How the collapse of Enron highlighted vulnerabilities within accounting

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Enron as the largest energy trader in the world, the company's total revenue is up to 101 billion U.S.dollars in 2000. Enron control 20% of the U.S's electricity and natural gas trading, Enron stock of all the securities rating agencies strongly recommend the blue chip stocks, shares up more than 70 U.S.dollars and is still on the rise.

On October 16, 2001, Enron Corp. announced that it was reducing its after-tax net income by $544 million and its stockholders' equity by $1.2 billion. October 31, 2001. The Securities and Exchange Commission (SEC) announce a formal investigation into the finances of Enron. Because of accounting errors, Enron announced on November 8 that it was restating its previously reported net income for the years 1997-2000. The result of this restatement was a reduction in stockholders' equity of $508 million. November 28, Standard & Poor's lowered Enron debt rating to "junk bond" level. November 30, Enron shares fell 0.26 U.S.dollars; the market value of the peak of 80 billion U.S. dollars fell to 200 million. December 2, Enron official ask to the bankruptcy court for bankruptcy protection, bankruptcy assets included in the list of up to 49.8 billion U.S. dollars. January 15th, 2002. It is revealed that Enron's auditor, Andersen, had shredded and deleted documents relating to Enron after receiving subpoenas from regulators. January 22nd, 2002. It is alleged that Enron itself had also shredded and deleted documents.

The reason why Enron collapsed quickly in such a short time is to keep its rapid growth, ENRON have to be a large number of lower cost of funds; and lower cost of financing in order to maintain and achieve large-scale financing, ENRON credit rating agencies must get a higher credit rating; In order to maintain a high credit rating, Enron's balance sheet generally cannot have too much debt, or may lead to credit rating agencies lowered its credit rating. Unfortunately, a large number of businesses to invest in high-speed expansion and increasing debt brought after, ENRON expansion plans did not proceed to adjust and digest debt. And they hide their debt in the statement, also overstated earnings

Enron use of "Special Purpose Entity" overestimated profits, undervalued debt. Enron's improper use of SPE meet certain conditions may not be included in the consolidated statements of accounting practices, will be included in the consolidated statements of the three SPE(JEDI、Chewco and LJM1), excluded from the scope of the preparation of consolidated financial statements. Lead to the company between from 1997 to 2000 overestimated the profit of 499 million U.S. dollars. Underestimated the hundreds of millions of dollars in debt.

According to the U.S. current accounting practices, if non-related parties (could be a company or individual) in a "special purpose entities" in equity capital investment more than 3%, even if the "special purpose entities," the risk is mainly borne by the listed companies, listed the company or not "special purpose entities" into the scope of the preparation of consolidated financial statements. Enron took advantage of the only legal form of attention, despite the economic substance of the loopholes in accounting practices, the establishment of thousands of "special purpose entities", as to conceal liabilities to cover up the loss of tools.

The accounting treatment of sales of Enron's merchant investments to unconsolidated (though actually controlled) SPEs as if these were arm's length transactions. (Benston, 2002) The company of LJM and LJM2 was set up in 1999; Enron was funded by LJM2 and LJM1 $ 16,000,000 and 394 million in capital. LJM established for the purpose is to make a purchase of assets from Enron's financial resources to the interests of Enron's investment partner, and lower the risk of Enron Investment Partners. So in the 2000, Enron broadband is latest major projects increasingly bleak prospects for the company, Enron's management is very worried. So then, Enron and LJM2 entered into swap contracts: If this part of asset appreciation Enron, LJM2 will share premium; if this part of the depreciation of assets Enron, LJM2 Enron to make up for depreciation must be part of it; Enron immediately get 1.2 billion in cash from the LJM, but if LJM2 liquidity crisis occurs, Enron will enter the value of 1.2 billion in cash or its equivalent in Enron stock. But the problem is Enron has not committed to issue a predetermined number of shares, but only to ensure the value of shares issued is equal to 12 billion dollars. If Enron stock prices have fallen sharply, it will be forced to issue more shares to gather the number of corresponding value, more dilute the existing shareholders of the stock value, resulting in further decline in stock prices. All along, though, Enron was frequent hedging itself with itself--which is of no economic value to Enron's stockholders and also it was not generated profit.(Benston, 2002) In fact, when LJM2's own funds crisis, accordance with the above agreement, Enron issue shares worth 1.2 billion of funds to enrich LJM2. But Enron shares also plummeted to the third quarter of 2001 has fallen below 40 dollars. Enron decided not to implement new stock sale scheme, so he had to rely on selling assets, redemption of other investors in LJM2 that LJM2 has become a wholly owned subsidiary of Enron. As a result, Enron financial statements that have not consolidated into a loss suddenly exposed. As the shares in Enron LJM enough to trigger consolidation statement, Enron and its auditor Arthur Andersen accounting firm have claimed their actions comply with U.S.GAAP. But in fact, the Enron assume all the risk.

Fair-value accounting resulting in restatement merchant investments that were not based on trustworthy numbers. (Benston, 2002) Enron sell assets as business income, fictitious profits, and always Enron sell assets to affiliated enterprises in the price significantly higher than normal market prices.

