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Threads on Accounting Tricks and Creative Accounting

Bob Jensen at Trinity University

Background Reference Links for This Document
Bob Jensen's homepage --- 
Bob Jensen's accounting theory documents --- 
Bob Jensen's threads on derivatives instruments fraud --- 
Bob Jensen's threads on revenue accounting --- 
Bob Jensen's accounting fraud documents (including Enron) --- 
Bob Jensen's threads of special purpose entities (SPEs) --- 
Bob Jensen's electronic commerce documents --- 
Bob Jensen's helpers for accounting educators --- 
Bob Jensen's archives of new bookmarks --- 

For Updates See
Creative Earnings Management, Agency Theory, and Accounting Manipulations to Cook the Books ---

Accounting Educators should pay more attention to the following blog that seeks out weaknesses in company filings of 10Q (and other reports) with the SEC

10Q Detective blog by David Phillips ---

Investors often overlook SEC filings, and it is the job of the 10Q Detective to dig through businesses’ 8-K and 10-Q SEC filings, looking for financial statement ‘soft spots,' (depreciation policies, warranty reserves, and restructuring charges, etc.) that may materially impact Quality of Earnings

Bob Jensen's threads on accounting theory are at

State of Accountancy in the Year 2002: My Lectures for Germany (Augsburg and Rothenburg) in June --- 

I have placed a draft of my forthcoming lectures this month in Germany. Some may find some value in these and many will find issues to dispute.  I would love to hear about any suggestions for improvements.  My email address is 

"Why Do CFOs Become Involved in Material Accounting Manipulations?" Harvard Law School Forum, December 20, 2010 ---

In the paper, Why Do CFOs Become Involved in Material Accounting Manipulations? we investigate why CFOs become involved in material accounting manipulations. To address this research question, we examine two possible explanations. CFOs might instigate accounting manipulations for immediate personal financial gain, as reflected in their equity compensation. Alternatively, CFOs could manipulate the financial reports under pressure from CEOs.

Using a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005, we investigate the costs and benefits associated with intentional financial misreporting for CFOs. We find that CFOs bear substantial legal costs when involved in accounting manipulations. We also document that these CFO equity incentives (measured by pay-for-performance sensitivity) are not significantly different from those of CFOs of control firms. However, CEOs of the manipulation firms have significantly higher equity incentives and power than CEOs of the control firms. Moreover, CFO turnover is significantly higher within three years prior to the occurrences of material accounting manipulations for manipulation firms than control firms, consistent with CFOs facing significant costs (loss of job) for saying no to CEO pressure. Finally, our AAER content analyses suggest that CEOs of manipulation firms are more likely than CFOs to be described as having orchestrated the manipulation and to be requested to disgorge financial gains from the manipulation. Taken together, our findings suggest that CFOs are likely to become involved in material accounting manipulations because they succumb to CEO pressure, rather than because they seek immediate financial benefit.

Some caveats are in order. First, we assume that CFOs of accounting manipulation firms are aware of or are involved in misreporting. We believe this assumption is reasonable given that one of the main job responsibilities of CFOs is to watch over the financial reporting process and make related decisions. However, in some unusual cases accounting manipulations could occur without the knowledge of CFOs (e.g., CEOs collude with divisional managers to create fictitious sales and hide the manipulation from CFOs). These cases are likely to add noise instead of introducing a systematic bias to our empirical results. Second, we assume that the companies identified by the SEC have indeed manipulated financial statements. This assumption seems reasonable given that the SEC spends effort and resources to establish evidence for the alleged manipulations. However, the SEC likely does not identify all the companies with accounting manipulations; as a result, some of our control firms might have “undetected” manipulations. This issue would be a concern if the SEC systematically pursues companies with characteristics examined and found significant in our empirical tests, but we are not aware of any evidence supporting this possibility.

While subject to these caveats, our paper contributes to the understanding of CFOs’ incentives when they face accounting manipulation decisions. Our findings suggest that CFOs are typically not the instigator of accounting manipulations. Instead, it appears that CEOs, especially powerful CEOs with high equity incentives, exert significant influence over CFOs’ financial reporting decisions. In other words, CFOs’ role as watchdog over financial reports is compromised by the pressure from CEOs. Overall, the findings of this study suggest a corporate governance failure for the accounting manipulation firms, and have important implications for current corporate governance reform. While researchers, practitioners, and regulators have generally concluded that stock-based compensation has provided managers with incentives to misstate accounting numbers, our results indicate that re-designing compensation packages for CFOs is not necessarily the only remedy. Improving CFO independence by alleviating the pressure of CEOs on CFOs could be critical to improving financial reporting quality. One possible way to achieve this would be to have boards or audit committees more involved in CFO performance evaluation and in hiring and retention decisions (Matejka, 2007).

The full paper is available for download here.--- 

Bob Jensen's threads on creative accounting are at

August 6, 2002 message from Miklos A. Vasarhelyi 

its is probably redundant with what you already do but i created a short list on "cooking the books" that i distribute to students and friends. happy to add you to the list... one or two articles a weekday max...


I don't know of a nice neat and concise summary. Any summary at this point will miss a lot of items, because so much is still under investigation. For example, a Bloomberg reporter called me yesterday and disclosed that Citibank and Enron had entered into a "credit swap" that was in fact just a ploy to keep a $1 billion loan off the books. Details as of yet are unknown.

I have just commenced to provide a listing of some of the tricks. This is only the start of a draft at 

A concise (and somewhat off-the-wall) summary of Enron dealings is provided in a PowerPoint slide show by Phil Livingston, President of the FEI. Go to 

You should note that Enron marketed its book cooking recipes --- 

The best single source (not concise) of the many Raptor deals is the Powers Report --- 

Another source (not concise) is a set of internal communications between Andersen Chicago and Andersen Houston ---

Probably the most complicated and the most unknown dealings are the energy trading activities combined with Enron's rather generous financing deals for its customers. Here I find inconsistencies between reports that trading in derivatives was a major source of disaster versus reports that the derivatives were the most profitable operations in Enron. If you find a good source on these issues, I would love to hear about it.

There are some gems in the memoranda links on a timeline at 

No professional wants to be deceived, but sometimes it just happens. Criminals lie to their lawyers, students cheat on tests given by their teachers, and clients alter financial statements prepared by their CPAs. 

It appears that major banks participated in Enron's plot to report loans and revenue.

"Energy Deals Made $200 Million In Fees for Citigroup, J.P. Morgan," by Paul Beckett and Jathon Sapsford, The Wall Street Journal, July 24, 2002 ---,,SB1027459914213766120,00.html?mod=todays%5Fus%5Fpageone%5Fhs 

WASHINGTON -- Citigroup Inc. and J.P. Morgan Chase & Co. made more than $200 million in fees for transactions that helped Enron Corp. and other energy companies boost their cash flow and hide debt, according to congressional investigators and others.

In a congressional hearing Tuesday, investigators also laid out evidence from company documents that suggested the bankers knew of Enron's aim to avoid scrutiny through the deals. Along with the banks' acknowledgment that they marketed such schemes to other energy companies, some legal specialists said the evidence raised the specter of possible criminal or civil liability for the nation's two largest financial institutions.

Both banks defended the transactions as legitimate Tuesday, often in the face of hostile questioning from the Senate Permanent Subcommittee on Investigations. The banks contend that none of the transactions broke any laws, and that it was not their job to audit how the energy company booked the transactions.

The hearing aimed to determine how much Wall Street enabled the complex arrangements that helped fuel the spectacular rise and swoon of the energy industry. As it went on, shares in both banks plunged.

In 4 p.m. New York Stock Exchange composite trading, Citigroup shares sank 15.7%, or $5.04, to $27. Its high, in September 2000 was $59. J.P. Morgan stock was off 18.1%, or $4.44, at $20.08 a share -- down from a March 2000 high of $67.

"If it looks like the banks gave companies intricate instruction on how to do all this, the banks are going to face a significant chance of being indicted," said Christopher J. Bebel, a partner with Shepherd, Smith & Bebel. Mr. Bebel is a former consultant for the Department of Justice and a former Securities and Exchange Commission investigator.

The structures the banks were promoting to Enron and energy companies involve prepaid oil and gas contracts, in which money is paid up front for future delivery of the commodity. Those are common in the industry. But energy companies employed complex circular trades among an offshore entity, the banks and themselves, enabling them to book that cash as part of their trading operations -- instead of as debt -- and also keep investors in the dark.

To help sell these financing deals, according to new documents released Tuesday, Citigroup and J.P. Morgan developed pitch books about how companies could use their services. Critics allege the strategies deceived investors by masking a company's true financial health.

One Citigroup presentation from last year, for instance, touts how using such an arrangement "eliminates the need for Capital Markets disclosure, keeping structure mechanics private" and that "ratings agencies will not view the proceeds raised ... as company debt." For its part, J.P. Morgan, in a July 1998 presentation, noted that such structures were "balance sheet 'friendly.' "

In one February 1999 e-mail disclosed Tuesday, Adam Kulick, a Citigroup vice president, told colleagues that "the client does not wish to have to explain the details of many of the assets to investors or rating agencies." The e-mail went to Citigroup's working group for the biggest of the Enron transactions, a series of deals dubbed "Yosemite." Neither bank commented on the individual documents.

