Financial accounting, the Enron fraud case

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Introduction

For Financial accounting 2 we choose the Enron fraud case because this case did had an impact on the accounting regulations as we know today. After the Enron scandal Sarbanes-Oxley regulations was passed by the Congress of United States in 2002. The passed Sarbanes-Oxley deals with important things like ensuring that management is held accountable for the financial report that they file with the SEC. The regulation also improves the independence of corporate boards, as well as the independence of auditors and it increased some of the penalties for those who shred documents or violate the security laws. In this paper we will analyze the Enron fraud. In chapter 2 we will describe the Firm followed by chapter 3,4 and 5 whereby we give indications and explanation of the Enron fraud . Finally we will give a summary and

conclusion in chapter 6.

Description of the firm

Before getting bankrupt in 2001, Enron Corporation was one of the largest integrated natural gas and electricity companies in the world. It marketed natural gas liquids worldwide and operated one of the largest natural gas transmission systems in the world, totaling more than 36,000 miles. It was also one of the largest independent developers and producers of electricity in the world, serving both industrial and emerging markets. Enron was also a major supplier of solar and wind renewable energy worldwide, managed the largest portfolio of natural gas-related risk management contracts in the world, and was one of the world's biggest independent oil and gas exploration companies. In North America, Enron was the largest wholesale marketer of natural gas and electricity. Enron pioneered innovative trading products, such as gas futures and weather futures, significantly modernizing the utilities industry.

New Markets in the Early 1990s

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In the early 1990s, Enron appeared to be reaping the benefits of the InterNorth-Houston Natural Gas merger. Its revenues, at $16.3 billion in 1985, fell to less than $10 billion in each of the next four years but recovered to $13.1 billion in 1990. Low natural gas prices had been a major cause of the decline. Enron, however, had been able to increase its market share, from 14 percent in 1985 to 18 percent in 1990, with help from efficiencies that resulted from the integration of the two predecessor companies' operations. Enron also showed significant growth in its liquid fuels business as well as in oil and gas exploration.

Beginning with the 1990s, Enron's stated philosophy was to "get in early, push to open markets, position ourselves to compete, compete hard when the opening comes." This philosophy was translated into two major sectors: international markets and the newly deregulated gas and electricity markets in the United States.

Beginning in 1991, Enron built its first overseas power plant in Teesside, England, which became the largest gas-fired cogeneration plant in the world with 1,875 megawatts. After that, Enron built power plants in industrial and developing nations all over the world: Italy, Turkey, Argentina, China, India, Brazil, Guatemala, Bolivia, Colombia, the Dominican Republic, the Philippines, and others. By 1996, earnings from these projects were 25 percent of total company earnings before interest and taxes.

In the United States, states were given the power to deregulate gas and electric utilities in 1994, which meant that residential customers could choose utilities in the same way that they chose their phone carriers. This looked like an enormous opportunity for Enron. CEO Lay was fervently in favor of deregulation, believing it would solve problems for consumers and utilities alike. The company moved into the residential electricity market in 1996, when Enron agreed to acquire Portland General, an Oregon utility whose transmission lines would give the company access to California's $20-billion market, as well as access to 650,000 customers in Oregon. In 1997, Enron Energy Services began to supply natural gas to residential customers in Toledo, Ohio, and contracted to sell wind power to Iowa residents. Through a subsidiary, Zond Corporation, the company contracted with MidAmerican Energy Company of Houston to supply 112.5 megawatts of wind-generated electricity to about 50,000 homes, the largest single purchase contract in the history of wind energy. Zond was to build the facility in northwestern Iowa, using about 150 of its Z-750 kilowatt series wind turbines, the biggest made in the United States. [1] 

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1930: The company is founded as Northern Natural Gas Company in Omaha, Nebraska.

1947: The company is listed on New York Stock Exchange.

1980: The company's name is changed to InterNorth, Inc.

1985: A merger with Houston Natural Gas Corp. takes place.

