Hidden Debt: From Enron’s Commodity Prepays to Lehman’s Repo 105s

Enron Corporation’s commodity prepays and Lehman Brothers’ Repo 105s are recent examples of hidden debt intended to improve the appearance of a company’s financial condition. Enron used derivatives to “transform” cash flow from financing to cash flow from operations; Lehman used sale-repurchase (repo) agreements to remove debt from its balance sheet for dates surrounding quarterly reporting periods. Both tactics relied on external auditors’ narrowly focusing on internal procedures and accounting rules. Companies have historically used a variety of means to reduce reported financial leverage. This article demonstrates two new methods—Enron Corporation’s commodity prepays and Lehman Brothers’ Repo 105s—and suggests some improvements in financial reporting. Enron used derivatives to “transform” cash flow from financing into cash flow from operations. Lehman used sale-repurchase (repo) agreements to reduce its recognized debt for dates surrounding quarterly reporting periods. Their outside auditors—Arthur Andersen and Ernst & Young, respectively—were aware of these activities but focused narrowly on internal procedures and accounting rules and did not deter the misrepresentations to investors. Analysts looking at only the (audited) financials had no idea of Enron’s or Lehman’s true financial condition prior to their bankruptcies.Enron used trilateral commodity prepays to borrow funds from banks without recognizing the liability as debt on the balance sheet. The role of the third party in the structure was to provide the appearance of separate transactions between unrelated entities. A bank subsidiary, typically a shell company, entered a commodity prepay transaction with Enron. The bank subsidiary made a payment in cash on Day 0 for the future delivery, on Day T, of some commodity (e.g., natural gas). Separately, the bank agreed to sell the same natural gas back to Enron on Day T, receiving the future spot price. In addition, the bank and Enron entered a commodity swap, thereby eliminating the price risk. Enron agreed to pay the bank the preset forward price on the natural gas, and the bank paid the future spot price. When combined, the transactions produced a simple cash payment on Day 0 and a repayment on Day T that included interest. The trilateral nature of the deal, however, “allowed” Enron to report the cash receipt as arising from operations and not from financing.The Roach Report on the Enron bankruptcy stated that the company had about $10 billion in recognized debt on its books in 2000 and about $4 billion in unrecognized prepays. If the commodity prepays were correctly accounted for, debt liabilities would have gone up by 40 percent and cash flow from operations would have been halved. Arthur Andersen, Enron’s external auditor, not only was aware of the commodity prepay program but also offered guidance on the rules so that the transactions would not have to be considered loans (and the cash received would not have to be considered as arising from debt financing).A repo is the functional equivalent of a collateralized loan. Standard repos are accounted for as secured financing: The collateral remains an asset on the balance sheet of the borrower, and the amount of the loan becomes the debt liability. Paragraph 218 of Statement of Financial Accounting Standards No. 140, however, opens the door to an exception when the amount of the “haircut” (the difference between the market value of the security and the amount of the repo borrowing) is larger than the normal 1–2 percent. Lehman used Paragraph 218 to build its Repo 105 program. When it entered a repo and gave a larger-than-normal haircut (at least 5 percent), it would “have to” characterize the transaction as a sale of inventory and forward agreement to repurchase. Conveniently, these exceptions to the norm typically spanned a quarterly reporting period, often by no more than a couple days on either side.Lehman used Repo 105s in massive amounts to reduce its leverage ratio in 2008 as the global financial crisis worsened, especially after the collapse of Bear Stearns in March. The Valukas Report on the Lehman bankruptcy stated that Lehman removed over $50 billion from its balance sheet at the end of the fiscal quarter in May 2008, which reduced net leverage to 12.1. If the repo financings had instead been treated as secured borrowings, net leverage would have been 13.9. Ernst & Young, Lehman’s auditor, was aware of the Repo 105 program. It surely should have insisted that accounting for repos in two drastically different manners depending of the relative degree of overcollateralization is something that should be conveyed to investors, either in a footnote or in some accompanying statement.We see in these examples more than the usual “airbrushing” of the snapshot of the company on a reporting date; we see outright “photo-shopping.” Suggested improvements to financial reporting include increased use of averages, ranges, and standard deviations for key variables and a more principles-based approach to auditing. Instead of just affirming that the financials are in accordance with generally accepted accounting standards, auditors should state that, to the best of their knowledge, the statements reflect true financial condition.