Financial accounting runs the world but should it?
By Melvin J. Howard
Financial accounting runs the world. This is so simply because money and finance run the world. 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 money supply of the non-bank public. 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 Reserves balance sheet. Financial instruments other than 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 be transformed into a real good such as food and clothing through the process of trade.
The reason financial accounting 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 wage and salaried 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 not understanding the system.
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 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 persons balance sheet.
For the financial system as we know it to survive it is the wealthy class, above all others, that must keep confidence in the global number accounting 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 is what has been happening recently in the debt and corporate paper market.
This ultra 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 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 is important for you to understand a little of what is going on in the accounting world. I will summerize. The accounting 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 hocus-pocus 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 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 or what I like to call QUNAMTUMNOMICS. 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 what we have is 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.
I have noticed lately that "managing earnings" have become a luxury for some corporations. The officials seen on TV after the Enron implosion mentioned 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 this is what you have to watch out for.
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. Lays 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 piles of money.
Frightened of being found out, frightened of being demoted from the throne belonging to one of energy’s most powerful company 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 Enrons 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 Enrons 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 Whitewings 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 company. 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 I 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 markets 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 prices 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 Poors 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. Now days you have to be a forensic accountant to understand just what is going on in some companies. So what does this all mean for investors don’t follow the heard mentality be selective do your homework keep it simple. Maybe Warren Buffet is right you think ?
