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A buyer agrees to pay at a given for the services or product. Buyer is liable to pay for specified periodic payments, although he or she has not take delivery of the services or products yet. For instance, an SPE that forms by two gas companies might build a refinery and agree to pay specific annual amounts for refined oil. These specific amounts of payments are made regardless of the actual delivery of the refined oil.
0ff-balance sheet financing
Off balance sheet financing is a type of accounting technique that make the large capital expenditures are kept off of a company's balance sheet through various classification methods. Therefore, a debt for which a company is obligated will not present on the liability part of the company's balance sheet. Companies often use this type of accounting technique to keep their debt to equity and leverage ratios low, especially if the inclusion of a large expenditure will would break negative debt covenants. (Negative covenants limit the amount dividends a firm can pay to shareholders and restrict the ability of the firm to issue additional debt). As a consequence, the companies will appear more creditworthy but this will misrepresent the financial structure of that firm to the shareholders, creditors and public.
Off-balance-sheet financing through hundreds of partnership enabled Enron to keep up the appearance of a rapidly growing and financially stable company until the bankruptcy was about to happen
Enron's financial arrangements were complicated and sometimes entailed transferring overvalued assets to partnerships which it had a controlling interest in but was not required including on its own balance sheet. On the another side, the partnerships raise most of their capital using Enron stock, transferred assets, or pledges from Enron as collateral by using minimal equity capital from outside investors..
Special purpose entity
AÂ special purpose entityÂ (SPE) is a legal entity that created by a party (transferor or sponsor) by transferring assets to SPE to perform a specific activity, purpose, or series of transactions without putting firm at risk. SPE's are typically used by companies to provide less-expensive financing and isolate the firm from financial risk.
SPE are backed by their sponsor. It is because the special purpose entities does not take part in the business transactions other than they created for. For that reason, they are able to raise funds at a lower interest rates compare to those available to the sponsors.
Normally the SPEs are formed to achieve the following objectives:
Keeping the associated debt off the balance sheet of the sponsors and financing certain assets or services.
Transforming certain financial assets, such as loans, trade receivables, or mortgages into the liquid securities.
Engaging in tax-free exchanges.
Sell-side analyst is an analyst that employed by a brokerage firm and evaluated companies for future earnings growth and other investment criteria. Unlike that of theÂ buy-side analysts employed byÂ mutual funds,Â researchÂ produced by sell-side analysts is normally available toÂ public. They sometimes place recommendations onÂ stocksÂ or other securities, whether should "hold", "buy", or "sell." They are incentivized by offering their recommendations to institutional investors'Â clients, as well as by seeking investment banking deals with the firms they cover, although the latter is subject to significant regulatory restrictions, particularly in the United States.
Mark-to-market accounting(Fair value accounting)
Mark-to-market accounting refers to the accounting for value of an asset or liability that based on the current market price. As market conditions change, mark-to-market accounting will make the values of asset or liability on the balance sheet change frequently. Mark-to-market aim to provide a realistic appraisal of the institutions or companies current financial status. In contrast, the book value accounting/historical cost accounting, which is based on the original cost or price, is more stable. However, the information can become outdated and inaccurate.
Mark to market accounting enhances transparency concerning the value of corporate assets and liabilities. For example, if a company acquires an asset whose value later drops dramatically, under historical cost accounting the value of loss would be reported only when the asset was sold. With mark to market accounting, the value loss is reported in the firm's periodic financial statements, regardless of whether it is sold.
However, if market values are unavailable, mark-to-market becomes mark-to-model. (Mark-to-model is the pricing of a specific investment position or portfolio based on internal assumptions or financial models). The requisite valuations frequently involve subjective estimates.
History of Enron
Kenneth Lay founded the company of Enron in 1985 through the merger of Houston Natural Gas and Internorth, two natural gas pipeline companies. Initially, Enron involved in transmitting and distributing electricity and natural gas throughout the United States. The company owns a large network of natural gas pipeline.
Enron Corporation was an American energy company. It is one of the world's leadingÂ electricity,natural gas, communications andÂ pulp andÂ paperÂ companies which based in Enron Complex in DowntownHouston,Texas.
Enron grew wealthy due largely toÂ marketing,Â promotingÂ power, and its high stock price. From 1996 t0 2001, Fortune magazine had named Enron as the "America's Most Innovative Company" for six consecutive year. Besides, it was on theÂ Fortune's "100 Best Companies to Work for in America" list in 2000. However, Enron's image was ruin and its stock price had plummeted nearly to zero within a year.
