In 2005, four years after Enron’s bankruptcy in 2001, but three years prior to Lehman’s bankruptcy in 2008, I proposed to the Financial Accounting Standards Board (FASB) the addition of a sixth standard financial reporting statement to be called the “Fair Value Statement.” The Fair Value Statement would have been in addition to the Balance Sheet, Income Statement, Statement of Comprehensive Income, Cash Flow Statement, and Statement of Stockholders’ Equity, which are authorized under FASB’s accounting standards codification.[1] FASB did not act on this proposal.
The proposed Fair Value Statement could have mitigated some of the damage arising from the Great Recession of 2008 by making the relative strength or weakness of earnings and assets contained in income statements and balance sheets more transparent to ordinary stockholders and creditors. Adding the Fair Value Statement today would increase transparency in financial reporting going forward, and I urge FASB to adopt the use of the proposed Fair Value Statement.
HISTORY OF FAIR VALUE MEASUREMENT
Fair value measurement is based on the difference between the original cost of an asset or liability and its current clearing value in the marketplace. The notion of using fair value (sometimes called “mark to market”) in financial statements has a long history. One of its earliest proponents was Kenneth MacNeal in his 1939 book Truth in Accounting.[2]
This approach was further developed by Edgar Edwards and Philip Bell in 1961.[3] They made a comprehensive proposal that included a method for recording fair value changes (unrealized changes in value), but they emphasized the need to report realized gains and losses separately from these unrealized values.
A realized value reflects an event that has already taken place, whereas an unrealized value reflects events that have not yet occurred, but which will occur with differing levels of probability in the future. A realized event is frozen, fixed, and unchangeable; an unrealized event is only true at a single moment in time and will change with future changes in the market.
FASB’S AUTHORITY TO DETERMINE GAAP ESTABLISHED BY THE SEC
The generally accepted accounting principles (GAAP) used by all public companies in the United States are established under the governing authority of the Securities and Exchange Commission (SEC). The Securities Act of 1933 and the Securities Exchange Act of 1934 provide that the SEC has the authority to establish the methods to be followed in preparing accounts and the form and content of financial statements filed under the acts.[4] The SEC has currently delegated its authority for setting GAAP to FASB under Accounting Series Release No. 150 (ASR 150).[5]
Historically, the SEC has delegated the authority to set GAAP to the private sector. From 1938 to 1959, the Committee on Accounting Procedure (CAP) was responsible for setting GAAP. In 1959, the Accounting Principles Board (APB) replaced the CAP, and the APB operated from 1959 through 1973. In 1973, the SEC delegated its authority for setting GAAP to FASB.
Criticism of the SEC’s oversight with respect to FASB’s rule setting increased following Enron’s bankruptcy in 2001. The SEC was concerned that FASB had become too “rule-based” and there was a push for more “principle-based” accounting standards. In 2002, Robert K. Herdman, then Chief Accountant of the SEC, noted that:
Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard. An ideal accounting standard is one that is principle-based and requires financial reporting to reflect the economic substance, not the form, of the transaction.[6]
EFFORTS TO ADDRESS THE ENRON FAILURE AT FASB
The Energy Trading Working Group (the Working Group) was formed by FASB to propose possible changes to financial reporting standards in response to weaknesses that had become apparent following the Enron bankruptcy in 2001.[7] The Working Group’s efforts were continued through the subsequent work of FASB’s Valuation Resource Group (I served on both groups).
In the Working Group, one issue that emerged was the lack of transparency in existing accounting standards regarding the quality of earnings, assets, and liabilities presented by financial statements. This difficulty arises from the “mixed attribute model” used pursuant to GAAP, which mixes realized and unrealized values in both the Income Statement and Balance Sheet. By showing realized and unrealized values in the same Income Statement and Balance Sheet, temporal logic is lost to investors and creditors trying to understand the timing and probability of future cash flows. Without a clear separation of realized from unrealized results, companies with less probable future income streams may appear to be as strong as companies with existing proven income streams.
I became convinced that knowing the quality of a company’s earnings was often related to its relative percentages of realized versus unrealized earnings. In addition, within a company’s unrealized earnings, there were significant differences between unrealized earnings that were fixed versus unrealized earnings that were subject to change. Based on my efforts in the Working Group, I published a series of articles setting out possible improvements.[8] Copies of these articles were provided to FASB.
