Disclosure in the dock

Financial reporting appears to have been worthless in the case of Enron’s spectacular demise and, although instances of fraudulent management are rare, investors have been gripped by the fear that all may not be as it seems, even when accounting rules are correctly applied. David Watts reports.

In the three months since Enron, the world's largest energy company, collapsed, a whole series of revelations about accounting sleights of hand, inflated earnings and dubious ownership structures have come to light. Is that just a coincidence? Yes and no.

Clearly, the Enron scandal is an extreme situation and lies far beyond normal experience, but equally, in one sense it is symptomatic of the bust that has followed on from the boom years. Even without Enron, investors were starting to pay greater attention to company accounts and asking more probing questions about levels of corporate disclosure. What they have belatedly woken up to, or started caring about, is that companies have been pushing aggressive accounting policies far beyond the level of acceptability. Nowhere has that been more evident than in the proliferation of off-balance sheet structures in recent years – a phenomenon that has left regulators haplessly attempting to keep up with the next structure.

Without the injection of liquidity from the Federal Reserve and other central banks last Autumn, the holes and discrepancies that are now being found in company finances would have surfaced earlier. "The injection of liquidity last year was unprecedented," says one banker, "and that papered over the cracks in the natural pick-up in corporate hardships. Because companies have been highly acquisitive and because growth is no longer coming through, investors are looking at the numbers and finding that they don't add up. Companies have given promises to investors that they have been unable to keep, so there has been a natural tendency to use less conservative accounting policies to flatter the numbers."

After blithely ignoring accounting and disclosure issues when markets were booming, investors might now be fairly accused of overreaction, not to mention panic, though that is not to say there is no need for significant change in these areas. Says Philip Crate, head of European credit research at Bear Stearns: "We are in a period where liquidity levels are tight and the markets are overshooting. If there is the slightest whiff of a problem – an accounting smell – there will be a sell off. This is end of the cycle stuff."

Klaas Smits, credit investment manager at Robeco Asset Management in Amsterdam, agrees that markets could currently be accused of pursuing a witch-hunt, with even the faintest suspicion of poor financial disclosure resulting in dire punishment for share prices. "Investors should always be aware that although most companies tend to have aggressive accounting standards it does not mean that they falsify records. There are many companies that are being unfairly punished because the market has a tendency to overreact."

But some of the fear is warranted. The ruling by a Los Angeles court against Cable & Wireless over the enhancement of Global Crossing's revenues appears to be justification enough for a certain amount of investor panic.

To say that regulators and the markets, particularly in the US, are now engaged in a period of intense soul-searching is an understatement. Pat McConnell, a tax and accounting analyst at Bear Stearns in New York, was damning in her assessment of financial disclosure in a late February conference call entitled 'Life after Enron'. "The failure of Enron has intensified the crisis in confidence that I believe began long before Enron," she says. "People I am talking to clearly doubt management credibility; they have less confidence in earnings releases; and they also doubt audited financial statements. They believe auditors lack objectivity and independence or at best lack intelligence. They are not even certain that accounting rules provide relevant and useful information even when they are applied correctly and without prejudice."

She adds: "None of the factors that contributed to the Enron failure are new in our view: they are as old as the financial markets themselves. Off-balance sheet financing, mark-to-market accounting, insufficient or incomplete disclosure, independence and the lack of regulation of the auditing profession are all areas that were recognised by regulators as problems long before Enron. It is clear that these areas need attention."

Although McConnell says that like past crises, this one should bring about real change to both disclosure of financial information and the auditing of it, she says it should not be forgotten that disclosure is better now than at any time in the past. "We must recognise the vast improvement in the quality of financial reporting over the last 25 years," she says.

The reality, though, is that confidence has collapsed, and not without good reason, leading to intense pressure on companies from investors. "There are so many pressures on companies that there will be a lot more transparency from now on," says one banker in London. "Not least, nobody will argue any more that off-balance sheet structures need not be disclosed. As an investor I would be forcing companies to adopt the position I want, namely, full disclosure about a company's finances. If investors do not have confidence in the financial communication from a company, it will affect prices (for the company in the equity and bond markets)."

Olivier Khayat, head of debt capital markets at French investment bank SG, agrees. "There will be enormous pressure from investors on companies to prove that there are not going to be any nasty financial surprises. If you go to roadshows right now and listen to what investors are asking, it is largely driven by disclosure issues. Investors are saying to companies: 'We are not going to buy your bonds unless you are absolutely straight with us'."

