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Once the seventh largest company in America, Enron was formed in 1985 when Inter North acquired Houston Natural Gas. The company branched into many non-energy-related fields over the next several years, including such areas as internet bandwidth, risk management, and weather derivatives), although their core business remained in the transmission and distribution of power. Enron had created over 3000 special purpose entities in between 1993 to 2001. Special Purpose Entities (SPEs) are defined as entities formed for some specific purpose or activity. The primary purpose of creating an SPE is to remove assets and liabilities from the balance sheet of the sponsor thereby artificially improving leverage, return on asset and return on equity ratios. These SPEs were also established to keep Enron's credit rating high, which was very important in their fields of business. Because the executives believed Enron's long-term stock values would remain high, they looked for ways to use the company's stock to hedge its investments in these other entities.
Enron had been buying any new venture that looked promising as a new profit center. Their acquisitions were growing exponentially. Enron had also been forming off balance sheet entities to move debt off of the balance sheet and transfer risk for their other business ventures.
Enron involved in partnership business deal with its various SPEs. The deals with CALPERS, ZEDI, RAPTER, CONDERS were those deals and the accounting treatment of those transactions, were responsible for inevitable demise of the Enron Company.
Deals with Raptors
Enron had created a partnership aiming to buy and sell stocks of other companies. Enron lent the partnership $ 500 million in Enron stock to operate Raptor and also guaranteed the load by promising to give more stock if Raptor was unable to repay the loan. Raptor issued a note to Enron that Enron considered assets. Raptor then bought stock in companies like Avici, a maker of high-speed net-working equipment, and the New Power Company.
Enron treated the loan to Raptor as an assets and claimed profit on the rising value of Raptor's holdings. The transaction worked until the stocks of the companies owned by Raptors fall down. Raptors could not pay the loan. Enron was obliged to cover the Raptor's loan as it guaranteed for that, it had to issue more and more shares although its own stocks were declining.
Deals with Condor
Condor is another SPEs. The executives of Enron created another partnership called condor to sale and buy the assets in the best possible price. Condor was established to buy assets from Enron. Enron had lent the partnership shares to Condor of Enron's stock.
Accounting treatment of the Enron's deals with Raptor and Condor
Raptors were not controlled by an independent party which possessed the substantial risks and rewards of ownership, so these entities were part of Enron and should have consolidated into Enron's own financial statement. But Enron recorded all the gain or losses including all the hedge transactions of its SPEs entities and did not consolidate it into its financial statements. Enron executives structured the deals so that losses would not show up as earnings, but instead as reductions of shareholder equity that had no effect on the income and earnings statements.
Enron recognised $800 million in cash flow from condor. In fact Enron should instead have been accounted for as an issuance of stock, But Enron counted it as cash flow.
A company may record gains and losses on transactions with the SPE; however the assets and liabilities of the SPE are not included in the company's balance sheet. Enron executives structured the deals so that losses would not show up as earning's losses, but instead as reductions of shareholder equity that had no effect on the income and earnings statements. There are several structures used by Enron for its accounting practices. One of them was to use SPEs to sell Â¨financial assetsÂ¨ (a debt or equity owned by Enron) at the end of a financial accounting period in order to improve their financial ratios and standing. The secret contracts between Enron and the SPEs gave Enron the right to buy shares of the SPEs. This ensured Enron control of the SPEs.
Mark-to-market accounting strategy:
Enron had implemented the Mark-to-market accounting strategy. It is the accounting strategy that, the price or value of a security is recorded on a daily basis to calculate profits and losses. Enron counted the projected earnings from long-term energy contracts as current income, but it not did not reflect the true economic value. All the income was estimated as the present value of net future cash flows. Mark to market strategy counted the future income as current income that increased the financial earnings however in future years; the profits could not be included. To keep the business growth and the investor's Trust over the business, company should include additional income from its new project at any way. So Enron did it through its SPEs.
Capital stock transaction
The transaction of issue of share by company should not ordinarily be recorded an increased to stock holders' equity until cash payment for the share is received. Enron issued share to its SPEs in exchange for notes receivable. That accounting treatment only overstated the notes receivable and share holder's equity. Enron used its own common stock to capitalise SPEs.
Enron recognised mostly from long term contracts where the value of the contract was determined based on subjective mark to market (MTM) strategy. It did not compute the fair value of a financial instrument when there was no active market for it. Furthermore Enron recognised revenue arising from an increase in the value of its own share using the equity method of accounting.
Recognizing increases in the value of Enron's common stocks
Enron had had partnership with its SPEs. Enron had given partnership shares to those SPEs. One of them ZEDI held 12 million share of Enron stock, which was carried at fair market value. Increased in the fare value of those share prices, Enron recorded it as income using equity method. But Enron did not recorded losses while ZEDI shares declined. That means Enron was recognising the increasing value of its own shares as revenue but losses were not.
The accounting and the financial disclosure that Enron had made was not adequate. Especially contracts that made with its SPEs, there was no systematic Procedure that could define about transaction made with related parties. Enron entered into a series of involving a third party LJM in June 1999, but the e effect of the transaction was not clearly disclosed to its investors, employees and other stakeholders.
On the email of Watkins to Lay, she commented that the footnote made on the transaction was not adequate and gave proper information to its related parties. Especially the transaction made with SPEs (Raptor, ZEDI), it was not appropriate and transparent. The footnotes did not explain properly about what transaction made with those SPEs, what the effect behind the transactions and so many other accounting and financing terms. If those terms are properly explained then, investors would know that the entities that Enron holding are thinly capitalised. Furthermore they would know all the value in the SPEs come from the underlying value of the derivatives and Enron stock.
But the footnotes disclosures of above transactions at consolidated statements were vague and difficult to understand. The Enron financial statement disclosure did not tell everything about the transaction that was made with its SPEs. The substance of the transactions that Enron entered into was difficult to distinguish from the footnotes to the financial statements, and since only the form of the transactions was reflected on the face of the financial statements, it was difficult for investors and creditors to obtain a clear view of the financial position and results of operations of Enron.
Arthur Anderson & Co (AA) was not only the auditor of Enron; it provided consulting services as well. Enron was paying millions of dollars to Anderson for the services and due to these relationships that, it was just too easy for both Enron and the accounting firm to work together in covering up financial losses and debt. Andersen was also responsible for some of Enron's internal bookkeeping. Andersen has responsibility to the investors and to the public interest under generally accepted auditing standards (GASS). Auditors are to remain independent in both fact and appearance but Andersen was involving in Enron business very actively consulting and auditing, so nobody could expect that they could execute their duties independently as Enron was providing huge revenue not only in audit fee but also in consulting fees. Generally accepted accounting Principles (GAAP) and GAAS could not prevent the fraud if the auditors themselves involved in constipation to commit the fraud.