In “Memo to FASB and IASB,” I first outlined my proposal to add an additional financial reporting statement—the Fair Value Statement—and described how it might be utilized in the future. What was not discussed in “Memo to FASB and IASB” was the fact that I employed this proposed methodology to deconstruct Enron’s final full year of financial reports (calendar 2000) for FASB.
DECONSTRUCTING ENRON’S FINAL FINANCIAL STATEMENTS
On May 6, 2005, I wrote to FASB. In this note, I told FASB that I was preparing pro forma versions of Enron’s calendar 2000 financial statements deconstructed using the methodology described in “Memo to FASB and IASB.” To establish a clearer temporal reporting framework, I segregated items measured at fair value (i.e., the unrealized values as of 12/31/00) that originally appeared as components of Enron’s 2000 Income Statement and its 2000 Balance Sheet into a pro forma “Fair Value Statement.”
The preparation of this pro forma statement did not benefit from hindsight. Instead, its purpose was to reformat the information presented to investors and creditors in early 2001 (i.e., prior to the bankruptcy filing) and to see whether a more useful form of presentation could have been prepared from the same underlying data set. To the extent that available public information was unclear or incomplete, I tried to make reasonable working assumptions.
These financial statements were then formatted into the “Enron Pro Forma Financial Statements” that I presented to FASB during 2005. In discussing the Enron Pro Forma Financial Statements, I told FASB that:
This deconstruction of Enron’s final year financial performance, which accepts all of Enron’s pre-bankruptcy valuations, indicates that (even using Enron’s own numbers) only 41% of Enron’s reported 2000 Net Income had been realized, and that only 65% of Enron’s Shareholders Equity was supported by realized results. A discrete presentation of unrealized events, like the ‘Fair Value Statement,’ separate from the realized results in existing financial performance reports, might prove useful in evaluating future market risks.
Enron’s originally reported Comprehensive Net Income was $735 MM. Of that $735 MM, I determined that $333 MM (i.e., more than 45 percent) was in the form of Fair Value Unrealized Net Gain, After Income Tax. The remaining $402 MM of Restated Realized Net Income is what appears as the Pro Forma Net Income. In addition, only 65 percent of Enron’s Shareholders Equity was supported by realized results ($7,511 MM out of the previously reported $11,470 MM).
To many investors and creditors, these numbers will speak for themselves.
ALTERNATIVES AND CONCLUSION
The need for separation of realized and unrealized data in financial statements became increasingly apparent as the larger bankruptcies of 2008–2010 began to emerge. With the benefit of hindsight, we can now see that the Enron failure in 2001 was in some ways a small-scale trial run for the much larger series of financial failures that began in 2008. By failing to learn from the 2001 Enron experience, the financial and legal communities unnecessarily and inadvertently helped set the stage for the more serious problems that arose in 2008.
[1] FASB Accounting Standards Codification, Presentation on Financial Statements, ASC ¶ 205-10-45-1A (Fin. Accounting Standards Bd.)
[2] Kenneth MacNeal, Truth in Accounting (MacNeal 1939).
[3] Edgar O. Edwards & Philip W. Bell, The Theory and Measurement of Business Income (1961).
[4] See, e.g., 15 U.S.C. §§ 77s(a), 78m(b)(1).
[5] SEC Accounting Series Release No. 150, 5 Fed. Sec. L. Rep. (CCH) ¶ 72,172 (Dec. 20, 1973).
[6] Testimony Concerning the Roles of the SEC and the FASB in Establishing GAAP Before the H. Subcomm. on Cap. Mkts., Ins., & Gov’t Sponsored Enters., Comm. on Fin. Servs. (2002) (Statement of Robert K. Herdman, Chief Accountant, SEC).
[7] Daniel Fisher, Enron’s Real Financials, Forbes, Feb. 3, 2003.
[8] Gordon E. Goodman, Differences in the Quality of Earnings, GARP Risk Rev., Nov./Dec. 2003, at 6; Gordon E. Goodman, Transparency Quest: The Battle to Improve Financial Accounting Standards and Avoid the Next Enron, GARP Risk Rev., May/June 2004, at 18; Gordon E. Goodman, Memo to FASB & IASB: How to Repair Statements, GARP Risk Rev., Jan./Feb. 2005, at 22.
