The Hindu Business Line : Enron & accounting issues: Yawning GAAP

THE Enron Corp imbroglio holds many lessons for Indian accounting professionals most of whom are working in a country which fancies itself as a software sweatshop and, therefore, have to deal frequently with tricky revenue recognition issues.

In fact, revenue recognition is so tricky that the Financial Accounting Standards Board (FASB), which sets the global benchmark for private sector accounting, has tagged it "the largest single category of fraudulent financial reporting and financial statement restatements".

But what do revenue recognition issues have to do with Enron? The answer is... just about everything.

Consider these facts: Between 1996 and 2000, the energy trading outfit reported an increase in its sales from $13.3 billion to $100.8 billion. In one single accounting year, 1999-2000, it doubled its reported sales. And said that it was set to double its sales again the following year.

How was Enron able to claim this phenomenal increase in sales revenue? Very simple — it exploited a loophole in accounting rules that allowed it to book revenue from energy-derivative contracts at their gross — as against net — value.

The basic incongruity of this practice becomes apparent if you examine the way a Wall Street firm — which is also in trading, although not energy trading — books its revenue. Let's say Wall Street Company X handles, on behalf of a client, the sale of 10,000 shares worth $500,000 of Company Y. It would record as revenue its commission on the sale or the spread between the bid price and the ask price — a few hundred dollars. But Enron (or any other energy trader in the US, for that matter) handling an energy trade would book the full $500,000.

According to Enron's 2000 annual report, it was in the business of building "wholesale businesses through the creation of networks involving selective asset ownership, contractual access to third-party assets and market-making activities". It seems to have used the term "wholesale businesses'' to mean trading, plain and simple. From which it made more than 90 per cent of its revenue....

To make matters worse, Enron bought and sold the same goods over and over again. And all this trading — a good amount of which was being carried on with purportedly independent partnerships which do not look very independent on examination — was being booked as revenue at full value.

It got away with this fancy book-keeping because the FASB just could not make up its mind about how energy contracts should be accounted for and, at some point or the other, decided that each company had a "free option'' to do what it wanted.

However, looking on the positive side of things, all this number-pumping without any basis in good accounting ensured that the Enron bankruptcy, in the words of the US Treasury Secretary, Mr Paul O'Neill, had no "spill-over effect.''

The downside, of course was that it did not do anything for its profits because of the steady erosion in its trading margins (caused, ironically enough, by the entry of many players into a market created by Enron) from 5.3 per cent in 1998 to less than 1.7 per cent in the third quarter of the current year.

In retrospect, it would seem that the company made frantic attempts to keep up its profits in spite of diminishing margins through various methods, including the setting up of several off-the-balance sheet entities represented as independent of Enron to which it sold assets or portfolios of assets.

It created so-called special purpose entities (SPEs) like the Chewco and JEDI partnerships to get assets like power plants off its books. Enron was able to do this because, under standard accounting, a company is allowed to spin off its assets — and related debts — to an SPE if an outside investor has put up capital worth at least three per cent of the SPE's total value.

These methods also stretched across the lumping of assets into its trading business and the booking as operating revenues the proceeds of the sale of fixed assets.

Gaps, it would seem, abound in GAAP....

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Enron & accounting issues: Yawning GAAP