-Boston reports on some of the ingredients.

PAUL SOLMAN:

Okay, you may know the basics about Enron already: A company called Houston Natural Gas becomes Enteron– until told that name suggested intestines; becomes Enron; becomes politically-connected player in the new deregulated market of energy trading; becomes part of the Internet revolution; claims to become huge and profitable; is lying about both; fails. But how did Enron manage to fool the world? That's what the world is now trying to figure out. And here's what we seem to know of the company's magic act thus far.

The key was what you might call "accounting alchemy," miraculously turning lead into gold, water into wine, losses into profits, making debts and bad investments, or anything they wanted to simply disappear. Or to put it differently, Enron played the all-in-the-family fantasy finance game, manipulating hundreds of subsidiary companies with names out of "Star Wars," "Jurassic Park," medieval Scotland. So back here in the New York apartment where I played fantasy games growing up, let's see how they did it.

In the early '90s, Enron made money, with, for example, an oil partnership dubbed Jedi, after the "Star Wars" knights. One of its many subsidiaries, Raptor, which invested in Internet firms, was virtually minting money as its portfolio soared. And when Enron made a deal with Blockbuster Video to deliver movies on demand over the fiber optic cables it was installing across the country, Enron seemed to be making all the right connections.

Soon Enron was America's seventh largest company in terms of revenues. But from the beginning, something was kind of fantastic. It turns out, Enron got so big, so soon, with some audacious sleight-of-hand accounting– call it "ledger domain." Enron recorded, as revenues, what on the stock market they simply refer to as volume. Accounting professor Doug Carmichael:

DOUGLAS CARMICHAEL, Baruch College:

Enron was able to book its energy trading contracts at the full contract price. It would be like a stockbroker taking credit for the full sales price when a customer sold stock, instead of the commission that they earned on selling the stock, which gave them a much inflated earning figure.

PAUL SOLMAN:

Or, since I'm back in my family apartment, if we tried this at home, it would be like setting up the brokerage firm Solman and Solman– that's me and my dad– get $1 million from you viewers to buy and sell stocks and bonds, then claim we're a multimillion dollar firm. Sadly, the accounting industry's board won't let us do that. Wall Street brokers can't either. But for companies like Enron, in this new industry, new regulations, or deregulations, applied. By the late '90s, however, with regulators otherwise engaged, Enron had begun to lose money.

But to keep its stock price and credibility as a trader from collapse, Enron needed to keep the game going. It started playing faster, looser. Take Enron's movies-on-demand deal with Blockbuster. That was a real partnership: To share profits 50/50 for 20 years. But before it could even go bad– which it did– Enron created a different company, code name: Project Braveheart. A Canadian bank invested $115 million in it, in return for the first decade of supposed future earnings from the Blockbuster deal.

Plus, Enron guaranteed the bank its money back if Braveheart fell. Then, get this, Enron recorded the bank's $115 million money- back guaranteed investment as Enron's profit! In most families, that would be outright fraud. Okay, how did they do it? Well, for one thing, their accounting alchemy was hidden in language even experts couldn't follow. Listen to a related deal, as read by Professor Carmichael.

DOUGLAS CARMICHAEL:

Enron and the third party amended certain forward contracts to purchase shares of Enron common stock, resulting in Enron having forward contracts to purchase Enron common shares at the market price on that day.

PAUL SOLMAN:

Can anybody understand this stuff?

DOUGLAS CARMICHAEL:

No. I think any objective evaluation would be that it's not transparent, it's not adequate disclosure.

PAUL SOLMAN:

But this is literally officially what they've disclosed to the government.

DOUGLAS CARMICHAEL:

Yes. In their filings with the SEC, that's all they disclosed.

PAUL SOLMAN:

And now, nobody said, "wait a second," "what does this mean?"

DOUGLAS CARMICHAEL:

Nobody, not the auditor, not the audit committee, no one.

PAUL SOLMAN:

No… And not the SEC?

DOUGLAS CARMICHAEL:

And not the SEC.

PAUL SOLMAN:

Is that amazing to you?

DOUGLAS CARMICHAEL:

It was shocking to me.

PAUL SOLMAN:

Shocking?

DOUGLAS CARMICHAEL:

Shocking.

PAUL SOLMAN:

Now, a key to this scam was perhaps Enron's main alchemical tactic: The use of its so-called related parties companies like Raptor or Braveheart, companies created and owned 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.

In the case we just heard about, another related party had invested in something called New Rhythms Net Connections. This is our fanciful representation of it. (Beethoven's "Ode to Joy" playing.) Unfortunately, New Rhythms had crashed. So Enron entered into something called a derivatives contract with its own subsidiary. The contract increased in value as New Rhythm's stock price went down.

So if the stock rose, Enron would report profits from the stock because it was an asset of the subsidiary. If the stock dropped, Enron would report the profits from the New Rhythms derivative contract, neglecting to report that the related party– the subsidiary– was losing exactly the same amount.

This is like me claiming my daughters have a separate company, which lost $100 million in an Internet stock, but I made $100 million on the deal because I had a contract with them where they had to pay me a dollar for every dollar they lost. Meanwhile, who would make good their debts to me? Me, their father.

Bottom line:

I lose $100 million, but report it as a $100 million profit, which is exactly what Enron did when the stock, in fact, tanked. By the way, Enron also pulled this with the related party known as Raptor, which had a whole portfolio of Internet losers. And then there was the old 1920s trick of watered stock, again with a related party.

DOUGLAS CARMICHAEL:

They gave the related party 3.7 million shares of their common stock.

PAUL SOLMAN:

Right.

DOUGLAS CARMICHAEL:

And they disclosed that they, among other assets received, 1.2 billion in notes receivable.

PAUL SOLMAN:

Notes receivable meaning just —

DOUGLAS CARMICHAEL:

I Owe You's

PAUL SOLMAN:

An IOU

DOUGLAS CARMICHAEL:

And what they don't tell people is that was a one-for-one exchange. They gave their stock for a 1.2 million-note receivable.

PAUL SOLMAN:

For an IOU from a company they owned.

DOUGLAS CARMICHAEL:

From a company they owned.

DOUGLAS CARMICHAEL:

And the SEC doesn't permit that. It's on its face a violation of SEC rules and accounting requirements. It's called watered stock, and it inflates the capital. It makes the company look like it has more equity than it really does.

PAUL SOLMAN:

Back in the family, this is like pretending to sell $1.2 billion worth of my own company's stock to myself, giving myself my own IOU for $1.2 billion in return, then recording the sale as if it were for cash. The SEC was literally established to prevent such abuses.

There were so many scams, we've almost run out of props. Enron borrowed money through related parties to hide its debts, sold off energy assets, then claimed the proceeds as pure profit, while never deducting the value of the asset it no longer had.

It sold now a nearly worthless fiber optic cable to one of its related parties, claiming a profit of $53 million, and then, without explanation, reported that same transaction again the following quarter with an additional $14 million profit, thereby just beating expectations on Wall Street.

And finally, remember that initially successful Jedi partnership in California? When Enron's partner took out its gains, Enron hid the fact by creating Chewco Investments– after Chewbacca the Wookie, from "Star Wars"– in a deal so complicated, the force would have to be with you to figure it out; so dark, Darth Vader would have shaken his head in admiration.

It all seemed like a fantastic game, and of course, that's the way we've played it here. But with billions gone, and thousands unemployed, you can say one last thing about Enron and its all-in-the-family accounting alchemy: It was no "Phantom Menace."