1986: The company's name changed to Enron; the new company is headquartered in Houston.

1991: Enron begins overseas expansion.

1999: Launches EnronOnline.

2001: Files for bankruptcy after previously hidden losses come to light.

Who committed the fraud and what were the motives, and the consequences

It isn't easy to say who particular committed the fraud because the fraud of Enron can be define as ''synergistic corruption''. There are suppose to be balances and checks in every businesses to recognize irregularities however in the Enron fraud the responsible accountants, financial analysts, lawyers and executives didn't stop the ''corruption''. They all took their share of the money and put it in their pockets. For instance accounting firm Arthur Andersen [2] was paid one million dollars a week for signing off the annual reports of Enron and being their consultant [3] . Furthermore lawyer firm Vinson and Elkins investigated the business partnerships of Enron and was paid $ 900.000 a week to make the investments of Enron reasonable. Moreover, world know bankers like CITIBANK, Deutsche Bank, Merrill lynch, Morgan Stanley and 94 other bankers were actually investors of Enron and received immense bonuses and weren't skeptical at all. As long Enron as continue his business all Enron 'partners'' received their extraordinary fees and that satisfied everyone. They became a part of the Enron process. Permanent investigator of the Enron case Sen Carl Levin was actually convinced that the banks participants knew of the wrong doing of Enron and did show some proven evidence in court. However, his statement was never confirmed by the CEO's of Merill Lynch, Deutsche Bank and Morgan Stanley, how surprising?

So, like said before the fraud of Enron included a lot of ''institutional'' participants. However three executives in charge were responsible of the Enron enterprise and were also responsible for creating the imaginary profits. The guilty persons in charge were Kenneth lay (chairman and ex CEO of Enron), Jeffrey Skillinger (President of Enron and CEO) and Andew Fatsow (CFO). See below.

Kenneth Lay (Chairman)

Jeffrey Skillinger (CEO) Andrew Stuart Fatsow (CFO)

Kenneth Lay was the chairman of Enron in 1985. One of his main points was to get the government out of the oil/gas and electricity industry. Ken lay supported the campaign of Bush junior in 1995 to become the senator of Texas by giving millions of donations. After Bush junior become senator the gas and electricity market was deregulated in Texas and gas/oil and electricity prices float with the currents of the markets.

This regulation did result that Enron could artificially increase the electricity prices by shutting down some power plants. This actually happened in California led by Tim Beldon (head trading Enron Enegry services). By the time Enron was finished it was estimated that they had stolen around 11 billion dollars from California.

After the summer in 2001 Ken Lay realized that Enron was to collapse in present future because the ''real'' debts were higher than expected. However Ken Lay was responsible for misleading stakeholders by still bringing good results. Meanwhile he converted that time 250 million dollar Enron stock.

Jeffrey Skillinger became the president CEO of Enron in 1987. At that time Enron was only active in the high segment market of energy which means producing gas/oil and electricity for the consumer market. Spillinger introduced the stock market for gas. He created this entire new industry by transform energy into financial instruments that could be traded like stocks and bonds. Moreover he introduced the market-to-market accounting which allowed using potential future profits on the very day a deal was signed. So, losses related to those deals were cover up by potential future profits. In other words, the profits of Enron became very subjective. At the time Enron used the market-to-market accounting the stock prices increased immensely. A few years later the main part of Enron business was focusing on the stock markets. Enron traders were risk takers and powerful, they also were supported by Skillinger. In the documentary 'Smartest guys in the room' Skillinger quote: "we like risk because you make a lot a money of risk''. In reality profits of trading weren't go up. Enron did makes gigantic losses by taking these trading risks. However Enron still paid millions of bonuses to executives based on imaginary profits.

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Skillinger was also the master brain of creating more new market concept for Enron like ''Video on demand on brandwith the so called Blockbusterproject'' and penetrating new energy market in India. In 2001 the magazine Fortune rewarded Enron for being '''the most innovative company of the world''. Noticeably, all the ''innovative'' projects failed however Enron reported huge profits due to market-to market accounting. Before Enron collapse in 2002 Skilling resign from his job as CEO and did cash 166 million dollar.

