Meet the Street: What to Look for in Financial Statements, Post-Enron - TheStreet

It's probably safe to say that after the spectacular collapse of

Enron

(ENRNQ)

, corporate accounting will never be the same.


Bob Willens, Accounting and
Tax Analyst,
Lehman Brothers

Recent Meet the Streets

Cohen & Grigsby Attorney
Bill Kelleher

Trading Psychologist
Dr. Thomas J. Ferraro

UPENN Law School's
Jeff Brotman

Credit Suisse's
Christoph Bianchet

Accenture's
Thomas Bell

American Benefits Council's
James A. Klein

Financial statements are being scrutinized as never before, and investors are increasingly favoring companies with clearer, more transparent accounting.

To shed some light on what questions investors should ask when examining financial statements and what rule changes might be in the offing,

TSC

turned to Bob Willens, an accounting and tax analyst, and managing director at Lehman Brothers.

Among other things, Willens discusses how off-balance-sheet accounting can be a legitimate accounting tool when used correctly. He also discusses the impact of the recent elimination of goodwill amortization on companies' earnings.

TSC: What are the main lessons we can draw from the collapse of Enron? Do you think Enron is an isolated case, or are there other Enrons waiting to happen?

Willens:

The big accounting issue that was a controversy in the Enron scandal is the notion of the off-balance-sheet activities. To answer your questions, yes and no. Yes, Enron is an isolated case in terms of degree, but no, not in kind.

I have to tell you that off-balance-sheet financing is very prevalent in corporate America. Whenever accountants are asked to assist companies during transactions such as acquisitions, one of the objectives is to keep the transaction off the balance sheet. But Enron flagrantly ignored the rules. To that extent, I believe that the case is isolated.

From the investor's point of view, you need to ask how to get your arms around the kind of exposure that the company has besides what it has recorded in its financial statements.

TSC: This information isn't readily available anywhere, though, right?

Willens:

It's hard to find. There are some things you need to do to get the sense of its extent or magnitude. When a company is accounting for something off the balance sheet, that means it has created a partnership or a venture in most cases. The company itself will own only 50% of the partnership, and some hopefully independent party, or parties, will own the balance of the partnership.

This way, a company can avoid consolidating the venture, which is what off-balance-sheet means. So the way for you to get a handle on the magnitude of it might be to look in the footnotes and see descriptions of what companies refer to as "investments and unconsolidated affiliates." That is all of the company's off-balance-sheet stuff. This won't be described in great detail. But it's a start.

In my judgment, what investors can get from statements like these is, at least, gauging the potential for an Enron-like situation. Maybe all of these equity investment methods should be consolidated and be on, not off, balance sheet going forward. You will never know for sure because, as an investor, you will not have access to the partnership or venture agreements companies make. But getting a feel for what may be going on in the background nonetheless is a valuable exercise.

TSC: Do you see any bona fide reasons for the use of off-balance-sheet transactions?

Willens:

They serve a totally useful purpose. Whether they reflect reality is another matter, if they're abused. In Enron's case, of course, none of it should have been off the balance sheet because the company had full exposure.

But when you have a true joint venture, the other party has the equivalent amount of exposure. Then, clearly, because you don't control the venture, you shouldn't have it on your balance sheet. It's a very tried-and-true method of financing. The key is you shouldn't abuse it.

TSC: In the aftermath of Enron, whose complex earnings reports baffled even analysts and accounting professors, do you think investors are starting to shun seemingly overcomplicated businesses and their financial statements?

Willens:

You might be on to something there. Complexity is now almost synonymous with chicanery and obfuscation. I really get the impression that investors are now looking for simplicity and companies with a very clean set of financial statements, which may be pure-play companies or ones with only one or two lines of businesses without a whole lot of bells and whistles.

TSC: Do you think some of the accounting reforms now being discussed will be pushed through at a faster pace as a result of these scandals?

Willens:

Absolutely. The group that will likely benefit most is the FASB

Financial Accounting Standards Board itself, which has been historically battered about by its constituents, namely corporate America. If you've ever listened to

current

Securities and Exchange Commission

chairman Harvey Pitt or

former SEC chairman Arthur Levitt, one of the biggest problems for the FASB is that it takes them so long to promulgate accounting principles. They are sometimes not as responsive as they should be, because they encounter huge opposition if they do something corporations don't like. The industry will make sure the process is very protracted, and often raises the specter of legislation to stop them.

I think the whole problem with off-balance-sheet financing could have been avoided, had the FASB been able to define and control this item. They have had a project on this issue going on for over 10 years and have been subject to intense political pressure.

Going forward, I think the FASB will become more responsive now and even emboldened to ignore a lot of the corporate criticisms and pressure. I think the FASB will emerge from this stronger and

more independent than ever.

TSC: What about the new rules regarding amortization of goodwill? How is that going in your view?

Willens:

Writedowns will no doubt be massive. It'll all hit home in the first quarter of 2002. No. 1 is that there will no longer be amortization of goodwill. But investors should also look beyond the earnings reports and read the footnotes. They will provide computation of last year's earnings on pro forma basis without goodwill amortization. That will allow investors to make valid apples-to-apples comparisons.

If you simply take this year's earnings and compare to last year's earnings, you might get a distorted view of a company's progress. So it's good to delve into the footnotes and try to understand what is really going on. It's in fine print, so take out the magnifying glass.

TSC: How does goodwill amortization impact a company's earnings?

Willens:

The absence of goodwill amortization will increase earnings because, remember, goodwill amortization is an expense. You're removing an expense item from the financial statement and thereby boosting earnings.

TSC: So do you think the writedowns will provide a clean slate for future earnings and simpler comparisons going forward?

Willens:

Well, I would say cleaner slate, but not entirely clean. Even though goodwill cannot be amortized from now on, there are other types of intangible assets called "separable" intangible assets. These would include customer lists, noncompete convenants and other intangible assets that arise in acquisitions. FASB has concluded that these intangibles still have to be amortized.

So it's not as though we have eliminated amortization entirely. Now if you're looking at a company, you need to ask is it proper or smart to ignore amortization of these intangibles and instead evaluate these companies on the basis of their cash earnings, which is net income plus adding back amortizations.

Many tech and health care companies, media and telecom analysts will adopt cash earning approaches and, in fact, ignore the amortizations. It won't help with the simplicity, but goodwill charges are gone, so earnings will have improved.