In this, the eighth edition of Wizards, we are going to take a look at what drives companies to “cook the books” – or lie about their earnings, and we’ll investigate just how widespread this problem might be. How much of the global economy is based on “smoke and mirrors” book-keeping wizardry? Is such fake wizardry a genuine weak spot in the financial system that could ultimately lead to a meltdown? These are interesting questions for people to ask and it is especially useful for activists to identify such weak spots. Book cooking is a topical issue in the wake of the implosion of the amazing disintegrating wizard collection known as Enron.
Both inside and outside the financial world people are asking the question “How many more Enrons are out there?” In this episode of the Wizards of Money we will first look at the pressures behind book-cooking with a glimpse at the Wonderland of Accounting. Then we’ll take a look at the activities of the once mighty Enron empire, from its contributions to America’s energy policy to its attempts to privatize the world’s water supply, and turn Mother Nature’s gifts – from the weather to forests to wind – into tradable securities. Finally we look at the mechanics of the accounting trickery that ultimately lead to its demise, enriching top executives while rendering employees pension plans worthless.
We will look at the Enron collapse from a perspective that’s a bit different. We will see that one of the primary forces driving the Enron collapse was the battle of the Enron giant’s desire to privatize nature and turn all resources into tradable securities versus the public’s desire for fair access to these goods. Interestingly one of the key markets involved was the water market that we spoke about in Wizards Part 7 on The Money Cycle versus the Water Cycle.
In this episode we will interview a former Enron Trader and Risk Manager, hear some excerpts from a January 2001 interview with the now disgraced former CEO of Enron and excerpts from a recent Congressional Hearing on the Enron collapse.
You can get the full text of all Wizards and further references on the Wizards of Money web site at www.wizardsofmoney.org
Mirror Images and Accounting Basics
Financial accounting runs the world. This is so simply because money and finance run the world. And we have learned from our previous editions of Wizards that money is just an entry on a balance sheet. Base money (currency notes) and bank money (bank deposits) make up what we will call the plain money supply of the non-bank public. As we saw in Wizards Part 1 plain money is simply the equivalent of the liability side of total bank balance sheets. On the other side of the banks total balance sheets we have bank assets which corresponds to the liabilities of the non-bank public in the form of house mortgages, car loans and credit card debts.
And so this process of mirror imaging continues right into all other forms of financial asset. Any financial instrument is simply a balance sheet entry on two balance sheets – a financial instrument is an asset of one person and a liability of another. In this fashion all financial instruments – be it money, stocks, bonds, or options – have a mirror image somewhere in some other book or in some other computer. All financial instruments exist merely as entries in a computer or a book. Even the dollar bills we use have a mirror image liability on the Federal Reserve’s balance sheet. Financial instruments other than plain money – say stocks and bonds – have bookkeeping entries that are usually a claim on some other financial instrument – often money – at some date in the future.
Any such bookkeeping entry can be used to generate future money, or can be transferred into different bookkeeping entries, or can miraculously be transformed into a real good such as food and clothing through the process of trade.
This is how the zero sum game financial system works. It is all based on the shuffling of mirror-image numbers around on bits of paper and as bits and bytes around in computers. It is, of course, quite bizarre that this number shuffling governs much of the world order and defines social relations and access to the basics of life.
But the reason the number shuffling game has so much power is because people have so much confidence in it as a way to define the social order and govern the distribution of real goods. Let us look at this confidence in the number shuffling that runs the world from the perspective of two different groups of people, and how these two groups come to have the confidence in this number shuffling that keeps the financial system alive.
- For the low wage worker or unemployed person the dominant financial instrument in use is just plain money, the instrument for which the underlying number shuffling of mirror image items around balance sheets is less obvious. Confidence is maintained in this number shuffling system partly through ignorance of the maneuvering that is actually going on to create and distribute credits and debits, but mostly through sheer necessity. The latter arises because there are only limited alternatives to money for distributing goods, but this is now changing with the growth in community currencies as discussed in Wizards Part 6.
