One of the basic problems with financial statements is that they look so authoritative. The numbers all line up neatly, and—if you check the math—
they all add up, too. Plus they have been printed or posted on a Web site maintained by the SEC, so they mustbe accurate, right?
Yes and no. For all their authoritative appearance, the numbers in finan- cial statements are simply a representationof reality. They can be an accu- rate or an inaccurate representation. They can accurately represent a reality that is now 6 months old—a century in Internet time. They can accurately represent a piece of the picture but mislead by omitting other relevant parts of the picture.
Jeffrey Skilling regarded Enron’s financial statements as truthful. He said so at a hearing of the Senate Commerce Committee:
SKILLING:I believe the financial statements were an accurate repre- sentation of my understanding of the financial condition of the company. And I’d like to address—as you brought up, I would like to address one of those issues. There’s been a lot in the press, and I think your question suggests that there is some issue of hiding debt, that the use of off-bal- ance-sheet or special-purpose entities had its intent in hid- ing debt. And all I can do is I can refer you to page 78 of the year 2000 10-K. There’s a section that’s called “Uncon- solidated Equity Affiliates.” “Unconsolidated Equity Affil- iates” would be partnerships and special-purpose entities that were not consolidated into Enron’s balance sheet.
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There’s a two-page description of the earnings that were appropriate or associated with those vehicles. And on the second page it shows the full . . .
SENATOR ALLEN:All right, let me interrupt . . .
SKILLING:. . .balance sheet. I’m—Senator, please—the . . .
SENATOR ALLEN:I just want . . .
SKILLING:This chart shows exactly—exactly what the total amount of the outstanding liabilities were that were nonconsoli- dated liabilities. So the whole issue of hiding debt, it’s not—it was in the 10-K. Anyone reading the 10-K would have a hard time missing this page.
SENATOR ALLEN:Okay, thank you, Mr. Skilling. A lot of people must have missed it. Now (laughter). . . .
Enron’s financial reports were certainly detailed, and they were accurate, as far as they went. Nevertheless, critical pieces were omitted from the reports in what appears to have been a systematic pattern of strategic omission.
Each of the following paragraphs keys off one such piece. The quoted passages are from an excellent article by Dan Feldstein of the Houston Chronicle.2
Leverage: Debt versus Equity Interest in Affiliates
Enron indeed listed several such affiliates, from Azurix to Whitewing. But the prose was obscure and the note only showed what Enron had put into the companies, not its possible debt exposure, said analyst John Olson of Sanders Morris Harris. By showing its equity interest in the partnership, but not the debt, Enron had not spelled out the relationship between the two, known as “leverage.”
This is a consequence of accounting for partnerships (“special-purpose enti- ties”) through the equity methodrather than consolidating their results with those of the parent company. Arthur A., the anonymous Web commentator at www.eraider.comexplains this: “Most observers have called the Special Purpose Entities a form of off-balance-sheet financing, in which Enron engages in transactions that it somehow doesn’t even record on its balance sheet. That would be illegal. Rather, Enron put them on the balance sheet, in plain sight for everyone to see, but just in a place that few people think to look. Enron had a choice in how to record the investment in and activi-
ties of the SPEs: It could consolidate them, or use the ‘equity method.’ Con- solidating them meant that the assets of an SPE become the assets of Enron, its liabilities become Enron’s liabilities, and so forth. Enron certainly didn’t want to do this, since it sought to avoid the SPE liabilities in the first place. In contrast, the equity method allows a firm merely to add the share- holders’ equity of a subsidiary or affiliate (such as the SPEs) to its own.
This way, Enron wouldn’t care about the revenues and expenses or assets and liabilities of the SPEs.”
This is extremely complicated and probably down to a level of detail that most readers of this book will not need to master. But you get the idea:
Enron found a “legitimate” way to represent its subsidiaries and affiliates that created a very misleading picture.
Missing: Debt
“Enron was doing leveraged buyouts with recourse to itself. This debt should have been fully disclosed in the footnotes of the minority inter- ests,” Olson said.
Missing: “Commitments and Contingencies”
The collateral could have been shown in “commitments and contingen- cies” in the balance statement. It isn’t. It also could have been in the foot- note discussing earnings per share.
Missing: “Contingent Stock Obligations”
If Enron stock faced the possibility of being diluted by new shares issued for the partnership, experts say, stockholders should have been warned under “contingent stock obligations.” It wasn’t. Things got even more con- fusing from there, analysts said. In some deals, the potential stock obli- gation simply wasn’t included in dilution calculations. But in others, Enron actually acted as if the stock had already been issued, including it in the total of outstanding shares. This effectively boosted Enron’s equity, mak- ing the company appear less dangerously leveraged, Olson said.
Peter Eavis produced a detailed analysis of Enron’s “contingent stock obli- gations” after the second 2001 restatement:
In its 2000 annual report, Enron included some disclosure of the 55 mil- lion shares connected with LJM2. It reads: “At December 31, 2000, Enron
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had derivative instruments on 54.8 million shares of Enron common stock.” . . .But these derivatives-linked shares don’t show up where they should in the annual report: in the table that breaks out the difference between the basic and diluted share counts.3
Conflicts of Interest: Only Part of the Story
Analysts’ final complaint is that they should have been told, explicitly, that Enron chief financial officer Andrew Fastow was also an officer in some partnerships and stood to make a lot of money from them. In Enron’s annual report, under the footnote for related party transactions, it says,
“Enron entered into transactions with limited partnerships whose general partner’s managing member is a senior officer of Enron.” That could have been any one of thousands of vice presidents, the analysts said. It was the CFO. But one disclosure was more explicit—in the company’s 1999 proxy, page 26, “Certain Transactions”: “In June, 1999, Enron entered into a series of transactions involving a third party and LJM Cayman, L.P.
(‘LJM1’). . . . Andrew S. Fastow, Executive Vice President and Chief Financial Officer of Enron, is the managing member of LJM1’s general partner. The general partner of LJM1 is entitled to receive a percentage of the profits of LJM1 in excess of the general partner’s proportion of the total capital contributed to LJM1, depending upon the performance of the investments made by LJM1.” That’s actually pretty clear.4
The Uses of Opacity: The Impenetrability of Enron’s Financial Reports
Because parts that would make the whole picture emerge were missing, Enron’s financial reports were considered opaque by the experts. “We’re pretty good at deciphering footnotes and other disclosures,” Jim Chanos of contrarian Ursus Partners hedge fund commented, “but these [Enron]
reports left us scratching our heads.”5
Arthur A. remarks: “Many smart analysts have spent years trying to understand Enron’s finances, and it was their nosy questions about a $1.2 billion charge to shareholders’ equity in its third quarter earnings release in mid-October that started the company down its fateful path. As those ques- tions boiled over, and Enron claims it got religion on disclosing everything to investors, it issued its sole official public document explaining its posi- tion—and few analysts could understand even that disclosure. I’ve been through last week’s 8-K filing several times and have only the most super- ficial idea of what took place.”6