Officials at ratings agencies Moody's Investors Service and Standard & Poor's said at the hearing that if they had known how Enron was boosting cash flow and hiding debt they would have given the company a much lower credit rating than the investment grade it enjoyed until just before its collapse.

In addition to Citigroup's 10 transactions with Enron through June 2001, the bank disclosed for the first time that it engaged in earlier prepaid trades involving special-purpose vehicles with other firms -- Arkla Exploration Co. in 1992 and Amerada Hess Corp. in 1993. A spokesman for Amerada Hess said all of the trades were accounted for properly. A spokeswoman for Arkla couldn't immediately comment.

Citigroup also said it had made presentations on financing arrangements similar to Yosemite to many of the best-known players in the energy business -- including Williams Cos., El Paso Corp., Reliant, Dynegy Inc., and Duke Energy. Citigroup said none of those companies took the bank up on its offer. Duke, Williams, Dynegy, Reliant and El Paso declined to comment.

J.P. Morgan said that besides Enron seven other companies used the same offshore vehicle it established, called Mahonia Ltd., or a successor. The bank named Columbia Natural Resources Inc., now part of NiSource Inc., Occidental Petroleum Co.; Ocean Energy Inc.; Santa Fe Snyder Corp., which is now part of Devon Energy Corp.; and Tom Brown Inc. Spokesmen for those companies said the transactions with J.P. Morgan were all accounted for properly.

J.P. Morgan said the widespread use of prepaid contracts bolstered the bank's contention that they were both legal and in accordance with accounting principles. "Prepaid forwards are widely used deals by a large number of companies," the bank said in a statement. "The fact that they were widespread demonstrates that several outside firms found that they were legal and appropriate."

Continued at,,SB1027459914213766120,00.html?mod=todays%5Fus%5Fpageone%5Fhs  

"System Failure:  Corporate America:  We Have a Crisis," Fortune Magazine Cover Story, June 24, 2002 --- 

Goldman Sachs CEO Hank Paulson is not a touchy-feely guy. Even by Wall Street standards, he's fairly buttoned down. But the daily drumbeat of news about horrifying corporate behavior would get to anyone--and it's clearly getting to Paulson. "In my lifetime, American business has never been under such scrutiny, and to be blunt, much of it deserved,'' he said in a recent speech. To FORTUNE he added, "You pick up the paper, and you want to cry.''

You sure do. Every day, it seems, a new scandal bursts into public view. Bankrupt Kmart is under SEC investigation for allegedly cooking the books. Adelphia's founding family is forced to resign in disgrace after it's revealed that members used the company as their own personal piggy bank, dipping into corporate funds to subsidize the Buffalo Sabres hockey team, among other things. Former telecom behemoths WorldCom, Qwest, and Global Crossing are all being investigated. Edison Schools gets spanked by the SEC for booking revenues that the company never actually saw. Dynegy CEO Chuck Watson denies that his company used special-purpose entities to disguise debt a la Enron--until the Wall Street Journal reports that, lo and behold, the company does have one, called Project Alpha. (Watson has just stepped down.) Most recently, of course, Tyco CEO Dennis Kozlowski resigns after informing his board that he is under investigation for evading sales tax on expensive artwork he purchased. Kozlowski has since been indicted--but even before the most recent disclosures, Tyco's stock was pummeled by the widespread suspicion that it used accounting tricks to boost revenues (a claim the company has consistently denied).

Phony earnings, inflated revenues, conflicted Wall Street analysts, directors asleep at the switch--this isn't just a few bad apples we're talking about here. This, my friends, is a systemic breakdown. Nearly every known check on corporate behavior--moral, regulatory, you name it--fell by the wayside, replaced by the stupendous greed that marked the end of the bubble. And that has created a crisis of investor confidence the likes of which hasn't been seen since--well, since the Great Depression.

Even Harvey Pitt and Bill Lerach, who are poles apart on most issues, agree on this point. "I'm really afraid that investor psychology in this country has suffered a very serious blow," says the controversial Lerach, the plaintiffs attorney best known as the lead counsel representing Enron's beleaguered shareholders. SEC Chairman Pitt, who made his name defending big corporations, concurs: "It would be hard to overstate the need to remedy the loss of confidence,'' he said at a recent conference at Stanford Law School. "Restoring public confidence is the No. 1 goal on our agenda."

Declining investor confidence is not the only reason the stock market is hurting, of course. (The S&P 500 is down 10% so far this year, while the Nasdaq has fallen 20%.) For one thing, the world is an unsettling place right now, with Pakistan and India busy saber rattling, the Mideast in turmoil--and the threat of more terrorist attacks on U.S. soil very much in the air. For another, stocks remain high by historical standards: Even with a 20% drop since its peak in March 2000, the price/earnings ratio for the S&P 500 is still 29, compared with the norm of 16.

Despite the constant reports of misconduct, investors can't cast all the blame for the market's troubles on the actions of CEOs and Wall Street analysts--much as they might like to. There was a time not too long ago when everyone, it seemed, was day trading during lunch breaks. As Gail Dudack, chief strategist for SunGard Institutional Brokerage, puts it, "A stock market bubble requires the cooperation of everyone."

Still, the unending revelations--and the high likelihood that there are more to come--have underscored the extent to which the system has gone awry. That has taken a toll on investors' psyches. According to a Pew Forum survey conducted in late March, Americans now think more highly of Washington politicians than they do of business executives. (Yes, it's that bad.) A monthly survey of "investor optimism" conducted by UBS and Gallup shows that the mood among investors today is almost as grim as it was after Sept. 11--and has sunk by nearly half since the giddy days of late 1999 and early 2000. Similarly, the average daily trading volume at Charles Schwab & Co.--another good barometer of investor confidence--is down 54% from the height of the bull market. "People deeply believed, as an article of faith, in the integrity of the system and the markets," Morgan Stanley strategist Barton Biggs wrote recently. "Sure, it may at times have seemed like a casino, but at least it was an honest casino. Now many people are questioning that basic assumption. Are they players in a loser's game?" Investing, notes Vanguard founder John C. Bogle, "is an act of faith." Without that faith--that reported numbers reflect reality, that companies are being run honestly, that Wall Street is playing it straight, and that investors aren't being hoodwinked--our capital markets simply can't function.

Throughout history, bubbles have been followed by crashes--which in turn have been followed by new laws and new rules designed to curb the excesses of the era just ended. After the South Sea bubble in 1720, points out Columbia University law professor John Coffee, the formation of new corporations was banned for more than 100 years. In the wake of the 1929 Crash--and the subsequent discovery that insiders had used their positions to skim millions from the market--dramatic reforms were enacted, including the creation of the SEC, the passage of the Glass-Steagall Act separating banks from investment houses, and the outlawing of short-selling by corporate officers.

Is the situation today as dire as it was in 1929? Of course not. But it is serious--serious enough that real reform is once again needed to restore confidence in the system. Already there has been a flood of proposals, which range from the good to the not-so-good. For instance, the New York Stock Exchange's recently announced plan to strengthen boards of directors has been widely lauded--praise, we believe, that is quite deserved (see item 5). If enacted, the NYSE reforms will help prod boards to finally act in the interest of shareholders--which, after all, is supposed to be their job. Similarly, the SEC's decision to crack down on Edison Schools sends an enormously important signal. Money that was going to pay, say, teachers' salaries was being booked by the company as revenue--even though the money never actually flowed through Edison. Believe it or not, Edison's accounting abided by Generally Accepted Accounting Principles, or GAAP. In going after Edison, the SEC was saying that simply staying within GAAP is no longer good enough--not if the spirit of the rules is being violated, as was clearly the case with Edison.

The above article discusses some major accounting tricks used in recent years.

When it comes to reporting earnings, U.S. companies have about as much credibility these days as the judges of Olympic figure skating. So how do you begin to restore investor confidence post-Enron, post-Tyco, post-you-name-it? By having companies state profits in a way that is more meaningful and less subject to manipulation. It's not as hard as it sounds.

First, get rid of the absolute funniest numbers--the so-called pro forma earnings companies use to divert attention from their real results. We're talking about things like adjusted earnings, operating earnings, cash earnings, and Ebitda (earnings before interest, tax, depreciation, and amortization). If companies want to tout such random, unaudited, watch-me-pull-a-rabbit-out-of-my-hat figures in their press releases, well, fine. But investors should immediately be able to compare these figures with full financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP) rather than have to wait 45 days or more for the company's SEC filing.

True, GAAP earnings aren't perfect. They, too, can--and must--be improved. Right now, for instance, they don't reflect the real cost of stock options. It's past time to make this happen, no matter how much Silicon Valley screams.