- At the opposite end of the spectrum are the very wealthy for whom plain money is much less significant as a financial instrument. Plain money for this class is merely a transitory stage between transactions in financial instruments and for converting financial instruments into real goods and services. In today’s world of very large wealth gaps, the wealthy have accumulated lots of excess financial capital. As in most past money-dominated empires they tend to “lend out” this excess to finance other projects in return for more money in the future than they are lending out today. So they might buy stocks or bonds which form familiar balance sheet entries in the form of debt and equity to the borrower and stock issuer. The mirror image of these bookkeeping items are, of course, assets on the wealthy person’s balance sheet.
For the financial system as we know it to survive it is this wealthy class, above all others, that must keep confidence in the global number shuffling game. For, if they lost confidence – first they would try and liquidate or sell all their financial instruments and hurry them into safer assets, which would first be plain money.
But there isn’t enough money to liquidate all these assets which are claims on future money. In this situation of mass selling the markets would actually freeze up and cause some kind of financial meltdown.
This wealthy class can cause a financial collapse more easily than others because they have the most financial assets and access to money on such a massive scale that they could force change very quickly. This means that they must retain confidence in the bookkeeping wizardry or number shuffling that goes on to account for stocks, bonds, derivatives and so forth.
This need to maintain the confidence of the class that can most easily collapse the financial system is what gives the profession of accounting its importance in the world. If enough people decided that what accountants are doing is fake wizardry and trickery and not a true representation of what their investment moneys will actually generate, the financial system will disintegrate just as completely as Enron did in December 2001.
So it’s important for us to look at just what is going on in accounting wizardry.
The accounting mirror images for stocks and bonds run as follows. The holder of a stock or bond will record them as an asset on their own balance sheet. This asset represents the value of future cashflow or plain money from that stock or bond. The issuer of a bond, lets say some corporation, will record the same instrument as a debt on its balance sheet and will record the stock as shareholder equity. For any corporation the following equality always holds: Total Assets = Total Liabilities (or debts) Plus Shareholder Equity. If shareholder equity gets too low, meaning that asset values may not be able to cover liabilities due, the company may be forced into bankruptcy.
Under both types of instrument – both stock and debt – the balance sheet items represent a promise to pay out money at certain dates in the future. For a bond or other debt instrument these dates are fixed AND debt and interest on debt for the company takes priority over payment to any shareholders.
The ratings agencies such as Standard and Poors and Moodys rate corporate debt according to the risk associated with repayment. A less risky bond gets an “investment grade” and risky bonds get rated as “junk”. On the stock side it is the stock analysts – usually part of the brokerage firms or investment banks – who assess what a stock might be worth, whether it’s over or under-priced based on expectations about future earnings.
Shareholders are entitled to all the money that’s left after all other expenses and debts are paid – which is what we call profits. The value of a share in a company to the investor is the expected value of future cash to come out of that company. Thus stock prices wobble around with expectations of future really true earnings, in the form of real cash, anticipated to be generated by a company. So, no matter how much accounting wizardry a company has going on to prop up confidence in its stock, sooner or later it will have to demonstrate that it can actually generate the cold hard cash expected to be generated in valuing its stock price.
Stock price levels are all about confidence – confidence that a company can generate an amount of earnings in the future to justify paying this price today. Many companies are valued, often by stock analysts, as a certain multiple of current earnings – the multiple being called the Price Earnings Ratio or PER. The PER is pretty much set by market sentiment – which is pretty much based on herd mentality. Company management therefore tries to “manage earnings” to make sure investors don’t lose confidence in their stock, though companies usually don’t like to admit that they “manage earnings” as opposed to “managing a business”.
