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This report aims to provide both clients and employees a review to explore key issues in collapse of Enron and comprises the main accounting and financial reporting issues involved in the case, following by detailed examples and analysis. Discussion of effects on the regulation of financial reporting after Enron's case is also included.
Introduction of Enron
Enron was an American energy company which grew from nowhere to be America's seventh largest company, employing 21,000 staff in more than 40 countries in just within 15 years. It was one of the world's leading electricity, communications, transportation and distribution of natural gas, broadband services, and paper companies and had achieved revenues of $100billion in 2000.
After the event of "9.11", the US stock market fell sharply. Due to Enron was a large energy company its stock price haven't been dragged down and it climbing from $25 per share to $35-40 whereas most of the companies in US were suffered from the impact of "9.11". Therefore Enron's stock had become one of the most favourable stocks for risk adverse investors.
On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code with assets of $63.4 billion, it is the largest corporate bankruptcy in the US history. Stock price of Enron reached a peak of up to $ 90 per share in August 2000 until the Enron's account reported financial condition was disclosure as a creatively planned accounting fraud, the situation got worsened and stock price declined from $90 per share to below $ 1, as the graph shown.
This result a substantial impact on the U.S. financial markets and even the global investment market, many banks, fund-holders and investors had suffered from "Enron Scandal".
Enron rewards bonus to most valuable employees due to their performance which lead to a dysfunctional corporate culture. Short-termism employees would look for high-sales volume to maximise their bonuses. Also, as employees hold shares of Enron, they would use various accounting method to keep the share price of the company to ensure the management could receive huge amount of reward from stock market.
Arthur Andersen, was one of the big 5 CPA firms and a long time auditor for Enron, was pressure by Enron's management to play around the figures from the special purpose entities. It earned $25m for audit fees and $27m in consulting fees hence it is questionable that whether they realized the problem but hide it for Enron as they just want to earn significant income. Their accountants try to save money for Enron by take advantages from capitalizing the loopholes in GAAP and found guilty by deleting thousands of email and documents to cover the debt for Enron. Enron would hire Ernst & Young or PWC to complete the account infrequently, so investors would believe the account present the "true and fair view" of the company. In order to review the collapse of Enron, we'll look into both the various ways Enron used to cover the debt and create a significant profit:
Enron as an energy supplier usually provide services like wholesale trading and risk management including derivatives, activities of this sort in addition to building and maintaining its facilities. When taking the risk of buying and selling products, companies are allowed to report the selling price as revenues and the products' costs as cost of goods sold.
Under the aggressive accounting of Enron, they tended to consolidate all the trading as revenue in term to window-dress the balance sheet. This method allows a sharp increase of Enron's profits and able to maintain its competitiveness. This is the method how Enron increased its revenue from $13.3bn to $100.8bn which is more than 750%.
Off-Balance Sheet financing
It refers to separate companies of which the parent holds less than 100% ownership such as letters of loans to separate legal subsidiaries that are guaranteed by the parent. GAAP allows these items to be excluded from the parent's financial statements but usually they must be described in footnotes.
Under GAAP rules in place at the time, Enron was not asked to consolidate these special purposes entity (SPEs) with its financial statements if independent third parties had a controlling and ''substantial'' equity interest in the SPE and there were vast of SPEs - reported 3500 to 4300.
SPES allows Enron to carry out arm's length transaction, a transaction between two related parties that is conducted as if they were unrelated, so that there is no question of a conflict of interest and the parent company may use the subsidiary company as a way to tax escape. They can also create to fulfil some temporary or specific need of Enron. It is notable that Enron can disclose the minimum information of these SPEs.
This will lead to lower gearing ratio which means lower risk shown on the balance sheet and higher profitability.
In 1997, Enron decided to buyout CalPERs, the State of California's pension system so CalPERs could invest in a larger partnership and Enron sponsored an SPE, Chewco in this takeover. Some part of this takeover was financed by independent outside investors solicited by Andrew S. Fastow, then Enron's Executive Vice President and Chief Financial Officer and also Barclay's bank loan. However, Enron's in-house and longstanding outside counsel, Vinson & Elkins suggested to Enron not to disclose the fact that Fastow was one of the senior officer of Enron so that Barclay's Bank the bank loaned almost all but $125,000 of the equity investment in Chewco which mean Enron should be responsible for the loan. But Enron did not consolidate Chewco or JEDI with its financial statements. Nevertheless, it takes the income gain from the takeover into the account which improves the profitability of Enron's account and provided a good source of information to boost the share price; hence the senior managers can gain a fortune from the changes of share price.
When it was discovered, Enron disclosed a 1.2billion write-off against shareholder's funds.
Kenneth Lay was the founder of Enron and also the chairman in the last few years of Enron, but he hired Jeffery Skilling as an executive and also approved the action of what skilling did. This allows Skilling continuously to use the mark-to-market accounting to conceal Enron's debt which under GAAP, the increase in value of stock cannot be recorded as income
It is known as fair value accounting which refers to accounting that will revalue an asset or liability or contract based on the current market price of the asset or liability to get a "fair-value or the true economics value" with underlying commodity, which is energy in this case and it is highly reliant on assumption. Once the long term contracts were signed, the revenue of the projects will count as net present cash flow in future.