Jeff Skilling resigned as CEO on 14th August 2001 by citing personal reasons and soon he sold large blocks of his shares in the corporation which is almost 60 billion. Kenneth Lay came to replace the CEO position. Later on, Sherron Watkins(Enron vice president) wrote an anonymous letter to the CEO to express her concerns with James Hecker, a former audit partner at Andersen.
On 22th October 2001, the Securities Exchange Commission opened inquiries into a potential conflict of interest between Enron, its partners and its special director. Next, Enron restated its prior four year financial statements. Thus, the earnings from 1997-2000 declined by $591 million, and the debt for 2000 increased $658 million. Enron entered merger agreement with Dynegy on 9th November 2001. However, Dynegy pulled out of the proposed merger on 28th November 2001. Enron's debt downgraded to junk bond status, making the firm liable to retire $4 billion of its $13billion debt. Finally Enron filed bankruptcy in New York in 2nd December 2001. On the same time, Enron sued Dynegy for breach of contract.
The Enron controversy involves several accounting issues. There are 2 sets of issues. First, Enron's trading business adopted Mark-to-Market accounting (fair value). A second issue is relied extensively on structured finance transactions that involved special purpose entities (SPEs).
Trading Business and Mark-to-Market accounting
CEO Jeffrey Skilling had a way of hiding the financial losses of the trading business by using Mark-to-Market accounting. This is used in the trading business that involved complex long-term contracts, which the cases ran as long as 20 years. Under Mark-to-Market rules, once the long-term contract was signed, revenue was recognized as the present value of net future cash flow. The present value of the expected costs of fulfilling the contract was expensed as well. Enron incorporated Mark-to-Market accounting for the energy trading business in the mid-1990s. There is a difficulty with application of these rules in accounting for long-term futures contracts in commodities such as gas. It is because there are often no quoted prices upon which to base valuations. So, it is difficult to judge the costs of these contracts and their viability. Thus, Enron free to develop and use discretionary valuation method based on their assumptions.
Enron used fairly straightforward accounting in natural gas business. However, when Jeff Skilling joins the company, he request to adopt Mark-to-Market accounting. There is some reason they thrived under Mark-to-Market accounting. It is because the asset value can be adjusted based on market fluctuation. Due to that, Enron executiveÂ can report increased asset valuationsÂ regardless of whether actually increased or not.Â In reality, many Enron's assets were below cost.Â The other reason is revenue recognition really gave the company the financial reporting license to perpetuate fraud. Under conventional accounting, revenue is recognized from a sales contract when the product is delivered or the service is performed. However, underÂ mark-to-market accounting, revenue was recognized on the day the deal isÂ completed before any work has been done or costs incurred to fulfill the contract.
In July 2000, Blockbuster Video and EnronÂ signed a 20-year contract to launch the on demand entertainment to various U.S. cities. Enron estimated profits more than $110 million from the deal, although analysts questioned the technical viability andÂ market demand. Blockbuster pulled out of the contract when network failed to work. The deal resulted a loss. Even so, Enron continued to recognize future profits.
Reporting Issues for Special Purpose Entities (SPEs)
Eron use SPEs to keep the failed assets off of the company's book, which mean that hide any assets that were losing money or business venture that had gone under. Furthermore, they also used it to fund or manage risks associated with special assets. Enron hide the debt from financing the acquisition in the balance sheets. They disclose minimal details on its use of SPEs. Chewco is a special purpose entity of Enron and the debt raised by Chewo will guaranteed by Enron. This enable Enron to acquire the partnership interest without identify any debt because they did not have to consolidate Chewco into their financials. For financial reporting purpose, it used to determine whether financial statement of SPEs establish by corporation should be consolidated with the corporation's financial statement.
In October 2001, Enron violated accounting standards that need at least 3% of assets to be owned by independent equity investors. The reason Enron ignore the requirement because they want to avoid consolidate with special purpose entities. As a result, Enron had understated its liabilities and overstated its equity and earnings in. Besides, Enron also allowed their employees such as their CFO Andrew Fastow to become partners of the SPEs. In this transaction, those employees are profited. On the other side, Enron's stockholders were being ignored.