Earnings in a period are basically an accounting item, a bookkeeping entry. They do not correspond to cash (or plain money) generated in that period, because in addition to cash, earnings include all other movements in the assets and liabilities of a company. And these assets and liabilities are themselves also values of expected future monetary cashflows, that may bear no relation to actual money flows in the period.
Much accounting creativity goes into coming up with quarterly earnings that are reported to the public through the quarterly company filings to the Securities and Exchange Commission or SEC. Strong steady earnings have a psychological effect on the market of inspiring confidence in a company, which leads to a strong stock value and the most desired outcome – easy access to the capital and debt markets. Any company without easy access to the capital and debt markets is likely to stumble and fail for, without such access, they may have problems growing their business and paying bills as they fall due. Access to capital depends entirely on confidence that a company will ultimately be able to generate the required returns for the investor in cold hard cash.
Once just a bit of confidence is lost in a company, difficulty in getting access to capital is often compounded by rating agencies and analysts downgrading companies and forcing even more lost confidence. Access to capital becomes even more difficult, leading to more downgrades and so the cycle continues. This downward spiral could keep feeding on itself to ultimately force a company into bankruptcy. This is what happened with Enron – confidence that its numbers represented reality was lost and the market came to the conclusion that Enron couldn’t generate the future money that investors had originally expected. This started the downward spiral to bankruptcy.
These features of the markets, especially the fear of getting onto this downward spiral, creates all kinds of pressures for grooming quarterly earnings to be just what the market expects. We already saw that falling short of market expectations can be quite disastrous, and exceeding them too much is also dangerous because it raises expectations for future earnings. Therefore an ideal world for management of a company is to keep earnings growing at a level exactly as the market expects. And so we have so-called “managed earnings”. The challenge then is to make sure the market has confidence that those are, in fact, the REAL earnings – that they really represent what the future holds in terms of generating cold hard cash.
This amazing area of wizardry known as “managing earnings” seems to be a luxury reserved only for corporations. You and I don’t have the luxury of being able to massage our income when we report to the IRS or apply for a mortgage. The pale faces of officials seen on TV after the Enron implosion after mention that the “Enron problem” might be systemic most likely is due to the widespread knowledge that – Yes, indeed companies do “manage earnings” even though what they are supposed to be doing is managing a business. But its just one of those things everyone knows, but nobody wants to talk about.
Excerpt: “The Other Side of the Mirror”. Stevie Nicks
The “Accounting in Wonderland” article begins as follows…
“General Electric is without a doubt one of the most beloved stocks in history. About the worst criticism ever leveled at the illustrious company is that its stunning run of profit growth – 101 straight quarters – is somehow artificial, the result of “managed earnings”. After all, the argument goes, GE never seems to have had a loss in one division that wasn’t happily offset by a gain in another. Can such an extraordinary record really be the result of an uncannily canny management – or is there a bit of accounting wizardry going on behind the curtain?” GE denies such allegations and the revered Jack Welch, former CEO of GE always said “GE manages businesses, not earnings”.
In some interesting statements, that would have been very prophetic if said about Enron at the time this article was written, reporter Jeremy Kahn goes on to say “If the company’s core operations were ever to hit a rough spot … investors might not discover it until its too late. Until very too late indeed.”
Concerned about this accounting wizardry Kahn says he “dove into GE’s financial statements and wound up having an adventure worthy of Lewis Carroll. When I landed, I was in a place where little was obvious, nothing was simple, and no one – not even the number crunchers at GE – seemed to know the difference between reality and fantasy”.
“It’s an extremely difficult company to evaluate because there are so many moving parts” says a GE analyst at Edmund Jones, ranging from television network NBC, to Jet Engines and Light Bulbs, to the largest business of all, the financial empire known as GE Capital. Kahn thought he’d start his investigation there.