Enron's income recognition practice of recording as current income fees for services rendered in future periods and recording revenue from sales of forward contracts, which were, in effect, disguised loans. (Benston, 2002) In the accounting issues, Enron took the lead with some technology that enables companies to record the profit and loss information which long-term contracts have not created profits. The business model for the Enron also has a significant impact on cash flow. Most of Enron's business is based on the "future market" contract, although the contract will be included in the financial statements of income, but before the execution of the contract does not bring any cash to give Enron. The more contracts booked, and the larger gap between the actual cash income and statement will be.

Enron's accounting for its stock that was issued to and held by SPEs. (Benston, 2002)

Inadequate disclosure of related party transactions and conflicts of interest, and their costs to stockholders. (Benston, 2002)

Arthur Andersen audited Enron's lack of independence. Andersen not only audited Enron to provide forensic services, and provide well-paid consulting business. Enron was Andersen's second largest customer, in 2000, Arthur Andersen and the Enron charge fees of up to $ 5,200, of which more than half of revenue for the consulting services (Reed Abelson & Jonathan Declarer, 2002). Simultaneously, many of Enron senior management as the former employees of Arthur Andersen, the close relationships between them at least undermine the formal independence of Arthur Andersen. Arthur Andersen has been aware of the issues in the Enron accounting, but not takes the necessary corrective measures. It is one reason that leads to Enron collapse.

What is more the financial report from Enron is hard to understand. In fact, even many securities analysts, lawyers and accountants have been complaining about ENRON's financial reports and other reports submitted to the Commission are too esoteric and difficult to understand the complexity, make people difficult to understand what happened. The reasons why this happened is Enron do not want to say clearly about company's situation. On the other hand, Enron lawyer the professional effort is an important reason. Lawyers habitually to get things done perfectly as far as possible, a big company such as Enron that is often has several lawyer drafting,review and polish of the annual report, and sometimes even word by word scrutiny, so that even after several dozen draft change down, the report will be the language into something often quite complex and legal English. And the lawyer also would fully research on the annual disclosure rules and found loopholes in it. Then they can hide the truth in the annual report to better.

The independent Director in the Enron is useless. Enron's independent directors are non-existent; there is no duty-bound. The company's 17 board members up to 15 independent directors, audit committee members are also seven independent directors, these independent directors are political, academic, business figures. They cannot supervise Enron is disappointing. For the Lord John Wakeham (board member since 1994) the Enron in addition to his board-member compensation, he was paid $72,000 in 2001 as a consultant to Enron's European operations. Enron donated more than $600,000 to the Anderson cancer center. Independent Directors get interests from Enron, the loss of independence.

At the same time, government officials also have benefited from Enron. According to "The New York Times" reported that, Enron is the biggest political career donors to President Bush campaign funds, Enron provided a total of 550 thousand dollars in campaign finance contributions. In the 2000 election, Enron's 71 incumbent senators and 188 House of Representatives,provided the current campaign finance contributions to give the Republicans and Democrats, respectively, contributed $ 1,770,000 and $ 681,000. (From U.S. political contributions oversight bodies) In fact, Democrats accused the Bush administration has always been a "special interest group representatives. The government should be impartial monitoring of the market; get responsible for the general interests of investors.

The United States broke the fraud case have seriously hurt the U.S. economy to recover their strength, also hit the confidence of investors and the public, causing the U.S. government and Congress's attention. American community strongly urged the U.S. government took strong measures to crack down on corporate fraud actions. Sarbanes - Oxley Act, the Sarbanes-Oxley Act in this context is introduced.

Sarbanes-oxley required that company should establish of an independent Public Company Accounting Oversight Board, the regulatory implementation of the public company auditing profession. PCAOB is responsible for monitoring the implementation of supervising to accounting firm and certified public accountant.

In fact, the independence of certified public accountants needs to be strengthening. The Requirements If the company's CEO, CFO, Chief Accounting Officer worked in other accounting firm for senior managers in the previous year, the accounting firm was prohibited for the company to provide statutory audit services. This problem is also in the Enron, Many of Enron senior management as a former employee of Arthur Andersen. Company should certificate of financial statements by members of the board. Audit partner and review partner must rotate every 5 years, the provisions of the CPA to be reported to the company's audit board matters.

And the Sarbanes-oxley also required increasing the company's financial reporting responsibilities. Requirements of the company's audit committee responsible for the selection and supervision of accounting firms, and also decided to standard payment for the accounting firms. And also has a ban on the provisions of certain non-audit services by the auditors of a firm. If the company's profits are found to have been misstated, the Sarbanes-oxley has a requirement for executives to reimburse incentive based compensation.