It has been a part of the Generally Accepted Accounting Principles (GAAP) in US since the early 1990s, and has been used ever more since then.
Andersen was reported to have consulted and participated with Fastow in setting up the SPEs. He was heavily linked with Fastow by agreeing Fastow himself and Kopper that they had met the 3% rule, thus agreeing that the SPEs were independent and allowing Enron from not putting those SPEs in its financial statements and at the same time recording the mark-to-market based gains on assets and sales. Hence Enron had become the first energy company who use this method to deal with long term contracts.
In the accounting policies note, it mentioned, "The market prices used to value these transactions reflect management's best estimate considering various factors including closing exchange and over-the-counter quotations, time value and volatility factors underlying the commitments." It is unnecessary to estimate market prices in an active trading commodity market. However, the price of commodity market would fluctuate in future; it is difficult to judge the future income and cost based on the variety. "The main difficulty in applying the fundamental accounting concepts arises from the fact that many business transactions have financial effects spreading over a number of years" noting in SSAP2, Disclosure of Accounting policies.
Enron got the natural gas future contract from SEC as no one realised the problem of Enron's account. Hence Enron use this method to improve its performance and meet prediction of Wall Street.
In September 1999, Enron sold to LJM1 for $11.3 million a 13% interest in a company building a power plant in Cuiaba, Brazil. This sale supported Enron's recording a mark-to-market gain of $65 million in 1999 due to alterations in Enron's accounting treatment of a related gas supply contract. In August 2001 it repurchased that interest for $14.4 million, even though the project had encountered serious technical and environmental problems. The $65 million recorded gain does not appear to have been reversed.
Changes after Enron's Scandal
After the bankruptcy of Enron, people were lack of confidence on financial reporting and auditing standard and the financial market collapsed. Although Enron was a company in US which UK had a completely different accounting standard with US and there were no equivalent failure in UK. The UK government provide a rapid response to the event to prevent similar case to repeat in UK and rebuild public confidence.
Co-ordinating Group on Audit and Accounting Issues (CGAA)
CGAA can improve the transparency and disclosure by audit firms about quality control and at the same time by companies about the activities of the audit committee. CGAA set up to improve disclosure of the breakdown of non-audit services with a high level of regulators and ministers. It is responsible for lending the review of the regulatory framework, including the key area of auditor independence, and for making recommendations for change. a review of the UK regulatory framework for auditor independence, a series of recommendations for the enhancement of audit or independence were developed by the review board after the case of Enron.
The reaction of public also led to the formation of Sarbanes-Oxley Act, enacted on July 30, 2002, a US federal law with new and improved standard for all US public companies, accounting and auditing company and management.
We mentioned that Enron use off-balance accounting to maximise the amount of profit and in 2010, the Lehman Brothers bankruptcy also brought these issues back into focus. Sarbanes-Oxley Act section 401 doesn't allow any off-balance sheet items and require SEC to study the account and provide a report in order to have a better knowledge of true picture of accounts and determine whether the account follow the accounting principle.
From section 302 of the Act, "responsible for establishing and maintaining internal controls " and "have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared." 15 USC 7241(a)(4) are necessary.
UK GAAP requires auditors to report a ''true and fair view'' of an enterprises' financial condition which is more preferable to the highly specified US model. The US model allows--even encourages--corporate officers to view accounting requirements as if they were specified in a taxcode. Due to the problems of companies and auditors ignored the rules of the accounting standard and the statement is too complicated to understand. The Sarbanes-Oxley Act called for more stringent enforcement of existing rules, but also called for an SEC study of an alternative accounting system, called principles-based accounting. Note that none of the accounting policies employed by Enron were illegal, they did not contravene GAAP and they were disclosed to some extent. The complex published accounting documents have become voluminous and prescriptive which displaced the role of professional judgement in financial reporting. Investors and even analysts failed to notice the controversial policies in the Enron accounts.
Some analysts argue UK standards adopt a more principled approach, which is less susceptible to the kind of loop holing that US GAAP seems to attract as people would just follow the rules and denied that mistakes can be made even followed the rules, whereas principle-based accounting is more flexible and comprehensive. It is more important to maintain true and fair view instead of adhering to detailed rules.
Despite the fact that collapse of Enron lead to disaster of financial market and thousands of workers have lost their jobs and retirement savings, and investors in stocks, including pension funds and other non-profit organizations, have suffered major losses, however, the adoption of International Accounting Standards will greatly improve the quality, and indeed usefulness, of financial reporting available to investors in a global economy. Hundreds of US firms which used so-called aggressive accounting methods to keep debts or one-off charges away from the headline figures have been affected. Audit partners will now be subject to a two-year cooling off period before they are allowed to join their audit client as an employee or director and the audit partner rotation rules will be tightened
There are difference remain between IASB approach to the rule those proposed by its counterpart in the US. The diverging standards will be a challenge that will need to be overcome if the world's largest economy eventually decides to take on international accounting rule. Moreover, European Commission announce a letter which shown the concern about the volatility that international standard may bring to accounts.
A global standard may not be feasible to achieve due to different laws, accounting standards and listing regulation and there are more needs to be done to keep pace with the rapidly changing market and to restore public confidence in the profession in order to reform better accounting standard that prevent similar case to Enron.