This investigation led Kahn to find a series of transactions and cross-holdings between GE Capital subsidiaries that not even the GE analysts on Wall Street understood. He goes on to observe that “analysts who cover the stock are much like the guests at the Mad Hatters tea party – blissfully oblivious to the illogic swirling around them.” This special practice in wizardry known as shuffling numbers around the subsidiaries and associates to optimize earnings will be important for us to remember because it’s a key part of the Enron saga. Only in Enron’s case its tricks involved invisible partnerships that didn’t appear on the balance sheets – money would just appear from them and disappear and reappear again.
Funny, Kahn found similar phenomena in the GE accounts. In his review of the losses emerging from the bursting of the Internet bubble he noted that he had no way of figuring out just how much money had gone down the tubes. This was “owing to … the Chesire Cat Effect: Certain investments suddenly appear, disappear, and then reappear in GE’s filing with the SEC. Meanwhile the value of some investments float, mischievously disembodied from reality.” Finally he got an admission out of GE spokesperson Gary Sheffer who said “There were some errors in our methodology for calculating value” and more errors were found in some of the mysterious disappearances and reappearances of certain items. So how many accountants missed these mistakes he wondered? LOTS.
And as for the amazing smoothness of earnings, amidst lots of ups and downs in each varied business unit, Kahn says he found it impossible to understand the so-called once-off charges and gains that miraculously always offset each other to smooth out earnings reported in the SEC filings.
It should be noted here that GE has won all kinds of awards for disclosure and transparency. But what are we to make of all this, when even the analysts and accountants aren’t seeming to understand what’s going on in the financial statements? And what of the issue of conflict of interest between a company and its auditors who review its accounts – are they really independent when they depend on the same companies for their revenue stream?
Let’s listen to some of the concerns coming out of Congress during the Capital Markets subcommittee hearing in the aftermath of the Enron collapse. This hearing was on December 12th and in the following you will hear a member of this committee ask the Chief Accountant of the SEC some pointed questions.
Excerpt: Accounting Issues. Capital Markets and Oversight Subcommittee Hearings Dec 12th.
The Making of the Enron Energy Empire
Now lets focus on the amazing disintegrating firm Enron, to study exactly how its accounting wizardry ultimately led to its demise. Before looking into the accounting wizardry lets first look at what Enron was and how it grew to such great heights.
To start off lets hear the story straight from one of Enron’s most revered Wizards at the start of 2001 when Enron was the darling of Wall Street. What follows is an excerpt from a Motley Fool radio show interview with now-disgraced former CEO of Enron, Jeff Skilling.
Excerpt: Motley Fool interview with disgraced-wizard Skilling
This bragging about Enron in the Motley Fool interview is notable for what it doesn’t say. Notably Mr. Skilling forgets to mention the serious problems Enron was facing at the time with its water privatizing extravaganza in Europe and its energy calamities in Brazil and India. We will come back to this point in a minute but in order to understand these troubled areas it is instructive to take a quick look at Enron’s involvement in the California Energy Crisis, their attitudes to any kind of government regulation and public goods, and their involvement in shaping the Bush administrations energy policy. First, we’ll listen to a bit more of the Motley Fool interview with the disgraced Wizard Skilling about the California Energy Crisis.
Excerpt: Motley Fool interview with disgraced-wizard Skilling – CA Energy Crisis
On this topic lets hear some more from the December 12 Congressional Hearing on Enron from a Representative in the State of Washington, discussing the need for a better look at Enron’s involvement in shaping America’s energy policy
Excerpt: Energy Policy Influence. Capital Markets and Oversight Subcommittee Hearings Dec 12th.
The Enron board and senior management clearly despised any kind of government regulation at all. In the United States, through Enron chair Ken Lay’s close ties with the Bush Administration, Enron was able to have troubling rules crushed and eliminated by its friends in government. This made all their US investments much more valuable. Perhaps it was this ability to steam-roll over democracy in the United States that led Enron to believe that it could squash regulation everywhere in the world and take over all public goods for its own private profit.