Other Accounting Problems
Basically, the issues of the financial reporting of Enron are more on Mark-to-Market accounting and Special Purpose Entities. In October 2001, Enron announced that the assets were write-downs. On October 5, 2001, Enron agreed to sell the electric power plant, Portland General Corp. at a loss of $1.1 billion over acquisition price. Due to the announcements of accounting irregularities and business failures, capital markets decrease Enron's stock price and increase its borrowing costs. On November 8, 2001, Enron want to avoid bankruptcy. So Enron agree acquired by a smaller competitor which is Dynergy. On November 28, Dynergy withdrew from the acquisition because Enron's public debt was downgrade to junk bond status. Finally, on December 2, 2001, Enron filed for bankruptcy.
Governance and Intermediation Failures at Enron
In this article, we know that Enron's problem not detected for a long a period, but many of the blame are toward Arthur Andersen and the "sell-side" analysts. However the author of this article, Healy and Palepu hypothesized that the intermediation problems is more serious because it will affect each of the intermediation that relating Enron's managers to the investors. For this governance and intermediation failures we can look from two side that are information supply sides and information demand side.
Information supply side
In this sides market it include top level management, Enron's audit committee and external audit member, Arthur Andersen.
Top level Management
The article mentioned that Enron compensate their top management by using stock options based on performance-based reward. Their management level was focus on creating expectations of the rapid growth and to meet up the reported earnings to Wall Street's expectation. This goal was likely exercised by them within three years and they were not restricted by rules on subsequent sale of stock acquired. This kind of reward created a conflict of interest in which the interests of management and shareholders were aligned. From the fall of Enron, the article concluded that the stock compensation programs can motivate managers to create short-term stock value but not suitable to create medium or long-term value.
Enron's audit committee consists of many experts in accounting area. However, they have few short meetings which covered huge amounts of important issues. Besides, their outside director did not actively concern about the company operation. They only relied on the information that given by the management or internal and external auditor. Therefore, they were unable to question whether the top management representations were valid or not and on some technical accounting questions about the special purpose entities. They also did not aware of the potential conflicts in related party transactions and no full disclosure required by them.
Arthur Andersen, Enron's external auditor had received the significant consulting fees from Enron which were creating a conflict of interest and as a result Arthur Andersen been accused of applying lax standard on Enron. Arthur Andersen wanted to retain Enron as a consulting and audit client because 27 percent of the audit fees contributed to the audit firm by Enron. When the problem of the special purpose entities became clear, they permitted Enron to defer recognizing the charges after the Enron's management gave pressure to them.
Besides, the changes in accounting industry in the 1970s gave the audit firms pressure to cut costs and generate alternative revenue sources increased the audit risks. As a result, the Enron scandal had made public misunderstood about the roles of external auditors.
Information demand sides
In this side it more toward the fund manager, financial regulators and sell- side analysts always demands information from supplies side's parties.
There are some reasons explain that why the leading fund managers were so slow to identify and recognize the problem at Enron. First, leading fund managers are misled by sell-side analyst or by accounting statement. That is because the company's stock price has been manipulated by unrealistic expectations of their company future performance, although before that Enron's reported is the real situation of his company performance.
As we can see from the exhibit 4, revenues and return on equity are based on real data from year 1994 until 2000. After this, the forecasted data is based on the levels needed to justified the stock price of $90 in August 2000. Based on this assumption, the return on equity will be remaining at 25% and grow revenues will be increase from $100 billion to $700 billion in 10 years. However, these assumptions are too aggressive; which to achieve that assumption, Enron need to dramatic extension their business. Besides, benchmark for historical averages in United States public company has 11% of return on equity from 1979 to 1998, compare that Enron expected 25% will be remain after year 2000.
The second explanation about the fund managers failed to identify or recognize the Enron's risk is because they only have modest incentives to act on high-quality and long-term company analysis.
Besides, the author believe that most of the fund manager have herding behavior that pay more attention identify other investor's decision rather than do their own fundamental analysis.
The reason to explain that why the sell-sides analysts so slow to identify or recognized the problem at Enron is because many analysts working at investment bank which are deal with Enron, therefore they had financial incentives to support their client by recommend Enron. There are 3 finding discover. First, there have potential conflict of interest from investment banking. Second, price appreciation expected by analysts of investment banks no current banking was an optimistic combination than appreciation by analysts with current banking relationship which would create a conflict of interest in potential for future business and current business itself. Third, analysts with no investment banking did not explain bias in analysts' recommendations and forecasts.