In recent weeks the new economy has done its best to keep investors on a state of high alert. First there was the launch of an investigation by the US Federal Bureau of Investigation into the use of long-term contracts in the accounts of Global Crossing, together with the use of clandestine swaps. Next came KPNQwest, which was put under the spotlight after it emerged that 15%, €120 million, of the firm's revenues came from capacity swaps. Under closer scrutiny analysts felt comfortable that the deals were not hollow swaps – buying and selling overlapping networks to boost revenue figures – but by then KPNQwest had been hit hard by the disclosure stick.

Other instances of investors’ nerves being sorely tested include a probe into accounting irregularities at Irish drugmaker, Elan; and an embarrassing climbdown by IBM after investors demanded a more detailed breakdown of earnings, in relation to the use of a $340 million sale to offset costs.

And always in the background, fears persist of another Enron coming to light. "The markets are clearly nervous that Enron may not be a one-off and that this could happen again, but who the next company might be is pure speculation," says Anja King, co-head of European credit research at Deutsche Bank in London.

In the credit markets, the anxiety over accounting and auditing practices has resulted in a collapse in demand last month. For example, only one-third of European investors polled in a recent JPMorgan client survey said they would be adding to credit last month, compared with 62% in January.

The obvious question, of course, is what will happen now? What changes are likely to be made to auditing practices and accounting standards? Given the can of worms that has been opened, it is difficult to provide a succinct answer.

Changes, though, there will be. To take just one area – fair value accounting – the Enron scandal has dealt a serious blow to the US’s Financial Accounting Standard Board's (FASB) drive towards fair value accounting for all financial assets and liabilities, including financial derivatives. As one banker points out: "The problem with fair value accounting is that there is little or no guidance on how fair value should be determined when there is no deep or liquid market, and Enron has underlined that in no uncertain terms."

Away from issues relating directly to the Enron debacle, the ditching of pro forma reporting is one change in accounting policy that may become quickly apparent, as companies respond to the overwhelming demand from investors for transparency. "Pro forma accounting will be laughed out of court," says one banker. "The idea of companies going to investors and saying 'we didn't make net profits but if you look at this particular figure', or 'this is a one-off restructuring charge' to be shortly followed by 'this is another one-off restructuring charge' – you can forget it."

The most obvious fall-out from the Enron default is the changes to the FASB’s guidelines on the consolidation of special purpose entities (SPEs), along with the more general reassessment that is taking place of the effectiveness of the US's General Accepted Accounting Principles (Gaap).

Gaap was viewed by many as the paradigm of accounting standards before Enron's failure. US Gaap's mechanistic approach to accounting – sometimes referred to as a 'bright lines' method – is very explicit on what should be disclosed and what is not permitted, but that philosophy is now being questioned.

"The truth," says Emmanuel Weyd, credit analyst at JPMorgan, "is that there was almost limitless faith in US Gaap and that faith has been shaken. If you shake absolute faith then people will start to doubt everything."

Frits Bolkestein, the European Union commissioner responsible for the internal market, does not prevaricate in his assessment of US Gaap. In a recent interview Bolkestein said: "I have asked accountants: was it [Enron's collapse] just hanky-panky or did the particular nature of US Gaap enter into the game? The answer is yes, it had something to do with the rules of US Gaap."

That sentiment strikes a chord elsewhere. "US Gaap is more prescriptive and rules-based than UK Gaap, for example, or the International Accounting Standards," says a banker in London, “so theoretically a company could go to its auditors and say ‘we have this idea for hiding something’ and theoretically, the auditor could get the rule book out and say, 'yes, if you interpret it in such-and-such a fashion it can be viewed as off-balance sheet'. With UK Gaap, on the other hand, it is more to do with substance than form. The auditor would be saying 'in a sense this complies with the rules, but the reality is that it is still your risk and as auditor I am not prepared to sign off on it'."

David Tweedie is chairman of the London-based International Accounting Standards Board, a privately funded independent setter of accounting standards. In mid-February Tweedie told a US senate committee that "taken as a whole US Gaap is the most detailed and comprehensive in the world. However, that does not mean that every individual US standard is the best, or that the US approach to standards is the best."

He added: "The IASB has concluded that a body of detailed guidance [like US Gaap] encourages a rulebook mentality of where does it say I can't do this. This is counter-productive and helps those who are intent on finding a way around standards more than it helps those seeking to apply standards in a way that gives useful information. The emphasis tends to be on compliance with the letter of the rule rather than on the spirit of the accounting standard."