Next, stop the abuse of restructuring charges. The cost of things like plant closings and lay-offs is just part of doing business and should count as an operating expense, not as a special one-time charge. Plus, companies too often set up a reserve to cover restructuring costs, then later quietly shift some of that money back into profits. If that happens, investors ought to know about it. The SEC should make sure they do.

Another favorite accounting trick that has to go: the use of overfunded pension plans to boost income. Standard & Poor's, in its newly formulated "core earnings'' measure, excludes pension income altogether, while including any pension costs. That's not a bad solution, since pension expenses are real, but a company can get its hands on pension income only by dissolving the plan, distributing benefits, and then paying ridiculously high taxes on the remaining money. At the very least companies should be forced to recognize the actual gains and losses of their pension plans--not simply estimate them based on prior years' returns.

None of this will make one iota of difference unless companies adhere to the spirit of accounting rules, not just the letter. Here's one way to help make sure that happens: Donn Vickrey, executive vice president of Camelback Research Alliance, thinks auditors shouldn't just sign off on clients' financial statements. They should also have to grade the quality of their earnings. A company that was ultraconservative in its accounting would get an A, while one that arguably complied with GAAP but used aggressive accounting tricks would receive a D. "Companies would then be under pressure to not just make their numbers but also get the highest-quality ratings,'' Vickrey says. Sure, auditing firms might then be under pressure to inflate grades. But earnings will never mean anything anyway if auditors remain pushovers.

Continued at 

From the June 14 edition of FEI Express

SEC Proposals on: Certification of Financial Statements and Additional Form 8K Requirements The SEC announced this week an additional 2 proposed new rules for public comment. The first would require a company's principal executive officer and principal financial officer to certify the contents of the company's quarterly and annual reports. This proposal is intended to enhance investor confidence in the quality of companies' periodic reports. The Commission also proposed that several new items or events be reported on Form 8-K in an effort to improve the quality, amount and timeliness of public disclosure of extraordinary corporate events. In addition, the Commission proposed that Form 8-K reports, also known as current reports, be filed within two business days instead of the current five to 15 days. Comments on each proposal are due within 60 days of publication in the federal register.

In other SEC news, the SEC announced late Thursday that they will be holding an open meeting on Thursday, June 20th to consider proposing rules to improve the oversight of the auditing process. "The proposed rules would create the framework for a new private sector regulatory scheme for the accountants that audit or review financial statements filed with the Commission. The proposed rules also would reform oversight and improve the accountability of auditors of public companies, thereby enhancing the reliability and integrity of the financial reporting process. Under the proposed framework, a new organization, among other things, would (1) conduct reviews of accounting firms' quality controls, (2) discipline accountants for unethical or incompetent conduct, or other violations of professional standards, and (3) either set or rely on designated private sector bodies to set auditing, quality control and ethics standards." View the other planned agenda items for the open meeting.

Bear Stearns Conference Here's a presentation I made as part of a debate at a technology investor conference hosted by Bear Stearns. You can listen to a replay of the debate on their system at 888-888-9540, PIN # 4520.

USC Highlights I spoke at the USC Financial Reporting Conference last week. Here's some of the highlights of the day, as promised in my last issue. Jackson Day, SEC Deputy Chief Accountant, opened the meeting. His key points were:

Financial reporting is on the front page of our national papers every day. He encouraged all the attendees to step up to the challenge and improve financial reporting. Critical accounting policies - one part is a focus on the estimates made in the financial statements. Alternative estimates that could have been made should be disclosed. Restatement of accounting policies is not the purpose of the disclosure. Also key choices that a company made between alternative policies should be disclosed. Proposals on the horizon - events under 8Ks within two days of the events, and some may be required by the day after the event. About a dozen events were identified, including cases where a company waives codes of conducts or permits exceptions to those policies. Accounting standards setting - substance must be addressed, not the form. The SEC is seeing cases where companies are undertaking transactions for which accounting results are the only purpose. SAS 50 letters are proposed to be eliminated by the auditing standards board and that move is supported by the SEC. These letters address specific transactions and give an accounting firm's opinion on the accounting treatment.

Ed Jenkins, FASB Chairman - spoke to the "E" word: Enron. FASB's focus has to be on the customer, the users of financial statements. They have no authority to enforce the standards. Their job is high-quality standards that will create transparency for the capital markets.

Enron's own investigations and restatements acknowledge that their accounting did not comply with GAAP. The local Andersen office didn't follow the advice of the national technical group.

Consolidations - the FASB is going to issue its SPE work shortly.

Ed also addressed principle-based vs. rule-based standards. The FASB standards are principle-based, but the problem (in his words) is they go on to answer every question that has come up in their comment period and consideration of the standard.

Ed thinks that what needs to be done to get to principle-based standards is: No exceptions to the principle - no more corridor for the pension plan accountings. No more exceptions for derivatives, for example. Companies must account within the intent of the standards. The SEC must also support that application of principle based standards.

On stock option accounting - the IASB's objective is to measure and expense stock options. In the U.S., all options are expensed except those issued to employees on certain terms. Outside the U.S., there are no standards, and even stock appreciation rights are NOT expensed. Ed thinks that if the IASB moves to a standard close to the U.S. standard, that would be a great improvement in global standards.

Derivatives cannot hedge derivatives for accounting purposes -- now or under FASB 133," Bass said. "Does Dave [Duncan] think his accounting works even under FASB 133? No way."
Carl Bass, Andersen Auditor in 1999 who asked to be removed from Enron's audit review responsibilities ---
The main reasons are given in FAS Paragraph 405.  FAS 133 Paragraph 21(2)(c) disallows hedged items to be derivative financial instruments for accounting purposes, because derivative instruments are carried at fair value and cannot therefore be hedged items in fair value hedges.  Also see Paragraphs 405-407.  Paragraph 472 prohibits derivatives from be designated hedged items any type of hedge, including cash flow, fair value, and foreign exchange hedges.  The reason is that derivatives under FAS 133 must be adjusted to fair value with the offset going to current earnings.  This is tantamount to the "equity method" referred to in Paragraph 472.  More importantly from the standpoint of Enron transactions, Paragraphs 230 and 432  prohibit a firm's own equity shares from being hedged items for accounting purposes.  Whenever a firm hedges the value of its own shares, FAS 133 does not allow hedge accounting treatment.  What good is an expert like Carl Bass is the system is designed to ignore his expertise?

Derivatives Instruments Fraud --- 

Overview of Derivative Instruments Accounting --- 

One of the most common "tricks" to keep debt of the balance sheet is to utilize the weak accounting rules for special purpose entities (SPEs).  To read more about the history of and use of SPEs, go to 

A Quote from FAS 123 History (1993)
Dennis R. Beresford and James J. Leisenring came to the Red Lion Inn on a hot August morning with a simple goal: to explain a change in an accounting rule. Before it was over they were lucky to have escaped the first lynching in San Jose in a half-century. Measuring out the rope were 300 seriously pissedÐ off Silicon Valley CEOs and other senior execs who could see the ruin of their lives' work because some glorified bean counters in Washington had decided to count sacrifice flies as home runs.
Michael S. Malone, Upside Today, November 1, 1993 --- 
You can attend a live performance by Dennis Beresford in San Antonio on August 13, 2002 ---  

Employee Stock Options:  My Letter to Senator Schumer ---

When Fortune magazine published its listing of the 500 largest U.S. companies this year, it listed Enron as No. 5 based on nine- month revenue figures. Next to Enron's name were a question mark, exclamation point, and a cross-reference to a separate article about the Revenue Games People (like Enron) Play. "No question about it," the article concludes, "the creativity of corporate accounting knows no bounds." But corporate accountants didn't catch the brunt of the magazine's criticism. Auditors did.

Revenue Round-Trip (Round-Tripping, Roundtripping)

In addition to Enron, Duke Energy Corporation, El Paso Corporation, Dynegy, CMS Energy Corporation, Reliant Resources Inc. and others have been accused by by the Justice Department of "Revenue Round Tripping" according to The Wall Street Journal, July 15, 2002, Page B8 ---,,SB1026489288613564240-search,00.html?collection=wsjie/30day&vql-string=%28Duke%29%3Cin%3E%28article%2Dbody%29

"The Revenue Games People (Like Enron) Play," Carol J Loomis, Fortune, April 15, 2002 --- 

Of all the accounting weirdness around--could anyone ever have dreamed that accounting would vie with pedophilia as front-page news?--the aspect that has most fundamentally affected the FORTUNE 500 is the handling of what are called "energy trading contracts."

These things, almost single-handedly, made Enron one of the largest companies on our list--No. 7 in 2000 and No. 5 this year. These contracts have also caused many other energy and utility companies to show big to enormous increases in revenues from what they originally reported for 2000. A company many of our readers have most likely never heard of, Idacorp (formerly known as Idaho Power), leaped onto the list thanks to a 454% revenue increase; at American Electric Power revenues rose 347%; Calpine's jumped 233%. Another company, Mirant, which was spun out of Southern Co., is popping up on the list for the first time with an astonishing $31.5 billion in revenues--more, for example, than Dell or Motorola. All these figures were blessed by the authorities that FORTUNE has always relied on: companies' outside auditors and their watchdog, the Securities and Exchange Commission

We will explain these wacky revenue leaps. But first, an explanation as to why the Greatest Leaper of them all, Enron, is fifth on our 2001 list. To begin with, Enron, going by the restated financials it issued for the first nine months of last year, inarguably was a huge company. In fact, its $139 billion in revenues for nine months exceeded General Electric's full-year revenues of $125 billion.

