by Paul B. W. Miller and Paul R. Bahnson
Many fascinating plot twists and turns continue to appear as the Enron story unfolds.
One that we find particularly ironic concerns Andy Fastow, the former chief financial officer who was forced out in the fall of 2001 as the mysteries of Enron's off-balance-sheet partnership obligations began to emerge.
Fastow, the architect of Enron's stealthy financing, is being vilified for the role that he played in keeping Enron's investors and creditors in the dark about the company's real financial situation. The reported fact that he made more than $30 million from the limited partnership deals adds fuel to the fire. He is perhaps first among many pariahs in this case.
Now, turn the clock back a mere two years. Guess who received the CFO Excellence Award for Capital Structure Management? That's right! None other than Fastow, who got the award for his "expert balancing act" in providing "huge amounts of capital without diluting the stock price or deteriorating [Enron's] credit quality," according to the story in the October 1999 CFO magazine, profiling him as the paragon of cleverness.
The article is interesting reading with today's hindsight. We would enjoy the irony of Fastow's O'Henry-like loss of status more if it were mere fiction and hadn't left so many people holding worthless investments. We see no clarion signals in the 1999 article that a reader could have used to sense that Enron was headed for a disaster. However, we do see a huge warning sign when we look through the lens of QFR, the acronym for our new reporting model called quality financial reporting.
And we think that that sign should be of particular interest to CFOs and others as a test of whether they are potentially at risk of being seen as "Enron-minded" by market participants who are interested in purging their portfolios of companies whose real financial status does not live up to what is in the statements. Articles in the press and comments by members of Congress suggest that investors, analysts and others are intent on doing just that.
We have been thinking and writing about QFR for more than five years now. In essence, QFR is a new financial reporting paradigm that says that managers ultimately win in the capital markets by truly putting investors' information needs first. We are not talking about lip service but actually walking the walk. Specifically, QFR leads managers to, first, find out what information the capital markets want to know and then provide it in a timely and communicative way.
The rationale for this strangely unconventional approach is that reducing investors' risk ultimately translates to a lower cost of capital and higher stock prices for managers that choose to pursue it. If there was any doubt that markets discount share prices when they're nervous about risk, there can be none now in the post Enron world. From what we know at this point, Fastow's practices are antithetical to QFR. However, bad examples are sometimes more persuasive arguments for change than good ones.
So, what warning sign do we see in the 1999 article about Fastow and Enron? It's what we call "breakthrough accounting." Some of you may remember a cartoon from a number of years ago in The New Yorker. It showed a chief executive with his hands on the shoulders of another man in shirtsleeves, telling him, "It's up to you now, Miller. The only thing that can save us is an accounting breakthrough."
As we see it, breakthrough accounting is the dark art of engineering financial statements to hide business problems. Who cares if your real earnings are volatile? You can always "fix" them with accounting. And by fix, we don't mean limiting or removing the real volatility, but merely papering it over with smoothed income statements. In the same way, is your balance sheet dragged down by too much debt? Breakthrough accounting can surely find a way to hide it somewhere out of sight even though it is still lurking about - and, at some point, will be a drain on corporate coffers.
To the credit of CFO magazine's editors, the January 2002 issue excoriates Fastow for deceiving both them and the public. They reported: "More than two years ago, as part of an interview with CFO, Fastow boasted that he had helped keep almost $1 billion in debt off Enron's balance sheet through the use of a complex and innovative arrangement. 'It's not consolidated and it's non-recourse,' he told the magazine. Maybe it depends on how you define 'non-recourse.' In fact, the 10-Q that Enron filed on Nov. 19, 2001, states plainly that the debt, ultimately, was Enron's responsibility. According to the filing, the $915 million debt was backed by Enron's obligation to extinguish it, if necessary with cash."
The editors went on to say, "That obligation, as reported in the 10-Q, would fall to Enron if the company experienced a downgrade below investment grade by any of the three major credit rating agencies. Sure enough, that downgrade took place shortly after the disclosure of the $915 million obligation, along with another $3 billion in similar off-balance-sheet liabilities." So much for Fastow as a paragon.
What are the signs that indicate that a person is an accomplished practitioner of breakthrough accounting? It all starts with a corporate culture of wanting more than is humanly possible - like raising large amounts of capital without adding debt or diluting equity. Throw in a large staff whose job it is to find the breakthroughs, led by someone who is comfortable playing outside the rules.
Of course, it helps to throw piles of money at them as rewards for past success. Finally, outside accolades confirm the merits of the gaming already done and provide further encouragement to venture even further out of bounds.
As Enron shows, breakthrough accounting is even better when served with substandard disclosures that keep users guessing. Never mind that it's a ticking bomb waiting to explode in the face of its builder.
The frightening question on many lips is what other Enrons are out there? It is a good time for all of us to ask about the paths we have chosen - the Latin expression is "quo vadis?"
If you're a corporate accountant, are your company's financial statements the products of breakthrough accounting? Clearly, special purpose entities are worrisome. But so too are poolings, operating leases, stock options kept off the income statement and other well known devices for elevating form over substance.
If you're an auditor, have you turned a blind eye to gaming or, worse yet, helped your clients make breakthroughs? Andersen seems to have done both for Enron and it is not sitting pretty. In answering this question, don't take any comfort in finding yourself within the pack.
Our sense is that the markets' tolerance for breakthrough artists in these post-Enron days will be nothing like it was before. It's time to adopt QFR. Voluntarily. It's the right path for the true paragon.