Andrew Fatsow was hired by Skillinger as CFO for Enron. In reality, the job of Fatsow was to cover up the facts that Enron was becoming a financial fantasy land of creating continuously high profits without any sense. Fatsow keep the stock price of Enron up and hide the 30 million debts of Enron by creating hundreds of companies. For outside investors cash was coming in to the ''enron door'' however in fact Enron was stashing his debts in Fatsows companies where investor couldn't see it. One created company (LJM) did allow stashing 45 million dollar for Fatsow himself.

Fatal floor of the Enron Fraud are: Pride, intolerance, greed!

Pride for keeping the Enron in business for several years despite the fact of losing millions of dollar.

Intolerance by avoiding critical questions about the Enron business and humiliate skeptical financial analyst in public.

Greed for sharing hundred of millions of dollars to the executives while Enron become bankrupt.

In this Enron case it seems to be all about complicated transactions but at the end it is a human tragedy. The bankruptcy of Enron did have an immensely impact on the economy on US with lot of consequences like:

20.000 Employees lost their jobs and medical insurance

Average severance was pay $ 4500 while top executives were paid bonuses totaling of $ 55 million.

In 2001 Enron employees lost $1.2 billion in retirement funds.

Retirees lost $ 2 billion in pension funds.

Enron' top executives cashed $116 million in stock

Kenneth Lay faced 40 years in prison plus fines, however he died before sentencing

Jeffrey Skillinger faced 24 years of prison and fined $45 million

Andrew Fatsow faced 6 years of prison followed by 2 years of probation.

Tim Beldon faced 5 years of prison and a $ 250.000 fine.

The accounting firm Athur Andersen collapse after this scandal and 26.000 employees become jobless. In Netherlands al the Athur Andersen employees were adopted by Deloitte.

Describe the fraud and indicate the methods of financial statement fraud used

Quffa defines fraud as following:

''Deliberate misstatements or omissions of amounts or disclosures of financial statements to deceive financial statement users, particularly investors and creditors''.

Methods of Financial Statement Fraud by Quffa:

Fictitious revenues

Timing differences

Improper asset valuations

Concealed liabilities and expenses

Enron particularly used two of the above mentioned methods.

Fictitious revenues

Concealed Liabilities and expenses

How Enron applied these methods to their advantage is going to be further explain in the paper.

Main characters involved in this fraud were: Andrew Stuart Fastow(CFO),Kenneth Lay(chairman) , Jeffrey Skillinger(CEO) and Tim Beldon

Fictitious revenues (Kenneth Lay and Jeffrey Skillinger)

Jeffrey Skilinger (CEO) and Kenneth Lay(chairman) tried to introduce "mark-to-market'' in the early 90's. The Securities and Exchange Commission(SEC) approved this method and Arthur Andersen signed the reports.

Mark-to-market allowed Enron to book future profits when the contracts were signed even when no cash came in. So Enron could estimate his future profits and this estimate would be shown at the outside world. Thus Enron was seen by many as a profitable company although it wasn't one at the time. As a result of this Enron invested in many projects around the world and these future profits had been booked by Enron like describe in chapter 3. However, many of these projects were unprofitable. For example, the biggest unprofitable project was in India. The Dabhol power plant was initiated in 1992 and took nine years to commence operation. The total project cost is $2.9 billion. Enron owns 65%,Bechtel Enterprises owns 10%, General Electric owns 10%, and the Maharashtra State ElectricityBoard owns 15%. The project is a 2,184 megawatts power plant, which Enron says is the largest gas-fired power plant in the world. The plant closed in June 2001, due to a payment and contract dispute between the Maharashtra state government and the plant owners. Enron says it incurred over $1billion in costs for the plant [4] . As a result of these unprofitable projects Enron had a debt and losses around the $30 billion dollar by the year 2000.These numbers wasn't publicly known. Contradictory, Enron publish in 2000 more revenue as a year before without concerning the disinvestment of India.