There are now growing calls for US Gaap to adopt the more flexible approach advocated by the IASB and used in the International Accounting Standards (IAS), the main rival to US Gaap. Bolkestein says that although rules are good in accounting practices they should not be excessively rigid. Accountants should not merely be required to tick boxes, they should be given a certain amount of latitude within which to work.

But John Davis, chief financial advisor at Schroders Investment Management in New York is doubtful that changes to US Gaap will be made along those lines any time soon. "The immediate reaction will be towards a less flexible approach: more prescriptive with a brightening of the lines," he says "In the short-term this will reduce the use of [off-balance sheet] finance vehicles but there is tremendous creativity in the financial markets so they will adapt relatively quickly. New vehicles will be developed for the new rules."

Adds Davis: "This would have a counter productive effect if it was long lasting but after the hysteria has died down then there will be homogenisation of international accounting standards. And of necessity this will be principle based."

Edmund Jenkins, chairman of the FASB disputes that current US regulations allow accountants to simply abide by the rule of the law while ignoring the spirit. "Auditors must not accept facile arguments by a reporting entity's management that the financial statements are acceptable just because the language of the standards does not explicitly prohibit an inventive reporting technique that is intended to hide information," he says.

Where the FASB is looking to immediately effect changes is the consolidation of asset-backed SPEs – changes that are expected to have far reaching effects. Under the present guidelines, a company is not required to consolidate an SPE's assets and liabilities if the vehicle is owned by an independent entity that has a "significant equity stake" in the SPE and is exposed to significant upside and downside in the transaction.

In practice a "significant equity stake" usually only represents 3% of the funding of the SPE. The FASB is now proposing that for an SPE to be unconsolidated, the equity interest should be raised to 10%, and even then, the equity interest would not be considered "significant" if there was not convincing exposure to the upside and downside of the transaction.

McConnell at Bear Stearns says: "Financial asset SPEs should have no problem with the new rules, but asset-backed SPEs will have to be measured in light of them. Will the rules – which are still to be exactly determined – affect existing SPEs? We think so; but on a prospective basis. In other words, companies will not have to restate previously issued financial statements, but may have to consolidate existing SPEs – that at least is our guess."

Adds Khayat at SG: "There are big consequences for the off-balance sheet business. Anything that is a deconsolidating tool could be affected. Considering the huge amount of financing that is done off-balance sheet, this is a critical issue." The US asset-backed security market is measured in trillions of dollars. Davis at Schroders thinks the changes to the FASB guidelines could cause up to 1% of this to be forced back onto companies' balance sheets.

The consequences for the creditworthiness of sponsoring corporations could be significant. In late January, the US Securities and Exchange Commission forced PNC Financial to consolidate some SPEs in its balance sheet instead of treating them as only partly owned, costing the company $155 million. Analysts say the move was not connected to the debate raging over whether or not SPEs should be consolidated, and would have happened with or without Enron. Nevertheless, it has done nothing to ease investors' anxiety.

Says McConnell: "For non-financial assets it could be any company in any industry [that is at risk of its SPEs not qualifying]. Probably any company is at risk unless it is clear that the substance of the transaction has moved the risks and rewards of ownership to independent majority owner of the SPE."

The way in which the CDO market has been dragged into the debate shows how far reaching the changes to the FASB's guidelines might be. "Although FASB's review of SPE accounting is not motivated by collateralized debt obligation (CDO) structures, the rule changes being considered could have a significant impact on the CDO market," noted credit derivatives strategist Alex Reyfman in a recent Goldman Sachs report. "Although the [FASB] rules have not been finalized and substantial proposals may take place, we consider some possible scenarios. For existing transactions, the manager will likely be the Primary Beneficiary. Except in the rare instance of 10% or larger equity class and zero manager holdings, CDO managers will probably face consolidation. Some managers, such as private partnerships, mutual fund groups, and mutual insurance companies may be fairly insensitive to consolidation.

“Additionally, entities not subject to US Gaap are unaffected by the changes being considered. Other manager types, such as banks and public equity insurance companies, find consolidating CDO assets and liabilities to be very painful. In these instances we expect to see either substantial restructuring of the CDO or an attempt by the manager to point to a different party – such as the largest equity investor – as the Primary Beneficiary.”

The disconcerting title of the Goldman Sachs report was "Unexpected fallout from the Enron default: Accounting uncertainty for CDOs." Plenty more unexpected fallout can be expected in the coming months.

Additional reporting by Hardeep Dhillon and Euan Hagger