Besides, sell-sides analysts also facing another potential serious conflict but less widely discussed. First, companies are less likely to provide that analyst access the critical management and also the express negative opinion about their company's prospect. Second, sell-side analyst may have another potential conflict is in the institutional Investor magazine there have an annual evaluation analysts rating by institutional investors who play an important role in that.
Enron was able to design the transaction that satisfied the content of the law but violated its intent like Enron did not reflect their financial risk in balance sheet.
However, the Financial Accounting Standard Board tries to obtain the consensus between the affected groups in setting new accounting standards. But, the process of setting standard is slow, political and difficult. Besides, when new standards are passed, they often tend to be highly detailed, inflexible and mechanical.
From this article, the author had listed out some problem that cause the fall of Enron and Arthur Andersen. In the end of this article he list out the respond of some new regulations were to expand the reliability of financial reporting for public companies to improve the problem and avoid Enron cases happen again in the future.
The first problem found by the author from this case is the key capital market participants were late to recognized Enron cases. For this problem there have two solutions one of it are the Securities and Exchange Commission need to add some restriction on the audit firm. For example restrict the audit firm to own consulting business or delete certain types of consulting service. Besides that, audit firm need to disclosure of analyst and compensation with firm's investment banking activities to Securities and Exchange Commission.
The other solution that author listed in the article also are changes in stock option. This can settle by limited the manager power to sale of stock until they leave office. In addition if the firm affected by fraudulent financial reporting, shareholder can asking gains from selling in market from executive level office. The last response for the first problem is adding independent members to firm board of directors to get financial expertise and have a longer time for audit committees to meet up to speak out their question.
For the second problem that the author address in this article is about the duty of audit committees in the firm. Investor should have a detail and clearly financial information of company before decide to invest. The detail and clearly financial information means reliable information about the company operation, future and risk will be faces. However, audit committee's duty is restricted on the technical works that make sure the firm financial report follow the generally accepted accounting principles only.
For that problem the author had address the response is audit committee change to transparency committees which focus on the investor to get adequate information about the currently firm financial condition. Then the main focus of the transparency committees is to help investor and the member of board of director knew the firm value proposition, strategy, and success key and risk. Lastly the transparency committees also help auditor to know that they responsibilities is toward the member of the board not the top management executive.
The other problem listed out in this article is there have the conflict between auditing and consulting practice. Therefore the response is they need to rethink their business model. Where there have propose the auditor to change their strategy from just only maximizing the value of audits to provide more complete insight of the auditor on the client's operation and risk facing.
For the litigation risk on auditor increasing problem, there have three responses. First is the audit firm need to well manage their business with risk facing by right incentive, checks and balance and suitable pricing policy. However the second response is the audit firm better not accept the client which are pursing nonvalue-creating business strategies because the probability audit firm blame for the failure of pure business as the company have a lot of revenue. Finally they need to change their system to handle business failure. That is not only litigation is the only result for business failure, it can be analyzed the failure by the independent body of expert to point out the shoddy work then the auditor will only be accountable.
The last problem listed in the article by the author is an alternative environment for institutional investor. This is because the failures in the supply of information by the auditor and audit committee and failure demand from the sophisticated institutional investor make the Enron's stock price increase to the level that the Enron unrealistic performance expectation. This situation would occurs in Enron case is because the incentives and information problem in the governance and functioning of the capital market intermediaries. Therefore the response for this is that capital market intermediaries need to have a detail consideration of their goal, incentives and the interaction so that would not have the Enron cases happen again in the future.
Enron and Arthur Andersen are the two companies' names that will live in infamy in our mind forever because of the events leading up in December 2001. The Enron left a deep and ugly memory on the modern business. This is because when Enron announce its bankruptcy, it result thousands of people lost their jobs, lost their pensions, and all of the shareholders lost their investment in the corporation.
These two largest and popular companies in the utility and accounting industries took benefits from investors, government and public, just to increase their personal wealth.Â Even so, it brings the good impact for the future of accounting industry as it reminds everyone need to responsible to the justice.
Enron's bankruptcy and the Securities Exchange Commission investigation have brought in many changes to the industry. For example, the accounting standards become more strictly and penalties become more heavily too. As a result, accounting industry become more reliable.Â
Although the changes on this Enron cases may be coming to an end, the changes that have occurred due to that case have leaved in the accounting industry and the economy to become stronger.Â Therefore accountants must continue to work hard to make it functional as what they expected.Â Only by this action the industry might be good enough to function effectively and even success in the future.