Earnings Management - Accounting Red Flags
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Richard J. Wayman

Off Balance Sheet Accounting

Off balance sheet accounting refers to the methods a company can use to remove assets and liabilities, as well as income and expenses, from its balance sheet and income statement. In one sense, off balance sheet accounting is good because, done properly, it can protect investors by moving business risk from the parent company onto independent partners and minimize taxes, both of which benefit shareholders.

There are three main ways companies can move assets, liabilities, income and expenses from their books; special purpose entities, spinoffs, and synthetic leases.

Off Balance Sheet Companies (Special Purpose Entities)

Off balance sheet companies are separate legal entities that are jointly financed by the parent company and supposedly independent outside investors. These companies are sometimes referred to as special purpose entities ("SPE"). GAAP and tax laws allowed these structures as a legitimate way to finance risky business ventures, such as oil exploration or developing a product that is radically different from the corporate parent's main line of business.

Under normal circumstances, off balance sheet entities are legitimate tools that can protect investors. For example, oil exploration is a high-risk/high-return business and one that might not appeal to investors in more steady business, like an oil refinery. In order to facilitate oil exploration, accounting "rules" allow the refinery to establish a separate business to explore for oil and that can be invested in by others who are willing to bear that risk. Removing this exploration risk from the parent actually protects its shareholders who invested in the refinery business and do not want any part of the riskier oil exploration business.

Originally, it appears that initially Enron was using SPE's appropriately by placing nonenergy-related business into separate legal entities. What they did wrong was that they apparently tried to manufacture earnings by manipulating the capital structure of the SPEs; hide their losses; did not have independent outside partners that prevented full disclosure and did not disclose the risks in their financial statements. Or to put it another way, they got greedy.

Any system can be abused and misused. If management uses nonpublic SPEs as a way to hide debt and manipulate earnings, it will lead to Enron-type disasters. Enron has highlighted serious flaws in GAAP that hopefully will soon be corrected. In the meantime, investors should make sure that companies using off balance sheet financing conform to a few simple rules.

There should be no interlocking management: The managers of the off balance sheet entity cannot be the same as the parent company in order to avoid conflicts of interest. This was clearly not the case at Enron.

The ownership percentage of the off balance sheet entity should be higher than 3% and the outside investors should not be controlled or affiliated with the parent: This is necessary in order to prevent the "Three-Card Monte" that was used by Enron. In order to circumvent the outside ownership rules, Enron funneled money through a series of partnerships that appeared to be independent businesses, but which were controlled by Enron management. While this type of Ponzi scheme is very difficult to detect, let's hope that the regulators act fast to plug this gap.

The financial risk of all off balance sheet entities should be disclosed in the parent's financial statements: If nothing else, this must be done in order for investors to evaluate the total risk of investing in any company. Footnote disclosures of the leverage risk and any guaranteed debt would have alerted Enron shareholders of the growing risk they faced.

Under current GAAP, companies are required to disclose (albeit barely) ownership in separate legal entities. If little else is disclosed, take that as a red flag.

Spinoffs

Spinning off a subsidiary into a separate publicly traded entity is another way to establish a SPE. The only difference is that the spinoff is publicly owned and must disclose its financial statements just like the parent. For example, Williams Companies spun off Williams Communications in order to separate the business risk of a telecommunications from their shareholders who wanted to invest only in an energy company. As part of the normal process, the parent had to guarantee the debt of the spinoff. With the telecommunications crash, banks are now relying on those guarantees, which are raising the concern about the parent's ability to handle all that debt.

Synthetic Leases

A synthetic lease is a way for a company to finance a new building or plant and improve its financial performance ratios (such as return on assets and return on equity) by keeping assets and debt off its books and boosting EPS by avoiding depreciation expenses. Under the synthetic lease, a company pays a relatively small lease payment for a number of years, which usually represents the interest on the loan used to finance the building. However, at the end of the synthetic lease, the company must take ownership of the building and refinance the debt, which may not be easy if the economy is in a recession or if the company is losing money.