Footnote 8

allowed Enron to recognize earnings before an activity generated cash created a “quality ofearnings” problem. As JP Morgan explained in 1999,[ENA] has significant flexibility in structuring contracts and hence booking earnings.It is primarily a financial business and hence uses “mark to market” accounting. Assuch, contracts can be structured to recognize the economic value of projects longbefore they are operational and cash is coming in the door. . . . This has two effects:front-end-loaded earnings that bias the denominator in the P/E ratio and a timingdisconnect between projects’ cash and earnings effects.JP Morgan Securities Report at 4 (quoted at Exam. II at 26).171. The Insiders also learned quickly that the rating agencies measured the earningsproblem as the gap between net income and funds flow from operations. That is because true fundsflow from operations represents high quality earnings that will likely recur and can be counted onto service debt and provide cash for operations in the future. A gap between book net income andfunds flow from operations makes the quality of net income suspect and puts into doubt whetherfunds will be available, as needed, to run the business. For example, if cash needed for day-to-dayoperations is entirely raised through financing (as opposed to operations), the business is likely introuble. On the other hand, a small gap between net income and funds flow from operations likelymeans the business is healthy – at least it does if the size of the gap has not been fraudulentlyengineered.172. The Insiders, however, realized that by “managing” the gap between net income andfunds flow from operations, they could hide the extent of any earnings problem MTM accountingcreated. For the Insiders, managing the gap came to mean characterizing cash Enron received intransactions involving SPE structures as cash flowing from operating activities instead of fromfinancing activities. Of course, knowing how a financial statement can be manipulated is not thesame thing as manipulating it. For help – and for financing – the Insiders turned to the BankDefendants.604041v1/007457-44-