Then, on Dec. 2, Enron went into bankruptcy (a fact that doesn't disqualify it from the 500 list), and it has yet to report fourth-quarter results. The missing quarter, in which we knew revenues had fallen dramatically, gave us a problem. So we took a stab at estimating full-year revenues and concluded they might reach a maximum of $160 billion. But rather than create a precedent of using revenue estimates on the FORTUNE 500 list, we decided to rank Enron based on its nine-months revenues of $139 billion--and that figure is what makes it fifth on our list, behind Wal-Mart, Exxon Mobil, GM, and Ford. (Had we used the $160 billion estimate, Enron would still have trailed Ford.) Given the questions that hang over Enron's profits, assets, and stockholders' equity, we didn't think we could report plausible figures for those categories.

So how valid are Enron's mountainous revenues? To answer that you need to understand a bit about energy trading contracts. These are commodity contracts, mainly for natural gas, oil, and electricity, and they are entered into by traders hoping to earn a profit on future shifts in market prices. The traders are not only energy companies but also--and this is a fact that's important to our revenue tale--Wall Street firms such as UBS Warburg, Salomon Smith Barney, J.P. Morgan Chase, and Morgan Stanley.

So let's imagine a contract for $1 million of natural gas (we'll skip the btu details), to be delivered six months from now. If a Wall Street firm sold this contract, nothing called "revenues" would ever be created. Instead, the firm would periodically mark the contract to market--that is, measure the profit or loss earned on the contract--and, when time came to report, put that dollar result into an income statement item called "trading gains and losses" (which is considered revenue on the FORTUNE 500). In accounting parlance, this is known as reporting "net."

But in the 1990s many energy and utility companies, with Enron apparently acting as Pied Piper, began to report a lot of contracts "gross," meaning that in our example they put the $1 million value of that contract directly into revenues. They concurrently offset those revenues with a roughly equal cost for the gas, and thereafter measure profit and loss just like the Wall Street firms. All other things being equal, they end up with an identical profit to what the Wall Street firm makes. But there's obviously a monster difference in reported revenues--zero dollars in the Wall Street case, $1 million in the energy case.



Stoking the Furnaces



Big volume in energy trading contracts, and a hot method of accounting for their revenues, have put the four biggest energy companies--Enron, American Electric Power, Duke, and El Paso--into the upper reaches of the FORTUNE 500.







FORTUNE 500 rank



American Electric Power



El Paso









FORTUNE 500 Median


Bob Jensen's threads on revenue accounting --- 

Read it and Weep

From Business Week Online as Reproduced by SmartPros (May 30, 2002) ---- 

Still Hoping for More From Harvey Pitt

May 30, 2002 (Business Week Online) — Earlier this month, Securities and Exchange Commission Chairman Harvey Pitt convened the first "Investor Summit" to listen and respond to investor complaints. (You can hear a replay of the May 10 discussion on the SEC Web site.) It was, at times, spirited.


Pitt and fellow Commissioners Isaac Hunt and Cynthia Glassman got earfuls -- both from investors at large and from a group of six panelists. Some of the sharpest criticism of the SEC's performance in the current crisis of confidence in Wall Street came from panelist Damon Silvers. He's an associate general counsel with the AFL-CIO, which is the umbrella organization for some 13 million members of different unions, who are beneficiaries of an estimated $5 trillion in pension assets.

After Silvers spoke at the conference, I reached him by phone at his Washington (D.C.) office and asked him to elaborate on the remarks he made and the questions he asked. Edited excerpts of our discussion follow:

Q: At the Investor Summit, you said that the ball is being dropped on reforming "issue after issue." What are those issues?

A: Well, I'll just do a short list for you.

Q: Shoot.

A: The first is the issues surrounding auditors, and in particular the issue of auditor independence and the creation of a public oversight board. The AFL-CIO put a rule-making petition into the [SEC] in December on auditor independence. As far as we can tell, the commission hasn't really done anything in that area. Everyone knows about the mess that auditor-oversight process turned into at the commission, and clearly it hasn't taken any steps to do the minimum in this area that was outlined by [former SEC Chairman] Arthur Levitt in his testimony in the Senate.

Q: Which was?

A: Creating a body that has a majority of nonaccounting industry people, with full enforcement powers and independent financing.

Q: What else?

A: The commission has missed an opportunity to deal with the problem of analysts' conflicts on Wall Street by failing to really do anything meaningful to regulate the power that investment bankers have developed over the analysts in the major Wall Street firms. The SEC also hasn't acted on the problems related to the independence of boards of directors at public companies.

Q: Such as?

A: Both in requiring meaningful independence of audit committee and compensation committee members and in disclosure. Those are the key issues where the commission has failed to act or has acted in a manner that is inadequate.

Q: Pitt wouldn't agree with that, and it's only fair to note that the reforms are a work in progress. In your view, why has the commission dropped the ball?

A: I wish I knew. The big [firms] in the audit world and the Wall Street firms have obviously been lobbying intensively for months to prevent effective action in these areas. We know that some of those people have met with Chairman Pitt. I believe that he has strongly held views about a number of these issues that predate his arrival as chairman at the SEC.

Q: How much of this is a result of there not being a full commission -- two of the five seats remain vacant.

A: I think that is underappreciated in the coverage of these issues. The Commission is, after all, designed to be a deliberative body. And there are currently only three commissioners, one of whom is clearly planning to depart.

Q: Commissioner Isaac Hunt?

A: Right.... There's a need for more diverse perspectives on the commission. I continue to believe that Chairman Pitt has the potential to do the right thing here. And the addition of commissioners with a more diverse set of views would help steer the SEC in that direction.

Q: So you're not in the group of people who think that Pitt no longer has the credibility to remain at the SEC?

A: There are people who have called for him to resign. Common Cause did so on the day of the Investor Summit.... We are critical of Chairman Pitt's performance here, on many levels, severely critical in fact. However, we're not ready to say that there's no hope here and that he's incapable of doing the right thing. If I believed that, I'm not sure that I would have participated in the summit.

Q: Some suspected the summit was 100% public relations -- nothing substantive. What's your view?

A: It might have been designed to be that way. I don't think that's what it was. I think we had substantial exchanges about a number of important issues -- ones in which, prior to the summit, no one really knew what Chairman Pitt's views were.

Q: Such as?

A: Mutual-fund disclosure and "aiding and abetting" liability. That being said, I think the question now is, "What's the follow-up?"

Q: You mentioned the "aiding and abetting" issue, which is a fairly technical set of legal precedents, but a very interesting one and one that's potentially important to investors. Also, I think that you got from Pitt a commitment to work with you on that.

A: Yes, that's right.

Q: Can you explain please what this "aiding and abetting" issue is?

A: This is really an outrageous situation in our securities law. The Supreme Court said in the early '90s, in a case called Central Bank of Denver, that despite the fact that everybody for decades had proceeded on the basis that the securities laws gave investors the right to sue and recover damages from people and institutions that aided and abetted securities fraud.... The Supreme Court found that there was actually no basis for that kind of claim in the statute.

Therefore, investors -- the people who were actually wronged by securities fraud -- could not sue those who aided and abetted.

Q: So?

A: This is important because the typical securities fraud is a product not just of a company that is the actual institution doing the disclosure but of the people who work with that company.

Q: Such as?

A: Investment banks, lawyers, and accountants. In most situations, the investment banks, the lawyers, and the accountants don't interact directly with the shareholder. They do so through the company. Making aiding and abetting no longer recognizable in the courts as something an investor can recover on, they basically made it impossible for investors to go after those folks.

Q: I see.

A: By the way, if you look at the defenses that have been raised by Arthur Andersen and others in the Enron cases, they all rest on this. They all say, basically, even if we did all of these things, even if we did everything you accuse us of doing, it's just aiding and abetting, and you have no right to sue for it.

Q: So what's the upshot for the individual wronged in the Enron case?

A: You're out of luck. If the aiding and abetting case defense holds in the context of Enron, where Enron is bankrupt, unsecured creditors like the investors who got defrauded are unlikely to get hardly anything.

Q: Given that, do the investors need to look to Congress for a fix?

A: Yes, you have to have a congressional fix here. The SEC can't fix it by itself. But what the SEC can do, which is what I was challenging Chairman Pitt to work with us on, the SEC can send a clear message to Congress that this needs to be fixed, and that would be very important.

-- Robert Barker, Business Week Online

And the bottom line is that reform efforts are stalled in Congress and will most likely die in hands of committees that held all of these “spectator” hearings!  There will, however, be some really neat new TV commercials for re-election, commercials paid for by the lobbyists.

