Years before Enron Corp. collapsed, wiping out thousands of jobs and billions of dollars of shareholder wealth, outside auditors from the big accounting firm Arthur Andersen found $51 million of problems in the company's books -- and decided to let them go uncorrected.
While auditing Enron's 1997 financial results, Andersen proposed that the energy company make "adjustments" that would have cut its annual income by almost 50 percent, to $54 million from $105 million, according to testimony Andersen has presented to Congress.
Enron chose not to make those adjustments and Andersen put its stamp of approval on the company's financial report anyway.
Had Andersen refused, some observers say, Enron's tale might have turned out differently. If it had been forced to use more conservative accounting practices, the Houston energy trader might never have risen to be the seventh-largest company on the Fortune 500 with a peak share price of $90. And it might never have drowned in a morass of misleading accounting, the largest corporate bankruptcy in U.S. history, its stock price reduced to less than a dollar.
"Maybe if Andersen had put its foot down a few years ago, then Enron might still be a viable going concern today," said analyst John P. Gavin, president of SEC Insight Inc., which researches corporate accounting for institutional investors.
Last month, after a host of accounting problems caught up with it, Enron corrected its books going back to 1997, reducing four years of audited profits by $591 million. The correction included the $51 million of adjustments that Enron and Andersen long ago concluded were unnecessary.
The disclosure of accounting errors helped plunge Enron into a downward spiral as investors and customers abandoned it, their confidence shattered.
Now, Enron and Andersen face shareholder lawsuits and congressional investigations. The Securities and Exchange Commission and the Justice Department are examining Enron's downfall to see if wrongdoing played a part.
The problems that Andersen spotted back in 1997 have been overshadowed by much larger flaws in Enron's bookkeeping, such as vast debts and losses ascribed to related partnerships that were improperly kept off the company's books.
But the story of the $51 million shows how, time and again, potential warnings of financial disaster have gotten past the outside auditors responsible for scrutinizing Corporate America's books and protecting the investing public.
In testimony to Congress earlier this month, Andersen chief executive Joseph F. Berardino said that, after proposing the $51 million of adjustments to Enron's 1997 results, Andersen decided that those adjustments were not "material." The term "material" means large enough to influence a reasonable investor's judgment and therefore require disclosure.
"Some have asked how adjustments representing almost half of reported net income could have been deemed to be immaterial," Berardino said in written testimony. The answer, he said, is that Andersen looked beyond net income and used a different standard of comparison, "what accountants call 'normalized' income."
The $51 million of proposed adjustments amounted to "less than 8 percent" of normalized income, Berardino said.
Berardino did not say how Andersen computed normalized income or what number it came up with. He said Andersen considered Enron's income for prior years, when the company reported much higher earnings -- $453 million in 1994, $520 million in 1995 and $584 million in 1996.
It made sense to look past the 1997 bottom line because Enron's income of $105 million that year reflected large "nonrecurring charges," he said. A report Enron filed with the SEC said Enron took a $463 million charge in 1997 for "contract restructuring."
Berardino's testimony also showed the flexibility that auditors and corporate managers have brought to accounting decisions. Some companies book adjustments "in the year after the auditor identifies them," he said.
Several accounting and auditing specialists interviewed for this story challenged Andersen's conclusion that the $51 million was not material. They said they were unaware of any basis in accounting principles or auditing standards to use normalized income the way Berardino described.
"The whole logic seems fairly shaky to me," said Bala Dharan, professor of accounting at Rice University in Enron's home city, Houston. "By any stretch of logic, $51 million is a significant, material amount."
"A cynic would say that someone was looking for a way to make something that was otherwise material not material," said Stephen A. Zeff, another accounting professor at Rice.
Douglas Carmichael, a professor of accountancy at the City University of New York's Baruch College and former auditing specialist at the American Institute of Certified Public Accountants, said, "It's very hard for me to see any real justification for not regarding that [$51 million] as material."
If auditors judge materiality by such a "fuzzy, loose concept" as normalized income, "almost anything can become immaterial," said Baruch Lev, professor of accounting and finance at New York University's Stern School of Business.
Asked what accounting rules supported Andersen's approach, Andersen spokesman David Tabolt said normalized income is "not a term that's used in the accounting literature." He said Andersen was looking at the "total mix" of considerations, as the SEC has advised, and he added that Berardino was trying to explain the process in language that laymen and members of Congress could understand.
Even using Berardino's yardstick, some accounting scholars said, a difference of 8 percent would seem to be material.
An Enron spokesman declined to comment.
Records of lawsuits and regulatory actions indicate that, in a series of corporate accounting disasters, the outside auditors privately asked their clients to remedy problematic accounting but then backed down, using the concept of materiality to avoid a showdown.
For example, the SEC has alleged that Andersen auditors identified early problems at two other big companies that later ran into trouble, appliance maker Sunbeam Corp. and trash hauler Waste Management Inc.
According to the SEC, Andersen decided that the problems were not material. At Waste Management, the misstatements at issue totaled $128 million at one point, the SEC alleged.
Much later, Waste Management disclosed that it had overstated several years of pretax profits by $1.4 billion, and the SEC accused Andersen of fraud. Without admitting or denying wrongdoing, Andersen agreed to pay a $7 million SEC fine in June.
The SEC was so troubled by auditors' judgments about what is and isn't material that it issued a bulletin in 1999 warning that "misstatements are not immaterial simply because they fall below a numerical threshold." Even small misstatements can be significant if they mask a company's failure to meet Wall Street expectations, involve an effort to "manage" reported earnings, or enable management to collect incentive compensation pegged to the financial results, the SEC bulletin said.