Public company should be real-time disclosed, which requires timely disclosure of company operations and financial condition led to significant changes in the information. And the company should quicker disclosure of directors' share dealings. By the SEC rules require public companies to disclose the financial position of the company has a significant impact on the all-important balance sheet transactions and relationships, and not misleading way to simulate the preparation of financial information. By the SEC has responsible for discoursing SPE Sheet transactions and make recommendations about it

Simultaneously, the sarbanse-oxley increased penalties for violations. Crime of securities fraud carries a maximum penalty of 25 years imprisonment. Guilty of fraud for individuals and companies the maximum fine of up to 5 million U.S.dollars, respectively and 2,500 million U.S.dollars. And the prisons terms of up to 20 years for company executives who certify false statements. Arthur Andersen for destroying Enron audit file events, specifically the formulation of relevant laws, regulations, audit files to destroy a maximum sentence of 10 years in prison,if when in the federal investigation and file bankruptcy destruction the file would sentence of maximum 20 years in prison.

In the Sarbanse-oxley there is a statement that lawyers serve the company not managers and have a duty to report transgressions to board. It means that lawyers should bear the responsibility of monitoring corporate reporting. If they found some problem in the trading and statement, they need report to board. Lawyers also are required independence when they write annual report.

Today's preparers and users should face to causes that led to Enron's collapse, and find way to fix the problems.

Independent audit should not exaggerate the role of supervision in the securities. In fact, independent audit is not only the cornerstone of development of securities market, but also one of institutional arrangements that listed companies to ensure that the quality of accounting information. However, the independent audit of the role of supervision in the securities market is limited. Arthur Andersen on Enron's collapse cannot shirk responsibility, but within this system works in the securities market regulation, other relevant departments are also not escape. For example in the case of Enron, Bush administration officials and many members of Congress who have received huge contributions from Enron, and their close, in their profound awareness or informed Enron of the financial crisis, they also have responsibility to report to SEC. But they did not do that for their own interests. Therefore the responsibility for securities market supervision is not only for the Independent audit. Other components for the securities market supervision such as lawyers, SEC, press and etc also need to get the responsibility. The examination and restraint mechanism for company insider abuse did not work staff that should perform an independent audit but compromise. Firstly, take effective measures to greatly improve the independence of certified public accountants. CPA is required in the practice of the use of professional judgments, and to judge the results of its independence a very important factor. If the accounting firm's main income comes from the same customer, a single customer's payment and accounting firms are too large compared to the scale, it may be due to economic reasons, the interests of the independence of certified public accountants. Therefore the accountants needs perfect CPA binding system to ensure their independence.

Although accounting and auditing standards is a form of control, which itself seems to be a need to control. The case of Enron indicated that rely entirely on market adjust and private self-regulate the accounting and auditing is not realistic. To accounting standards, the accounting system and criteria developed entirely by the private sector, and its authority must be weakened, supervise the implementation of its efficiency is low. But if it developed entirely by the government in improving the authority and supervision of the implementation of efficiency, may reduce the development of the independence, it is also difficult to ensure the high quality of accounting systems and standards. So people need focus on accounting standard setters can be truly independent and whether get the responsibility for the public interest to social , truly objective and fair. Enron showed that the integrity of education should be comprehensive. For rounded analysis, CPA needed credit education, lawyers, securities analysts, investment banks, credit rating agencies, medium and small investors the stock market participants and government officials, regulators and the news media and other securities market watchdog, also need credit education

At the same time, the CAP should fully develop the professional quality. The case of Enron happened, the important reason is Enron's business is relatively new, derivatives trading complex. If the CPA lack of understanding of the industry and business, it is seems to be deceived, improper handling cannot be found. Therefore, the CPA should become specialized for different industries to establish a special audit team to avoid the do not understand the characteristics of the industry, the lack of industry knowledge which led to the audit risk. In addition the accountant's report requires a simple language; make the people easy to understand.

Media should further improve the information disclosure system of norms. Disclosure should not be measured by the number; it should disclose such information to investors and users of financial statements for the practicality, understandability to consider. Although there are many of Enron's disclosures, even the professionals cannot really understand the complicated financial data. In fact, standard & Poor's financial analysis and data professionals also cannot figure out the reason, moreover, ordinary investors. Therefore, the disclosure should be emphasized that reflect the substance of transactions, to disclose their risks. Disclosure of transactions should make the investors to understand the substance and the risks.

Characteristics of GAAP UK: a). The True and Fair View is Overriding, as long as the financial statements provide a true and fair view, can sometimes deviate from the requirements of accounting standards, or even depart from the United Kingdom "Company Law" in the relevant accounting requirements; b). accounting concepts clear and explicit; c). attention to the constraints of the legal environment. In order to provide "true and fair view" requires departure from accounting standards, they only need to disclose the occurrence of the deviation and the reasons can be. If they use IAS or GAAP UK, Enron's balance sheet financing will be reflected in its consolidated financial statements. Scandal such as Enron appears to be ahead of that. So that investors and markets to minimize the loss.


Firstly, Enron is an example in the development of the company itself of the failure, in the improve market regulatory and accounting standards to give us alarm. Secondly, Failure of Enron showed the vulnerabilities in the accounting standards, audit system and etc. Supervision of listed companies need be in the whole society to work together. Securities Regulatory staffs need to uphold their professional ethics; get responsible for shareholders and investors. Thirdly, the Government and various departments need to speed up development and improve relevant laws and guidelines for reducing vulnerability. Finally, the preparers and users need to face to Enron's every question which reflects to us carefully: and continue to find new problems for improving the rules published financial statements.