The above article must be juxtaposed against this earlier Washington Post article:

"Andersen Passes Peer Review Accounting Firm Cleared Despite Finding of Deficiencies," by David S. Hilzenrath,  The Washington Post, January 3, 2002 --- 

But the review of Andersen reflected the limitations of the peer-review process, in which each of the so-called Big Five accounting firms is periodically reviewed by one of the others. Deloitte's review did not include Andersen's audits of bankrupt energy trader Enron Corp. -- or any other case in which an audit failure was alleged, Deloitte partners said yesterday in a conference call with reporters. 

. . 

Concluding Remarks
In its latest review, Deloitte said Andersen auditors did not always comply with requirements for communicating with their overseers on corporate boards. According to Deloitte's report, in a few instances, Andersen failed to issue a required letter in which auditors attest that they are independent from the audit client and disclose factors that might affect their independence.

In a recent letter to the American Institute of Certified Public Accountants, Andersen said it has addressed the concerns that Deloitte cited.

Microsoft Gets Slapped for Having Bill Gate's Hands in the Cookie Jar

From on June 3, 2002

Microsoft Corp. (MSFT) agreed to stop using an accounting practice that allegedly understated revenues and misled investors, the Securities and Exchange Commission said on Monday.

However, the world's largest software maker will not have to change any previous earnings reports.

Microsoft consented to a cease-and-desist order but did not admit or deny charges that from 1995 through 1998 it maintained seven reserve accounts containing a total of $200 million to$900 million in unsupported and undisclosed reserves.

A significant amount of the reserves did not comply with generally accepted accounting principles, which resulted in inaccuracies in filings that Microsoft made with the commission, it was alleged.

Microsoft shares were down 79 cents to $50.12 in pre-afternoon trading on Nasdaq. The company was not fined. In addition, Microsoft said the settlement will not require restatement of any reported financial results.

"The company is pleased to resolve these matters with the SEC and looks forward to an open and constructive relationship with the SEC on important accounting issues affecting the software industry," a company spokesman said.

The SEC has been aggressive in probing accounting irregularities involving overstatement of revenues. The Microsoft probe was unusual because it involved allegations of deliberately understating revenues.

For more than two years, the SEC had been looking at Microsoft's alleged practice of taking reserves that can be used to pad revenues during lean times, commonly known as "cookie jar accounting."

"Companies must properly document the bases for their reserves and other accounting entries so that they and their auditors can verify that the accounting is proper," enforcement chief Stephen Cutler in a statement announcing the settlement.

"This case emphasizes that the commission will act against a public company that issues financial statements with material inaccuracies, even in the absence of fraud charges," he added.

The Controversy Over Revenue Reporting 

From The Wall Street Journal Accounting Educators' Review on May 23, 2002

TITLE: SEC Broadens Investigation Into Revenue-Boosting Tricks; Fearing Bogus Numbers Are Widespread, Agency Probes Lucent and Others 
REPORTER: Susan Pulliam and Rebecca Blumenstein 
DATE: May 16, 2002 
TOPICS: Financial Accounting, Financial Statement Analysis

SUMMARY: "Securities and Exchange Commission officials, concerned about an explosion of transactions that falsely created the impression of booming business across many industries, are conducting a sweeping investigation into a host of practices that pump up revenue."

1.) "Probing revenue promises to be a much broader inquiry than the earlier investigations of Enron and other companies accused of using accounting tricks to boost their profits." What is the difference between inflating profits vs. revenues?

2.) What are the ways in which accounting information is used (both in general and in ways specifically cited in this article)? What are the concerns about using accounting information that has been manipulated to increase revenues? To increase profits?

3.) Describe the specific techniques that may be used to inflate revenues that are enumerated in this article and the related one. Why would a practice of inflating revenues be of particular concern during the ".com boom"?

4.) "[L90 Inc.] L90 lopped $8.3 million, or just over 10%, off revenue previously reported for 2000 and 2001, while booking the $250,000 [net difference in the amount of wire transfers that had been used in one of these transactions] as 'other income' rather than revenue." What is the difference between revenues and other income? Where might these items be found in a multi-step income statement? In a single-step income statement?

5.) What are "vendor allowances"? How might these allowances be used to inflate revenues? Consider the case of Lucent Technologies described in the article. Might their techniques also have been used to boost profits?

Reviewed By: Judy Beckman, University of Rhode Island 
Reviewed By: Benson Wier, Virginia Commonwealth University 
Reviewed By: Kimberly Dunn, Florida Atlantic University

TITLE: CMS Energy Admits Questionable Trades Inflated Its Volume 
REPORTER: Chip Cummins and Jonathan Friedland 
ISSUE: May 16, 2002 


Bob Jensen's threads on revenue reporting are at 

Deception Gems
There are some gems in the memoranda links on an Enron timeline at 

Enron Sold Recipes on How to Cook the Books and Provided Its Own Chefs as Teachers --- 

Ever heard of Enron? Unusual funds shift boosts PeopleSoft results --- 

Human resources software powerhouse PeopleSoft pulled a nifty accounting trick that has helped it turn development costs into income, the San Jose Mercury News reports. As reporter Elise Ackerman explains, in 1999 when Craig Conway took over PeopleSoft, the company knew it needed to rewrite its desktop software for the Internet and knew that process would cost a bundle. "But thanks to a creative accounting maneuver by his predecessor, PeopleSoft founder David A. Duffield, Conway didn't have to worry about crushing development costs," Ackerman reports. Six months before, Duffield had set up a subsidiary with $250 million. "PeopleSoft hired that subsidiary, Momentum Business Applications, to write new software, and Momentum, in turn, hired PeopleSoft programmers at a markup. The arrangement transformed the high cost of creating new programs into a source of revenue for PeopleSoft." As Ackerman discovered, not everyone in the business world finds the set up entirely kosher. "It is within the boundaries of generally accepted accounting principles, but it is really an intent to deceive," the story quotes Peter Knutson, an associate professor emeritus of accounting at the University of Pennsylvania's Wharton School. Worth reading.

"Bush's Aggressive Accounting," by Paul Krugman, The New York Times, February 5, 2002 --- 

Senator Kent Conrad actually got it wrong yesterday when he criticized the Bush administration's new budget for its Enron-like accounting. Last year's budget, the one that included that big tax cut, was the one with a strong touch of Enron about it. This year's budget involves a different, though equally pernicious, kind of aggressive accounting. Enron's illusion of profitability rested largely on "mark to market" accounting. The company entered into contracts that would yield profits, if at all, only over a number of years. But Enron jumped the gun: it treated the capitalized value of those hypothetical future gains as a current profit, which could then be used to justify high stock prices, big bonuses for executives, and so on.

And that's more or less what happened in last year's budget. The Bush administration took a bullish 10-year surplus projection — a projection that had a built-in upward bias, and in any case should have been regarded as no more than a guess — and treated it as if it were hard fact. On the basis of those surplus fantasies the administration — aided by an audit committee, otherwise known as the U.S. Congress, that failed to exercise due diligence — gave itself a big bonus in the form of a huge tax cut.

A year later the wrongness of the assumptions behind last year's budget is there for all to see, and in a rational world the administration would be called to account for misleading the American public. But instead the Bush administration has turned to the political equivalent of another increasingly common accounting trick: the "one-time charge."

According to, one-time charges are "used to bury unfavorable expenses or investments that went wrong." That is, instead of admitting that it has been doing a bad job, management claims that bad results are caused by extraordinary, unpredictable events: "We're making lots of money, but we had $1 billion in special expenses associated with our takeover of XYZ Corporation." And of course extraordinary events do happen; the trick is to make the most of them, as a way of evading responsibility. (Some companies, such as Cisco, have a habit of incurring "one-time charges" over and over again.)


How Stock Options Become an Accounting Trick ---

It's certainly good news for investors that bellwether companies such as General Electric (GE:NYSE - news - commentary - research - analysis), IBM (IBM:NSYE - news - commentary - research - analysis) and American International Group (AIG:NSYE - news - commentary - research - analysis) have announced that they will release more detailed information on their financials.

The changes will include more detail on the performance of individual business units, gains and losses from the sale of assets, and off balance sheet partnerships. It's unlikely that the extra information will be enough to enable investors to easily understand these three companies -- the authors today of truly inscrutable financial statements -- but it's a start.

Unfortunately, no CEO is volunteering to take on the biggest accounting issue hanging over U.S. companies and their stocks right now. Today's accounting rules for stock options make up the most powerful tool available for manipulating earnings. Stock options accounting is the 800-pound gorilla lurking in every discussion of accounting reform taking place right now: Everyone knows the issue is too big to ignore, but everyone worries that a serious fix would take down the entire technology sector -- and perhaps more.

That's not to say that absolutely no one is talking about it. Jeffrey Skilling, former CEO of Enron, brought up the topic at his recent appearance before the Senate Commerce Committee. Taunted by California Democratic Sen. Barbara Boxer for defending the right of a CEO to use his company's stock to improve his company's reported earnings, Skilling shot back that companies do it all the time. "You issue stock options to reduce compensation expense and therefore increase your profitability."