Indeed this is the approach that Enron took to water and there is no shortage of evidence to suggest that Enron wanted to privatize the world’s water – recall that we spoke about this water market logic in Wizards Part 7. Thankfully, the water investments ultimately played an important role in drowning Enron in its own arrogance. Why – those pesky Europeans considered water to be a public good, even after Enron went and spent all this money on water investments there. Similarly, politics and the desires of the pesky public played a significant role in devaluing Enron’s energy investments in South America and India.
Oh No! Imagine if shareholders found out that all this money was spent on water and offshore energy businesses and now these investments were proving to be worth not very much. Then Enron would be in big trouble and people would realize it wasn’t the powerful and important wizard it had been claiming to be all these years.
And so the accounting wizardry began!
A July 30th 1998 article in the Economist entitle “Wet Behind the Ears” begins “Allowing electricity to come in contact with water is dangerous.” The article then goes on to talk about the huge price that Enron paid for Britain’s Wessex Water business and all the financial dangers that come with privatizing a good that everybody else considers to be public.
A November 2000 edition of Democracy Now! Gave a pretty thorough account of the problems that Enron was having with the government and people of India in its energy operations there, as well as the close ties between Enron’s chairman Ken Lay and the Bush Dynasty.
References to both of these sources can be found on the Wizards of Money web site for people who want a better understanding of these offshore deals and their associated problems.
Both of these sources appear to have identified two key financially troubled areas of Enron well before Wall Street did. Evidently Enron thought it could carry its power over governments to the rest of the world to make them behave the way Enron wanted them to – expecting this to happen in Europe, South America and India. But Mr. Lay’s charms didn’t seem to work so well in these arenas and Enron ended up having to stomach democratic forces in its offshore operations and in the process was losing pots of money.
Frightened of being found out, frightened of being demoted from the throne belonging to one of energy’s most powerful wizards Enron decided that honesty was the worst policy. It then cooked up some bookkeeping wizardry to hide the losses and overspending on these disastrous offshore investments that had been devalued by democratic forces.
As documented in the company’s Third Quarter 2001 SEC filing Enron set up some Limited Partnerships to take the assets so troubled by democratic forces off of its books. One partnership was called Whitewing Associates and it owned a special entity called Osprey which in turn bought Enron’s troubled power operations in Europe and South America. Enron set up Whitewing to borrow the money from outside third parties to buy the troubled offshore assets and thus hide these disastrous investments from Wall Street. But the rest of the market wasn’t as naïve as Enron in assuming that government regulation would soon be scuttled to provide necessary returns on capital. The investors in Whitewing debt apparently thought the Enron investments were pretty dodgy and demanded additional guarantees from Enron. It is these guarantees that Enron management seemed to keep secret from everyone else and which ultimately contributed to Enron’s demise.
The Whitewing investors – whoever they were – seem to be pretty savvy. In order to invest in the Whitewing debt securities used to buy Enron’s troubled assets they demanded that Enron agree to issue them extra Enron shares if the troubled assets were having problems generating the cash needed to pay off the debt. But the investors wanted to cover every contingency and they knew that even this guarantee would not be good enough if someday Enron wasn’t the golden child of energy anymore and its stock price plummeted. They demanded the added guarantee that if Enron stock fell below a certain price level and if Enron debt ever got downgraded to junk, ALL the debt on Whitewing’s balance sheet would become immediately payable by Enron itself.
Enron did EXACTLY the same thing with its troubled water investments when the rest of the world was saying that they thought water should be a public good. They set up the Atlantic Water Trust and used it to set up a special entity called Marlin which was used to raise funds in the form of debt securities. This was then used by Marlin to buy the troubled European water businesses and take them off Enron’s balance sheet so that Enron didn’t have to reveal these bad bets to The Street.
