The following is from the Feb. 16, 2006, edition of The Wall Street Journal.


Profit tweaking may lose favor after Enron trial

By Gary McWilliams and Kara Scannell
The Wall Street Journal

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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