The rejoinder was particularly effective because Skilling, and everyone else in the room, knew that Boxer represents Silicon Valley, which lives and dies on stock options. In the mid-1990s, Boxer worked hard to kill accounting rules that would have ended the ability of companies to inflate their earnings through the use of stock options.

That battle went like this: Stock options clearly have value. Companies offer them to valued employees instead of cash compensation or as an extra reward for special achievement. Options are dangled in front of CEOs and other managers to motivate them to reach certain revenue or earnings targets. And financial analysts have even invented ways to value these options in the publicly traded market for options, where investors who want to hedge or leverage positions in a stock can buy the right to buy or sell shares at specific prices in the future.

But according to current accounting rules, companies that issue millions of shares of options each year don't have to charge a dime in cost against earnings. In 1993 the Financial Accounting Standards Board proposed rules -- pages and pages of them -- on how companies should value the options at the time they were issued and how they should subtract them from earnings.

After a bitter fight that included high-level congressional lobbying against the rules, the Financial Accounting Standards Board withdrew a key part of its proposal. Companies would not have to deduct the cost of options from their reported earnings unless they wanted to do so. Instead, they could provide a footnote to their financials stating what earnings per share would have been if the cost of options (calculated using the widely accepted Black-Scholes method for valuing options) had been deducted from earnings. And that's where investors can find the number today -- if they care to search for it. Small Print, Big Numbers That fine print hides some big numbers. In 2000 Intel (INTC:Nasdaq - news - commentary - research - analysis), for example, reported earnings of $1.73 a share. Pro forma earnings after deducting for the cost of options came to $1.40 a share, according to the company's 10-K filed with the Securities and Exchange Commission. At Cisco Systems (CSCO:Nasdaq - news - commentary - research - analysis), another big user of options, charging the cost of options against earnings would have increased the loss per share in the fiscal year that ended in July 2001 to 38 cents from the reported 14 cents. At eBay (EBAY:Nasdaq - news - commentary - research - analysis), including the cost of options would have reduced earnings for 2000 from a reported profit of 19 cents a share to a loss of 36 cents a share. And at Microsoft (MSFT:Nasdaq - news - commentary - research - analysis), accounting for the cost of options would have resulted in earnings of 91 cents a share for the year ended June 2001, instead of the reported $1.32 a share. You'll find these numbers in the footnotes to a company's financial statements in its annual 10-K.

The reductions in earnings per share at these technology companies -- 20% at Intel, for example -- are dwarfed by the drop in earnings per share at new technology companies that had to reprice options after their stocks tanked in 2000. Some of these companies had to issue huge numbers of new options in 2001 -- or still face the necessity of doing so in 2002 -- because options issued in 1999 and 2000 were so far underwater that they were valueless to the employees they were designed to compensate and motivate. Brocade Communications Systems (BRCD:Nasdaq - news - commentary - research - analysis), for example, issued 20 million options in April 2001 to workers whose existing options were underwater. For the fiscal year that ended in October 2001, Brocade reported earnings per share of 1 cent. By including the cost of options, that figure transforms into a pro forma loss of $2.68 a share.

But this is all just part of the way that options accounting distorts corporate earnings. The bigger problem -- and the much more lucrative side of options as far as corporate cash flow is concerned -- becomes evident when a company that has issued options to its employees goes to pay its tax bill. At this point a company gets to deduct the difference between the cost of the options at the exercise price and their market price.

For example, let's take a company whose employees exercised a million options in 2000. Those options had an initial average strike price of $80 a share. The initial Black-Scholes value of those options (taking into account such factors as the volatility of the stock, the time until the option expires, and the relationship between the price of shares and the price at which the option allows the option holder to buy shares) was roughly $20 a share. But the stock has moved up in price since the options were granted, and as the stock soared in price, the right to buy shares at $80 became increasingly valuable. By 2000, those options using the same Black-Scholes valuation method were worth $40 each. The company would, therefore, have been able to take a $40 million tax deduction for the "cost" of those options -- even though the initial "cost" was just $20 million. The higher the stock had climbed in price, the bigger the tax deduction would have been.

Have you noticed what's really so lucrative about this kind of tax accounting? The tax deduction expands along with any climb in the value of the stock. And it's not limited by the initial Black-Scholes cost of the option. Juicy Tax Break The resulting tax break can be very juicy indeed -- although it's not easy to find in a company's financial statements. You'll see it, though, if you go to the corporate cash flow statement and look for a line with a name like "Tax benefit from employee stock plans." That's how the figures are labeled in Intel's 2000 10-K, for example. That year, Intel's total tax break from options came to $887 million. At Cisco the total for fiscal 2001 came to $1.4 billion. At eBay it came to a comparatively paltry $37 million. And at Microsoft, a princely $2.1 billion in fiscal 2001.

In most years, I'd give any effort to reform this set of accounting and tax rules no chance at all. Lined up against reform you'll find the same powerful coalition of technology companies and politicians that killed tighter rules back in the mid-1990s. These folks are motivated to defend the status quo with energy and cash, and they have a lot of the latter. Reform, on the other hand, lacks a natural and energized constituency. You may be outraged that Intel can claim $1.73 a share in earnings when it really made $1.40, and that the company is getting a $900 million tax break from the U.S. Treasury to boot. But if you're an Intel shareholder directly or through a mutual fund, do you really want to see Intel's shares take another hit in exchange for accounting accuracy? Personally I believe that the long-term benefits to the capital markets of honest numbers are worth the short-term pain to individual stocks, but as an Intel shareholder I have to admit that I feel ambivalent about any call for reform, even my own.

However, thanks to the Enron fraud and scandal, this isn't a normal year, and the proponents of options accounting reform have come up with an ingenious strategy. (Especially ingenious because the Senate can't force the Financial Accounting Standards Board to adopt any specific accounting rules.) As written into Senate Bill 1940, it would offer companies a choice between keeping some of their tax breaks and giving up their accounting freebie. Companies that included the cost of options in their reported earnings numbers would, under the terms of the bill, still get to claim a tax deduction for the full cost of the option. Companies that didn't include the cost of options in their reported earnings wouldn't be entitled to a tax deduction at all. And all deductions would be limited to the original Black-Scholes value of the option -- no more sky's-the-limit deductions if the stock price soared like a rocket.

The bill's backers -- on the Democratic side of the aisle, Sens. Carl Levin, Richard Durbin and Mark Dayton, and on the Republican side, John McCain and Peter Fitzgerald -- still face a tough fight even to get this legislation out of the Senate Finance Committee. And I suspect that the legislation has even less chance of success in the House of Representatives.

But the Enron scandal, and the other investigations into the activities of companies such as Global Crossing (GBLXQ.OB:OCT BB - news - commentary - research - analysis), could produce a surprise with the potential to create enough investor anger to push proposals like this into law. Watch the progress of SB 1940 carefully. If it gets out of committee, this bill could make technology investors even more nervous than they are now.

Rice professor examines Enron meltdown --- 

The best single source (not concise) of the many Raptor deals is the Powers Report: The 208 Page February 2, 2002 Special Investigative Committee of the Board of Directors (Powers) Report--- 

From the FEI Foundation


In the February FEI-NACT Treasurers Newsletter, see the link to the "Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp." (Powers Report): . Cheryl de Mesa Graziano, Manager of Research at the FEI Research Foundation, analyses the Powers Report in a recent Issues Alert .

It highlights Enron's failures in executing the transactions involving Special Purpose Entities (SPEs) and emphasizes oversight shortfalls at many levels, including conflicts of interest and corporate governance issues. Of special interest are analyses of two key SPEs, the Chewco transactions and the LJM transactions. Graziano comments: "The problem was that Chewco was financed primarily with Enron debt, rather than at-risk equity from an outside investor. The Powers Report estimates that Chewco was more than 50% short (at least $6.6 mill!ion) of the 3% required equity."

The Spring 2002 issue of Strategic Investor Relations includes the article, "Fallout from Enron: The Finance Function Perspective," by FEI President Phil Livingston. Livingston discusses the causes of the crisis, what happened at Enron, and his recommendations for change. Click here for the full article: . Enron has also influenced the agendas of both the SEC and the FASB, as Francine Mellor of Ernst & Young discusses in her column below.

RECENT DEVELOPMENTS AT THE SEC AND THE FASB Francine Mellors, Ernst & Young, New York

SEC RELATED ISSUES Informative And Timely Disclosures The SEC plans a series of rule proposals to improve the financial reporting and disclosure system. The first rule would codify FR-60 and require MD&A disclosure about critical accounting policies. The second should significantly expand the number of events that must be reported in a Form 8-K filing. That rule proposal also is expected to accelerate the filing of the Form 8-K following reportable events. A third is expected to accelerate the deadline to file annual and quarterly reports with the SEC. The SEC said that it intends to propose accelerating the due date of Form 10-K from 90 days after year-end to 60 days, and quarterly reports on Form 10-Q from 45 days after quarter-end to 30 days.

