HOUSTON -- Can a penny be enough to trigger a prison
sentence?
The Justice Department's case against two former Enron
Corp. executives includes accusations that the one-time energy
giant's earnings-per-share figures were tweaked improperly --
once again spotlighting the murkiness of such calculations.
Prosecutors allege that former Enron President Jeffrey
Skilling at one point pulled a penny out of thin air to avoid
falling short of Wall Street stock analysts' expectations,
which might have caused investors to slam the company's share
price. Defense attorneys for Mr. Skilling and co-defendant
Kenneth Lay, Enron's former chairman, insist that such changes
were routine refinements to initial estimates, saying
accountants often "sharpen" their pencils and "scrub" books in
search of legitimate earnings when wrapping up financial
reports.
Fallout from the wave of corporate accounting scandals that
broke in recent years, including tougher standards imposed by
the Sarbanes-Oxley Act of 2002, helped to trigger a record
number of earnings restatements last year, 620 of them by 580
companies. The Enron trial's outcome could further influence
the earnings-reporting processes at corporations, especially
if per-share-earnings manipulation becomes the basis for a
conviction.
"If, per chance, this is something that the case turns on,
my goodness, we're going to have CFOs trying to better
document every judgment call," says Paul R. Brown, a professor
of accounting at New York University's Leonard N. Stern School
of Business.
The Securities and Exchange Commission tried to clarify
right and wrong in this arena with a bulletin issued in 1999.
U.S. generally accepted accounting principles long have
required companies to disclose any "material" changes they
make to assumptions or estimates that go into earnings
calculations. The SEC bulletin sought to clarify what sums
should be considered "material," saying changes that affect
earnings, even by a small amount, must be disclosed when there
is "a substantial likelihood that a reasonable person would
consider it important."
That still leaves substantial room for judgment calls,
however. Though profits have to be derived from readily
documented revenue and expenses, chief financial officers make
estimates and assumptions about numerous things, including
taxes, product returns and even future stock-option exercises.
"I don't think there is any clear law on when those
decisions have to be made or exactly what kind of calculations
you need to justify," says Alan R. Bromberg, a law professor
at Southern Methodist University in Dallas. "There are a whole
bunch of judgment questions that need to be made before you
can put all the numbers to bed." One thing is clear, he adds:
When financial judgments affecting earnings are made early
enough -- not right before quarterly results are announced --
they are more easily defended.
The SEC bulletin didn't prevent subsequent corporate
scandals, as companies found ever-more imaginative ways to
manipulate earnings. For example, WorldCom, now part of
Verizon Communications Inc., padded earnings by using money
set aside for future expenses -- known as accruals -- or by
improperly accounting for expenses over several years. Those
two maneuvers have since become red flags for investors. If
the government details different accounting moves used by
Enron to find extra pennies, "those two or three will have a
bunch of CFOs deciding, 'I better cover (myself) on those,' "
Mr. Brown says.
Some companies already do more than is required to prevent
earnings manipulation. The Sarbanes-Oxley Act, passed in the
aftermath of Enron's collapse and other accounting scandals,
puts the onus on chief financial officers and chief executive
officers to certify that reported results are straightforward.
But Cinergy Corp., a Cincinnati gas-and-electric utility
holding company, requires lower-level employees involved in
financial reporting to certify their own work before each
earnings announcement. In all, 250 employees endorse their
calculations before they ever reach the finance chief and CEO.
First begun in 2003, the process allows employees to express
concerns about pending financial disclosures, says a Cinergy
spokesman.
The process "sends a message, not only to the people in the
organization but to others, that we're serious about this,"
says James R. Duncan, a former controller at KFC Corp., now a
unit of Yum Brands Inc., and currently a professor at Ball
State University, Muncie, Ind. "If a CFO doesn't have that
process, I wouldn't want to be that CFO."
In the Enron trial, the former investor-relations chief,
Mark Koenig, testified that on Jan. 17, 2000, the day before
Enron was to report fourth-quarter results, he informed Mr.
Skilling and others that Wall Street's consensus earnings
forecast had risen by a penny to 31 cents a share. At the
time, Enron was preparing to announce profit of 30 cents a
share, the witness said.
"I was trying to see what could be done to have earnings
match that," Mr. Koenig testified. By the next morning, he
said, the earnings announcement had been changed to 31 cents a
share. On cross-examination, he conceded he wasn't sure where
the extra penny had come from, nor did he ask anyone why the
figure was changed, but he said he believed it was
manufactured to meet analysts' estimates.
Later that year, the company was preparing to announce a
32-cents-a-share second-quarter profit, just meeting analysts'
expectations, Mr. Koenig testified. But after Mr. Skilling
told subordinates that he wanted to beat expectations by two
cents, the figure was raised to 34 cents, Mr. Koenig said.
Defense attorneys said allegations that Messrs. Skilling
and Lay misled investors are baseless. Judgments on what to
include or exclude in earnings calculations, they said,
routinely are decided in executive suites up to the time
results are reported publicly.
To bolster their contention that the defendants had been
straightforward, the lawyers played videotapes of the accused,
who in discussing earnings with analysts and employees,
admitted that the company faced challenges.
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