Firms Reverting to by-the-Books Balance Sheets

As investors burned by the Enron scandal punish companies with even a whiff of accounting irregularity or other questionable behavior, some firms have found a new strategy: an old-fashioned, forthright balance sheet and income statement.

Espousing a cleaner-than-thou philosophy, corporations are turning away from finance practices that not only are legal but in other times might have won them praise for creativity.

Experts say the message these companies want to convey is “We’re not Enron.” Some are swearing off complex ways of reporting sales and profit that strike critics as misleading or simply difficult to understand. Some are working to bolster the independence of their boards, mindful of the tarring Enron directors have taken for apparent conflicts of interest.

The Enron debacle has given the American public a quick lesson in complex accounting, introducing such arcane terminology as synthetic leases, special purpose entities, derivatives and pro forma.

Investors are taking a microscope to accounting methods that seldom raised questions before the Enron scandal. IBM, Qwest Communications and Marriott International last week joined a list of companies whose shares have been rocked by accounting concerns, among other factors.

If companies are being punished for tangled financials, perhaps the flip side is that others will be rewarded for clarity. “Because of Enron, a premium will be attached to companies with sterling governance structures and financials that are very, very plain vanilla,” said Charles Elson, who heads the University of Delaware’s Center for Corporate Governance.

Much of the housecleaning is meant to reassure worried stockholders and buff firms’ public image, but there is a more pressing concern: The Securities and Exchange Commission, itself criticized for missing Enron’s problems, has put corporate America on notice that within the year, it will more closely examine the books of the Fortune 500, the nation’s largest companies.

The SEC also has warned that adherence to the letter of accounting rules may no longer be enough; companies that produce misleading financial statements, even if they technically comply with regulations, could be punished.

Some firms are making changes on their own initiative, others only after the posse has arrived.

Krispy Kreme Doughnuts last week decided to scrap a synthetic lease it was using to finance a new factory. It didn’t act, however, until it had been zinged by Forbes magazine for the arcane debt instrument and then slammed by a headline in the tabloid New York Post: “Krispy Kreme Bites.”

“While this type of lease is both common and complies with the most rigorous accounting standards, the company . . . will instead use conventional, on-balance-sheet financing,” Scott Livengood, Krispy Kreme’s chairman and chief executive, said. “There is no reason for us to do anything that could be misinterpreted, regardless of how legal and acceptable it may be.”

Although firms are anxious to calm investor fears, you aren’t likely to see TV commercials touting clean balance sheets or conservative revenue recognition, communications experts say.

“An ad campaign is far too blatant,” said Jerry Swerling, who runs the public relations program at USC’s Annenberg School for Communication. “Besides, it’s not the kind of thing you’d advertise.”

Instead, companies are using their own investor relations staffs or hiring outside public relations agencies for help in delivering the we’re-not-Enron message, he said.

One of the key questions raised by Enron’s implosion has been, where was the board of directors? Although board members contend that key information was withheld from them, critics also have noted that seven of Enron’s 14 directors either did business with the company, worked as paid consultants to it or were affiliated with organizations that received large donations from Enron or its top officers.

With board independence in the spotlight, Interpublic Group, the world’s largest advertising firm, this week announced that four of its executives would step down from the board and an unaffiliated member would be added. This leaves the board with two Interpublic executives and seven outsiders, whereas the old split had been six and six.

“The interests of Interpublic shareholders will be best served by a board that is primarily made up of independent, outside directors,” Chairman John Dooner said in a statement that did not mention Enron.

Procter & Gamble recently went out of its way to tell Wall Street analysts that it has “no material off-balance-sheet financing.” A year ago, such a comment might have drawn blank stares, but today anyone can see it’s a direct reference to a finance and accounting practice that was at the heart of the Enron collapse.

Enron used limited partnerships, some headed by former Chief Financial Officer Andrew S. Fastow, to artificially boost profit and keep large amounts of debt off its corporate balance sheet. Enron’s slide toward bankruptcy became steeper Nov. 8 when it acknowledged that these arrangements were improper and reduced its previously reported profit by $586 million.

Henry Silverman, chief executive of the hotel and real estate firm Cendant, which has had serious accounting problems in the past, complained in a recent television interview that the harsh new scrutiny amounts to “the McCarthyism of guilt by association.”

Nevertheless, Cendant bowed to the pressure and said that in the future it would reduce the number of special “one-time” charges it takes against earnings.

Financial watchdogs, including former SEC Chairman Arthur Levitt, have criticized firms for excessive use of such “extraordinary” charges. Many companies routinely offer separate versions of their income statements each quarter and encourage analysts to focus on the one with the better numbers.

The idea is to disclose charges as required by generally accepted accounting principles, or GAAP, in one statement, but then to whisk away the charges in a rosier pro forma statement, which is a hypothetical description of a company’s finances.

If firms can persuade Wall Street that the pro forma statement gives a truer picture of their financial status, there is an incentive for them to label all kinds of expenses extraordinary.

Post-Enron, however, that practice may be on the wane. Several firms, including computer chip maker Xilinx and electronics manufacturer Solectron, recently decided to stop issuing pro formas entirely.

Kris Chellam, Xilinx chief financial officer, acknowledged in an interview last week that because of the Enron blowup, “everybody gets cast in a bad light” for practices that once were widely accepted.

The only major effect the change will have on Xilinx relates to its acquisition in 2000 of a company whose main asset was a group of talented engineers. The engineers signed contracts agreeing not to compete against Xilinx for a specified period of time should they leave the company.

According to GAAP, Xilinx must take regular deductions from income to reflect the declining value of those non-compete agreements as time runs out on them. Now it will no longer produce a separate pro forma statement excluding the deductions.

“The change in reporting will cost four or five pennies in [earnings per share],” Chellam said, “but that’s immaterial compared to the benefit.” He said he expects firms to be rewarded in the stock market for greater simplicity in their financial reports.

“Ultimately, if the people don’t understand your business and don’t like what’s going on, you’ll suffer,” Chellam said.

Investors, however, shouldn’t fool themselves into thinking that more rigorous accounting methods will magically iron out the rough spots in the stock market, said Robert Olstein, a Purchase, N.Y., money manager who revels in accounting nuts and bolts.

“Every company in my portfolio does something that we have to adjust for,” Olstein said. “The notion that GAAP produces economic reality is a fantasy.”