Other SEC rule proposals are expected to require more timely reporting of significant transactions by corporate insiders, and to require timely posting by public companies of their SEC reports on their company websites. Click here for copies of current SEC proposals: .

(The FEI Research Foundation staff is currently preparing MD&A Trends and Techniques: What's New for 2001, an Issues Alert that scheduled for late April release. This report will summarize current best practices in preparing MD&A, including critical accounting policies, forward-looking information and sensitivity analysis, credit rating information, and segment information analysis. Check availability at .)

Accounting Roundtables The SEC hosted three recent Financial Disclosure and Auditor Oversight roundtables in New York City, Washington, D.C. and Chicago; others may follow. An "Investor Summit" is scheduled in May to solicit input from investors. The roundtables discussed potential reform measures to improve corporate disclosure requirements and restructure the regulation of the accounting profession. The financial disclosure panel discussions focused on the information needs of investors, making financial disclosures more intelligible, and accelerating financial communications. The auditor oversight panel discussions focused on the structure, membership and funding of a new accounting and auditing oversight body. For a transcript of the March 4 Roundtable, click here: . For information about other Roundtables, click here: .

SEC Reporting Following Andersen Indictment On March 18, the SEC issued guidance for Andersen clients in light of the March 14 indictment of Arthur Andersen LLP. It addresses procedural matters in a variety circumstances that Andersen clients may encounter in SEC filings. The SEC will accept financial statements audited by Andersen provided Andersen continues to provide specific assurances regarding its audits. The SEC has adopted a number of relief measures, effective immediately, to minimize potential disruption if an Andersen client must or chooses to change auditors. Check availability at .

New Project on SPEs at the FASB The FASB's project on consolidations has been on its agenda for almost 20 years. The project was tabled in January 2001 after several FASB members questioned the "operationality" of certain provisions of the proposed consolidation model as set forth in the original Exposure Draft (i.e., the four presumptions of control). Many felt the problem was special purpose entities (SPEs) and not the basic more than 50% long-standing rule. Due to recent changes in the Board's membership and because of Enron's downfall, the project was rekindled in the 4Q01 to address issues involving SPEs.

The Board has tentatively concluded that additional interpretive guidance relating to identifying and accounting for SPEs will be issued in the form of a proposed Interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, and FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries, (the Interpretation). Statement 140 qualifying SPEs will be excluded from the scope of the interpretive guidance. The FASB plans to issue an Exposure Draft soon and to finalize the Interpretation by July 31, 2002.

The Interpretation's objective is to provide consolidation accounting guidance for SPEs, recognizing that the ARB 51 and Statement 94 control-based approach does not adequately consider the uniqueness of SPEs in which controlling rights may not be substantive. SPEs typically have limited abilities and enter into activities that are specified by predetermined arrangements. As a result, the FASB is redirecting the focus of determining whether or not a primary beneficiary should consolidate an SPE to the economic substance of the SPE and away from an assessment of control over the entity. Under the proposed Interpretation, entities that lack sufficient independent economic substance will have to be consolidated by their primary beneficiary.

The fundamental issues revolve around the characteristics of an SPE (i.e., when does an SPE exist), determining whether it has sufficient independent economic substance, and determining the party that is the primary beneficiary. The primary beneficiary is assumed to control the activities of the SPE and establishes its control either through the documents that establish the SPE or some other mechanism.

Another significant issue revolves around multi-seller/multi-lease conduit entities that lack sufficient independent economic substance. The Board has tentatively agreed that multi-seller/multi-lease conduit entities that lack sufficient independent economic substance and in which a single primary beneficiary cannot be located, would generally have to be disaggregated and each transferor/lessee would record its own assets and related portion of the obligations.

The proposed Interpretation in its preliminary form will mean that most off-balance sheet leasing arrangements, as well as most structured financing arrangements, in their current forms would not hold up to the proposed guidelines and will likely be consolidated by their primary beneficiaries at the effective date of the Interpretation. It is expected that the final Interpretation will be effective for all SPEs on the first day of the first fiscal year beginning after December 15, 2002 (January 1, 2003 for calendar year-end companies); thus, there will be no grandfathering. However, all SPEs created after the issuance of the final Interpretation (July 31, 2002) are expected to have to apply the new guidance.

(Cheryl de Mesa Graziano has written an FEI Research Foundation Issues Alert, Special Purpose Entities: Understanding the Guidelines. For free download click here:  . This Issues Alert describes the basic characteristics of an SPE, provides a simple timeline of the Enron SPEs, and summarizes existing accounting guidance for SPEs. This is a must read if you have any dealings with SPEs.)

Accounting Faces Crisis of Competence, Not Integrity "
Andersen-itis" Isn't What Ails the Industry --- 

The real cause for concern is a crisis of competence that is eroding customer satisfaction with external auditors in corporate America, says an April 2002 survey of companies that purchase outside accounting services conducted by NFO WorldGroup, one of the world's leading providers of research-based marketing information and counsel.

Using the NFO TRI*M Index, an innovative relationship and reputation management tool, businesses using outside auditors give the profession an overall performance score of 61 equivalent to a D grade. By comparison, general B2B services average 80 (B). Top performing businesses with the strongest relationships fall in the range of 90 to 100 (A).

This low rating is reflected in client evaluation of auditor performance. Fifty-five percent of the respondents ranked overall performance of their auditor as excellent or very good, compared to 70 percent to 75 percent typically seen in the professional services. Similarly, only 55 percent said they definitely or probably would recommend their auditors to business colleagues, versus 75 percent to 80-percent for the professional services category.

"These weak scores should be a clear warning bell that the accounting profession has serious, fundamental client relationship problems that are different from the issues dominating the headlines about Andersen and Enron," explained Shubhra Ramchandani, stakeholder management practice leader for North America, NFO WorldGroup, and leader of the TRI*M study. "The problem isn't integrity -- it is value. Most clients rate their outside accountants' business ethics very highly, but what they question is the performance and value of the services they receive. The NFO TRI*M research reveals some vital insights into what the profession can do to raise its D grade to an A for customer satisfaction and loyalty."

According to the TRI*M results, the respondents gave HIGH performance marks to auditors in regards to:

However, the industry scored AVERAGE to BELOW AVERAGE on critical performance factors like:

Loss of Reputation is a Kiss of Death for a Public Accounting Firm:  An Empirical Study
Andersen Audits Increased Clients' Cost of Capital Relative to Clients of Other Auditing Firms
Especially note the graph after October 1991!

"The Demise of Arthur Andersen," by Clifford F. Thies, Ludwig Von Mises Institute, April 12, 2002 ---

From, Andrew and I downloaded the daily adjusted closing prices of the stocks of these companies (the adjustment taking into account splits and dividends). I then constructed portfolios based on an equal dollar investment in the stocks of each of the companies and tracked the performance of the two portfolios from August 1, 2001, to March 1, 2002. Indexes of the values of these portfolios are juxtaposed in Figure 1.

From August 1, 2001, to November 30, 2001, the values of the two portfolios are very highly correlated. In particular, the values of the two portfolios fell following the September 11 terrorist attack on our country and then quickly recovered. You would expect a very high correlation in the values of truly matched portfolios. Then, two deviations stand out.


In early December 2001, a wedge temporarily opened up between the values of the two portfolios. This followed the SEC subpoena. Then, in early February, a second and persistent wedge opened. This followed the news of the coming DOJ indictment. It appears that an Andersen signature (relative to a "Final Four" signature) costs a company 6 percent of its market capitalization. No wonder corporate clients--including several of the companies that were in the Andersen-audited portfolio Andrew and I constructed--are leaving Andersen.

Prior to the demise of Arthur Andersen, the Big 5 firms seemed to have a "lock" on reputation. It is possible that these firms may have felt free to trade on their names in search of additional sources of revenue. If that is what happened at Andersen, it was a big mistake. In a free market, nobody has a lock on anything. Every day that you don’t earn your reputation afresh by serving your customers well is a day you risk losing your reputation. And, in a service-oriented economy, losing your reputation is the kiss of death.

Gelernter Blames Enron Collapse On Hierarchical File ... ... Please. The guys at Enron were able to sneak by all the safeguards of the law ... have used cryptic terms like "CHEWCO" instead of "my unethical accounting trick" --- 

Interesting Business History in the Context of the Enron Scandal

A very interesting story, much more so than 'The Untouchables'...

The key accountant if there was one, was actually one of his lawyers, Edward O'Hare, who advised Capone on business ventures. 'Fast Eddie' O'Hare became a prominent lawyer and was involved in many businesses with Capone. During Capone's imprisonment for the Valentine's Day massacre in 1929, the laws had been changed to enable taxation of illegally earned profits. Capone and his associates, including Eddie, became a focus of IRS operations in 1930.

Fast Eddie decided to turn on Capone to settle up with the IRS. This was a breakthrough for the IRS. In addition, a set of accounts seized years earlier was properly analyzed provided further evidence of Capone's illegal earnings.