In this way Enron avoided taking huge losses on these bad bets to its balance sheets and Wall Street continued to think that Enron was a powerful energy wizard. But people didn’t know about all these costly guarantees granted by Enron in order to create the entities that took the assets and associated debt off Enron’s books. Instead all they saw were miraculous gains on these sales to the secret partnerships. Little did anyone know that one day the trickery would be discovered and the debt was to all land back on Enron’s books and force it to go bankrupt.
All that it would take to trigger the chain of events was some small loss of confidence in the company that could ultimately send it on the type of downward spiral we discussed earlier. At some point on this downward spiral the “debt trigger” in the secret partnerships would be released and things would get much, much worse.
The initial trigger was released around March 2001 when all the telecommunications companies were getting into trouble because of over-investment in infrastructure. Enron, having invested so much in bandwidth trading, had its share-price hit by this market’s down turn and by the beginnings of a general recession. Also some of the brighter analysts were starting to notice that since Enron was really mostly a trading company its Price to Earnings ratio should really be much lower than it was and this also contributed to the share price’s downwards direction.
By Summer 2001 Enron’s share price had dropped to less than $40 per share which was below the trigger thresholds on the guarantees on some of the secret partnerships. Enron management was getting nervous that these deals might unravel and rear their ugly heads to the world. CEO Jeff Skilling quit suddenly. Around the same time it was revealed that there was a whole slew of other secret partnerships called LJM and LJM2. These were involved in all kinds of mysterious relationships with Special Purpose Entities (SPEs) with names like Raptor, Chewco and JEDI.
These secret partnerships and SPEs were not on Enron’s balance sheet but had been run by Enron’s CFO Andy Fastow who had been making handsome profits from them according to several Wall Street Journal articles that ran in October. Enron revealed in its second quarter SEC filing that Fastow suddenly got out of the partnerships, leading many to wonder not only what these partnerships were but also what was going wrong with them that Fastow wanted out and Skilling had quit Enron. In retrospect we understand that at this time certain triggers had been flipped in the partnerships’ guarantees and the deals were starting to explode all over Enron’s balance sheet.
Confidence in Enron was dealt a further blow when these partnerships had obviously started falling apart bringing the bad investments and associated debts back onto Enron’s balance sheet. By Halloween the SEC had launched a formal investigation.
Losses were so large and confidence so shot that Enron’s only hope would have been rescue from the energy company Dynergy. But as more losses kept emerging and more injected cash kept disappearing they too got nervous and called off the deal.
Standard and Poor’s finally downgraded Enron’s debt to junk and pushed all the triggers on the Whitewing and Marlin entities so that all that debt on their balance sheets became immediately payable by Enron.
Enron didn’t have the cash to pay the huge debts , nobody in their right minds would invest in them, and they were forced to declare bankruptcy.
On December 4 about 4,500 employees of its Houston headquarters were marched out of their offices and told to go home. For an inside look at what this roller coaster ride was like here is an interview I did with Ogan Kose a former Enron employee in the Global Markets and also the Risk Mangement area of Enron at its Houston headquarters a few weeks after the collapse.
Interview with Ogan Kose, former Enron employee.
For the holidays all lots of employees got was unemployment and worthless pension plans. The responsible executives have been found to have enriched themselves and have declined to present themselves for questioning. No justice appears to be on the horizon for the rest of the employees. Here is an excerpt from the December 12 Congressional hearing describing how much the Enron executives made out of this extravaganza.
Excerpt: Insider Trading. Capital Markets and Oversight Subcommittee Hearings Dec 12th.
Given the Enron managers’ fetish for Star Wars characters such as JEDIs and Chewbacca, there is some comfort in knowing that this Evil Empire was defeated in part by the effect of overseas governments representing people and people wanting to hold on to public goods. The irony is that the home country’s government, which we are told is the only good empire these days, was the closest ally of the evil energy empire throughout the whole saga.
That’s all for Wizards of Money Part 8. Please visit the Wizards of Money web site at www.wizardsofmoney.org. for the full text of all Wizards episodes and for more references.