Andrew Stuart Fastow (Concealed liabilities and expenses)

The chief financial officer Andrew Fastow and his team were responsible for analyzing and measuring the financial numbers. He used various tactics to hide these losses and debts. Andrew Fastow created hundreds of "special-purpose entities" designed to transfer Enron's debt to an outside company and get it off the books without giving up control of the assets that stood behind the debt. These SPE's allowed Enron to move money-losing assets off its balance sheet.Enron would sell the assets thus booking it as a profit.The goal of Enron was to maintain the image of a succesfull company and keep the stock price rising [5] .

Jeffrey Skilinger knew that Fastow was doing these transactions and motivated him to keep doing these transactions as long as they make profit.

These transactions began in 1993 and continued till the discovery of the accounting scandal.

Tim Beldon(unethical practice)

Tim Beldon was an employee of Enron whom believed in free markets and also supported Ken Lay in his lobby to deregulate the energy markets. Once California decided to deregulate their electricity market, Tim Belden poured over the new rules for the deregulation of California's electricity market. Tim found many loop holes in which California could be exploited for the financial gain of Enron and himself.  After Belden found the loop holes in the new rules the Enron traders used their knowledge of the electrical grid to unethically control the buying and selling of electricity into California. The Enron traders looked for arbitrage opportunities in California's electrical grid to create an artificially low supply of electricity. They accomplished this by rerouting the electricity out of the state or by calling up electricity generation facilities and falsely stating that there was low demand and to shut down for a few hours. Once there was a large enough demand for electricity and the price for electricity reached a level that the Enron traders could make abnormally large profits, they would reroute or turn generation back online and sell the electricity back. This process of wheeling power in and out of the state and then selling it and making abnormally large profits is what Enron called and arbitrage opportunity. By the time Enron was finished it was estimated that they had stolen around 11 billion dollars from California. After Enron's bankruptcy hearing they settled with California and agreed to pay them back 1.52 billion dollars of which only 202 million is actually expected to make its way back to California because of Enron's other debt holders [6] .

Were there indications for fraud (red flags) before the fraud was actually discovered

In this part, we analyze whether there were indications for fraud, or red flags, in the financial statements of Enron, in the years before its bankruptcy in 2001. Based on the literature, we could make distinction between different types of red flags. Many of the indications for fraud were related to the measuring and reporting of total revenues by Enron. Furthermore, there were red flags related to the measuring and reporting of the profitability and cash flows of Enron. In the next part, we will first describe the red flags based on Enron's measuring and reporting of its total revenues.

Other than most firms in the energy industry, Enron did not grew large by merging with other firms but simply by using different accounting methods for measuring and reporting of its total revenues. [7] For its energy contracts Enron made use of the mark-to-market valuation method. The mark-to-market valuation method allows revenues to be recognized as earned at the beginning of the contract, so even before service is provided. [8] To recognize the revenues as earned at the beginning of the contract, Enron had to estimate what would happen over the whole period of the contract. Enron was free to develop and use calculations methods based on its own assumptions and estimates about the future, but since there were no real market prices available yet for the whole period, this measurement does sometimes not accurately reflect the underlying contract's true value. [9] The main problem with this valuation method in comparison with other more conservative valuation methods is that firms can (intentionally) overestimate future unrealized profits and hide or understate future unrealized losses.

For reporting the revenues of its trading activities, Enron made use of a so-called "merchant model" whereas most firms in the energy industry made use of a more conservative "agent model". [10] The difference between these two models is that under the agent model, firms are only allowed to report the trading or brokerage fee as its revenue, but not the entire value of the transaction. In contrast, in the merchant model Enron reported the entire value of each trade as its revenue. [11] 

Now it is interesting to look at the effects of using the mark-to-market valuation method and the merchant model for revenue reporting rather than using the traditional accounting methods. The main effect was that Enron's reported revenues and cost of goods sold were much higher than under more traditional accounting methods. However, because both the revenues and the cost of goods sold increased, this effect did not lead to an increase of the gross profit of Enron. When we compare solely the revenues, most and major firms in the energy industry that made use of the more conservative methods and models for revenue reporting grew much slower than Enron. However, when comparing the gross profits of these firms, Enron suddenly did not grow larger and in some cases even much slower than other firms. [12] This fact in combination with the fact that Enron made use of different accounting methods for measuring and reporting its total revenues, should had been an indication for fraud (red flag) for analysts.

