Enron Corp. was hardly the only company
in the nation to keep important elements of its finances off its books,
out of public view. Since Enron's highly publicized unraveling, several
companies have set their books straight, disclosing transactions that
were once invisible. Anxious shareholders have been selling stocks of
corporations whose financial statements seem unusually difficult to understand.
Many investors are wondering just how much of corporate America's financial
picture may be hidden, and how the omission of significant facts could
have been allowed in the first place. "Enron is the tip of the iceberg,"
said Frank Partnoy, a professor at the University of San Diego School
of Law who testified at a Senate hearing on Enron's collapse last week.
Enron's spiral into bankruptcy followed the disclosure last fall that
it had vast debts lurking in off-the-books partnerships run by its chief
financial officer. The Houston energy trader, it turns out, remained on
the hook for substantial, undisclosed risks, because it provided financial
guarantees to other investors in some of its off-the-books partnerships.
Accounting experts say there is no way to measure how much corporate debt
does not appear on balance sheets. Many companies move assets off their
books for a variety of legitimate business reasons, such as raising cash.
Doing so is not misleading if a company divorces itself from the risks
and rewards associated with the off-the-books activity.
"There's skepticism about financial reporting that is not justified
by reality," said Philip Ameen, vice president and comptroller of
General Electric Co., whose books have been criticized for opaque accounting
and disclosure practices. Though he said the public reaction is "understandable,"
corporate America is "much better than we appear to be." On
Wednesday, PNC Financial Services, a large Pittsburgh banking firm, cut
its earnings for last year from $567 million to $155 million after the
Federal Reserve Board forced it to move back onto its books $550 million
in loans it had sold to three entities created exclusively to buy and
resell them. Payments on almost a quarter of the loans are past due. Two
weeks ago, discount retailer Dollar General Corp. corrected its financial
results for 1998 through 2000, slashing previously reported earnings and
adding $511 million of long-term debt to its balance sheet.
The company said it determined that debts associated with "synthetic
leases" for real estate -- about 400 stores, two distribution centers
and the company's Tennessee headquarters -- were improperly kept off its
books, and expenses associated with those leases were understated. Yesterday,
Cendant Corp., which franchises Days Inn hotels and Coldwell Banker real
estate brokerages, put detailed information about its off-balance-sheet
partnerships on its Web site. Chief executive Henry Silverman said the
move was an effort to "provide clarity and eliminate further misunderstanding."
And credit rating agencies, which are supposed to get a closer look at
a company's books than the average investor, said they are beginning to
ask more questions about off-the-books liabilities. The rating agencies
also are asking about any circumstances, such as a fall in stock price,
that might force a company to spend money to prop up those entities. Bill
Stromberg, director of equity research at T. Rowe Price, the big Baltimore
fund family, said there are several ways of structuring off-balance-sheet
items. "There's nothing structurally wrong about any one of them
as long as they are adequately disclosed and clear enough for analysts
to figure out what is going on economically," he said.
But he added: "The disclosure rules could be firmer. Sometimes you
can operate within the letter of the law but be very opaque about it."
GE, which is largely a finance company, has about $55 billion worth of
assets such as loans, leases and credit card receivables off its books
in "special-purpose entities." They represent about 10 percent
of GE's total assets. But GE spokesman David Frail said those are "fairly
high-quality assets" and "circumstances would have to be absolutely
extraordinary" for the off-the-books businesses to affect GE. "There's
no comparison between an Enron and GE," Frail said, adding that GE
plans to expand its disclosures in the future.
SPEs, as they are often called, grew up in the 1980s at the behest of
Wall Street firms looking for "creative" ways for clients to
finance their operations. SPEs have myriad uses, such as attracting new
investors, participating in complex credit deals and improving the tax
treatment of certain transactions. As Joseph F. Berardino, chief executive
of Enron auditor Arthur Andersen, told a House committee in December,
the entities permit business to raise capital or boost borrowing "without
adding debt to their balance sheet." Enron ran afoul of an accounting
convention that says an off-the-books enterprise must get at least 3 percent
of its capital from an independent third party. For at least one of Enron's
partnerships, the third-party investor, a big bank, had put at risk only
half the required amount.
The story of the 3 percent test shows how murky accounting standards can
be on important issues. It began more than a decade ago, when the Securities
and Exchange Commission was concerned that businesses were using legal
charades to put title to property -- office buildings, rail cars, airplanes
-- in the names of SPEs and avoid booking debts. Though companies and
their auditors now treat the 3 percent test as accounting gospel, it is
almost apocryphal. In 1991, a task force of the Financial Accounting Standards
Board, a private group that writes the rules for accounting, issued a
document to provide guidance on when such leases could be kept off a company's
books. It said companies should put such leases on their books if, among
other things, the special-purpose entity lacked a "substantive"
capital investment from an independent owner. The task force didn't say
what it meant by "substantive."
The 3 percent figure entered the accounting literature when the SEC staff
wrote a letter commenting on the task force's conclusions. The letter
noted that members of a panel formed to advise the task force believed
that 3 percent was the minimum acceptable outside investment. But the
SEC staff said it believed "a greater investment may be necessary
depending on the facts and circumstances." It is unclear whether
the task force's guidelines were ever intended to apply to anything other
than leases.
Some members of the working group said 3 percent was chosen because that
was the amount of capital leasing companies were putting into deals at
the time. But people at the SEC worried that a mere 3 percent outside
investment was too small to "make this thing look real" and
justify keeping a venture off a company's books, one person familiar with
the history said. The task force that produced the original guidance included
representatives of major accounting firms such as Arthur Andersen, Coopers
& Lybrand, Deloitte and Touche, and Ernst & Young, along with
corporate executives, such as one from General Electric. The group that
advised the task force was chaired by Robert K. Herdman, who was then
with Ernst & Young. Herdman is now the SEC's chief accountant. Herdman
declined to be interviewed for this article. Through an SEC spokesman,
he said the 1991 task force statement "was an appropriate approach
for its time," but "present circumstances require a more comprehensive
approach." Herdman predicted that accounting standard-setters will
come up with a new standard this year.
In Enron's case, standards board President Edmund L. Jenkins said, it
appears that side agreements to repay partnership investors should have
required the assets and debts to be consolidated with its own books. Jenkins,
a former Andersen partner, said it was Enron's behavior, not the rules
themselves, that was at fault. "We haven't seen anything yet to indicate
where current required reporting standards failed. We don't know why [Enron]
didn't follow them," Jenkins said.