A very interesting wrinkle was that Eddie planned ahead for his son Butch. Terms of the deal with the Feds included acceptance of Butch at Annapolis. Eddie cooperated, and Capone was convicted.

In November, 1939, Eddie was executed by mob associates for cheating another boss, Frank Nitti, on a deal, and perhaps as (somewhat overdue) payback for Capone. According to  several months later, Nitti married Eddie's fiance (Eddie had divorced Butch's mother much earlier).

In the meantime, Butch graduated from Annapolis, and in 1942 became a war hero, the first US Navy Ace, by single-handedly downing 5 Japanese bombers and buying time that saved the carrier USS Lexington from destruction. According to  President Roosevelt called his outstanding performance, "One of the most daring, if not the most daring, single action in the history of combat aviation." He was subsequently shot down at night in Nov, 1943 and lost at sea.

In 1949, Col. Robert H. McCormick, publisher of the Chicago Tribune, led the charge to rename the Chicago-area airport (formerly named Orchard Field) to O'Hare's International Airport. And so it is named today.

I wonder if anyone from Enron is making similar deals...

Other links:

Kevin Kobelsky PhD CA*CISA
Assistant Professor Leventhal School of Accounting,
Marshall School of Business
University of Southern California Accounting Building
125 Los Angeles, CA 90089-0441 Voice: (213) 740-0657 Fax: (213) 747-2815

April 3, 2002 message from Dennis Beresford [dberesfo@TERRY.UGA.EDU

One of the things that I find most fascinating about the Enron/Andersen saga is how much inside information is being made public (thanks to our electronic age). Yesterday the House Energy and Commerce Committee released a series of internal Andersen memos showing the dialogue between the executive office accounting experts and the Houston office client service people. While I haven't had a chance to read all 94 pages yet, the memos are reported to show that the executive office experts raised significant questions about Enron's accounting. But the Houston people were able to ignore that advice because Andersen's internal policies required the engagement people to consult but not necessarily to follow the advice they received. As far as I know, all other major accounting firms would require that consultation advice be followed.

You can view and download the 94 pages at: 

Denny Beresford

April 8 Reply from Kobelsky, Kevin [kobelsky@MARSHALL.USC.EDU


Thank you for I'm not sure how far you got through the material, but to help others find their way, I suggest the most salient pages explaining how the SPEs work and the decisions that were made be read in the following order: 1. Enron transaction by Bass 2/1/00 (p.4 of all 95 pages if you download them all-about 2 megs) 2. Enron option by Bass 12/18/99 (p.1,2 of 95) 3. Enron by Bass 3/4/01 #3 "raptor" (p.11-12 of 95) which documents that $100 million in losses was hidden in one transaction. 4. Re: Enron Derivative Transaction by Bass 2/4/00 (p.7 of 95)

Please let me know of other items in there I've missed.

Kevin Kobelsky PhD CA*CISA 
Assistant Professor Leventhal School of Accounting, 
Marshall School of Business 
University of Southern California Accounting Building 125 Los Angeles, CA 90089-0441 
Voice: (213) 740-0657 Fax: (213) 747-2815

Bob Jensen's SPE threads can be found at

"Creative Accounting," by Wendy Grossman, The Inquirer, January 11, 2002 --- 

I HAVE BEEN reading with some fascination this week the Washington Post's four-part investigation of MicroStrategy, one of those rags-to- riches-to-rags stories of the dot-com bust.

Coupled with the announcement that the US Department of Justice is taking over from the Securities and Exchange Commission and mounting a criminal investigation into the recent Enron crash and last month's examination in Business Week of current practices in reporting earnings (here), it's highlighting the fact that although investors have far greater access to information about the companies they put money in, it's increasingly difficult to wade through all that information and arrive at any realistic assessment. I'd say it was a job for professionals except that MicroStrategy's and Enron's accounts were all signed off by their auditors, people like PriceWaterhouseCoopers and Arthur Andersen (whose employees, according to this morning's Independent, destroyed a few relevant documents).

Accounting standards are now confusing enough that it seems likely we'll be seeing a few more of these scandals over the coming months. Are earnings are generally accepted accounting principles (GAAP), operating earnings, or the pro- forma earnings beloved of high-tech companies, especially those who can turn losses into profits by excluding lots of expenses? Are restructurings, layoffs, and factory closures special charges or the ordinary cost of doing business? And should companies be required or allowed to include investment income and losses as part of their ordinary business?

The boom years saw a number of companies set up internal venture capital funds to invest in start-ups. Intel Capital, for example, has investments in more than 550 companies in 20 countries (here). During the boom years, a number of companies, Intel among them, benefited handsomely from these funds. Even smaller companies did well out of the stock market during the boom when they spun off subsidiaries. RSA Data Security, for example, got a nice boost to its earnings for several years from selling off portions of its stake in its former subsidiary, Verisign. It's not the company's fault that online tables showing company data did not distinguish between the one-time proceeds of those sales and its actual business earnings in calculating the company's price/earnings ratio.

Business Week blames the dot-com boom. It's certainly true that during the most, er, optimistic period classifying all kinds of charges - marketing expenses, say - as "special" allowed a number of companies to inflate the speed of their success. Other questionable practices of the time (here) included booking barter deals - you carry my ads, I'll carry yours - as revenues, booking the full sale price of third-party products instead of just the business's commissions on them, booking rebates as marketing expenses, capitalising marketing costs, and so on. Capitalising marketing costs was the issue between the SEC and AOL (here) when AOL restated its earnings for 1995 and 1996 under new rules, the accounting change wiped out all the profits the company had ever made.

That example shows how non-trivial these niceties can be. Business Week highlighted the difference by comparing the average earnings per share for the S&P500 under GAAP ($6.37, for an overall P/E ratio of 38), S&P itself ($9.17), and the figures from First Call calculated from analysts ($10.78, for a P/E ratio of 23). There's also the problem that sometime in the last few years people have shifted from valuations based on last year's actual earnings and this year's "projected earnings".

It's the equivalent of my saying to the bank when applying for a mortgage, "Hey, I know I only earned $20,000 last year, but that's OK, I'm figuring on earning $50,000 this year, so my request for a $150,000 mortgage really isn't out of line."

Related to this is another common problem involving when revenue is recognised. If you, an individual, get a contract for work that will pay you $50,000 a year for ten years, you don't claim the whole $500,000 as revenue in the first year. Some companies do. Nor do you claim revenue when you sign the contract; you claim it when you get paid. But some companies do the former; in May 2001 the Motley Fool pointed out that a tiny note in RSA's most recent 10-Q annual filing indicated that the company was switching to recognizing revenues when products were shipped to distributors. (Here).

But of course anyone who thinks these things started with the dot-com boom is wholly out of line. You have only to read the great classic The Intelligent Investor by Benjamin Graham to see that companies have always tried to get away with as much as they can in making their quarterly reports look favorable. Graham also highlights something we can expect to see a lot of this year: the big bath. That is, one side effect of the September 11 attacks will be that companies will take advantage of the public's hugely lowered expectations for the year to wash out anything and everything they can. Then they'll all look so much better in 2002.

Last time I wrote about this, in early 2000, the SEC was proposing to crack down on such practices. They are, as recent events have made clear, going to have to do a lot more work.


Recommended Reading:

Financial Statement Fraud: Prevention and Detection by Zabihollah Rezaee and Joseph T. Wells
ISBN: 0471092169 
Publisher: Wiley, John & Sons, Incorporated 
Pub. Date: March 2002 

The Financial Numbers Game: Detecting Creative Accounting Practices, by Charles W. Mulford Eugene E. Comiskey 
ISBN: 0471370088
Publisher: Wiley, John & Sons, Incorporated
Pub. Date: February  2002

New Creative Accounting How to Make Your Profits What You Want Them to Be, by Ian Griffiths 
ISBN: 0-333-62865-9
Publisher:  Business Books
Pub. Date:  1995

How to Detect Creative Accounting, by Harry Domash --- 

"THE ETHICS OF CREATIVE ACCOUNTING," by Oriol Amat, John Blake, and Jack Dowds, December 1999 --- 

The term 'creative accounting' can be defined in a number of ways. Initially we will offer this definition: 'a process whereby accountants use their knowledge of accounting rules to manipulate the figures reported in the accounts of a business'.

To investigate the ethical issues raised by creative accounting we will:

· Explore some definitions of creative accounting

· Consider the various ways in which creative accounting can be undertaken.

· Explore the range of reasons for a company's directors to engage in creative accounting.

· Review the ethical issues that arise in creative accounting.

· Report on surveys of auditors' perceptions of creative accounting in the UK, Spain andNew Zealand.

Making Enron's $600 million restated financial statements look like a mistake in a child's allowance, the U.S. Treasury has admitted an accounting error and a resulting loss of $17.3 billion.
A billion here, a billion there!  Yawn!

For Updates See
Creative Earnings Management, Agency Theory, and Accounting Manipulations to Cook the Books ---

Bob Jensen's homepage is at