In this part, we will describe other possible indications for fraud by Enron. First, we will describe the red flag based on Enron's measuring and reporting of its profitability. In the last four years before Enron's bankruptcy it reported an average annual growth of 16,9% with respect to the net income and an average annual growth of 164.6% with respect to the revenues. [13] As the revenues grew much larger than the net income in that period, the net profit margin of Enron decreased to a low percentage. The fact that also the reported cost of goods sold increased large leaded to a decrease of the gross profit margin of Enron. Profit margins are important for firms as a higher profit margin indicates a more profitable firm that has good control over its costs. [14] The fact that Enron reported very high revenue growth in comparison with other firms in the energy industry but at the same time also lower profit margins should had been an indication for fraud (red flag) for analysts.

Other red flags were based on Enron's measuring and reporting of its cash flows, in particular its free cash flow. Free cash flow is calculated as operating cash flows minus capital expenditures, i.e. free cash flow is the amount of cash that a firm has left over after it has paid all of its expenses, including investments. [15] Negative free cash flow is not necessarily an indication of a bad firm, provided that a firm should have a good reason for spending so much cash, i.e. it should be earning a sufficiently high rate of return on its investments. [16] In the last three years before its bankruptcy, Enron reported large negative free cash flows, very high operating cash flows but at the same time also decreasing and low profit margins. This should had been a major red flag for analysts.

Summary and conclusion

Based on the research we did, we can conclude the following:

Enron was, before getting bankrupt in 2001, one of the largest integrated natural gas and electricity companies in the world. It marketed natural gas liquids worldwide and operated one of the largest natural gas transmission systems in the world.

The fraud committed at Enron is a "synergistic corruption". Accountants, financial analyst, lawyers and executives in charge all took their share of the money and put it in their pockets.

Enron particularly used two of the methods mentioned by Quffa.

Fictitious revenues

Concealed Liabilities and expenses

Main characters involved in this fraud were : Andrew Stuart Fastow(CFO),Kenneth Lay(chairman) , Jeffrey Skillinger(CEO

Jeffrey Skilinger (CEO) and Kenneth Lay(chairman) tried to introduce "mark-to-market'' in the early 90's. The Securities and Exchange Commission(SEC) approved this method and Arthur Andersen signed the reports. Mark-to-market allowed Enron to book future profits when the contracts were signed even when no cash came in. So Enron could estimate his future profits and this estimate would be shown at the outside world.

Many of the indications for fraud were related to the measuring and reporting of total revenues by Enron. Furthermore, there were red flags related to the measuring and reporting of the profitability and cash flows of Enron.

Enron did not grew large by merging with other firms but simply by using different accounting methods for measuring and reporting of its total revenues than other firms in the industry. For its energy contracts Enron made use of the mark-to-market valuation method. The mark-to-market valuation method for financial assets allows revenues to be recognized as earned at the beginning of the contract, so even before service is provided.

For reporting the revenues of its trading activities, Enron made use of a so-called "merchant model" whereas most firms in the energy industry made use of a more conservative "agent model".

There are two red flags in the Enron case namely: the income grew in the period 1996 - 2000 in relation with the revenue growth. And the financial statements were signs of poor earnings quality as indicated by several key cash flow measures.

So our conclusion is that the fraud could be discovered in a prior stadium. Moreover, is very important to update accounting regulations to eliminate potential fraud situations.For instance the introduction of Sarbenes Oxley regulation after the Enron Case.