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Enron is known as the one of the largest fraud scandals in the history of United States. It is the 7th largest U.S. Company in 2001 filed for bankruptcy in December 2001. Enron was “a provider of products and services related to natural gas, electricity and communications to wholesale and retail costumers” (Chary, 112). It was the leader of producing, transmitting, and marketing natural gas and electricity as well as it delivered energy and other commodities such as bandwidth internet connection, and provided risk management and financial services to the clients around the world. Enron has its roots in Omaha, Nebraska of United States. It was formed as merger of two company named Houston Natural Gas and InterNorth in 1985 which provides nation-wide gas pipeline system.
In 1988, Enron first started overseas business in England. A year later Jeffery Skilling joined Enron and introduced Gas Bank, a program by which buyer could enter into a contract for longtime at fixed prices. At the same time, the company started to provide financing to other Oil and Gas producers.
In 1992, Enron extended to South America by acquiring ‘Transportadora de Gas del Sur'. A year later Enron runs its first power plant in England which is considered one of the first successes of Enron's international strategy. Later in 1994, Enron stared to do electricity trade which turned later as the biggest profit source for coming years. By establishing trading center in London, Enron entered into the European wholesale market.
In 1996, Enron started building Dabhol power plant in India but later on it is hampered due to political problem. Enron later decided to sell the project in 2001. A year later in 1997, Enron bought Portland General Corporation for about more than $1.9 billion. Enron continued its policy of acquiring companies and in 1998 acquired Wessex Water in UK which formed the basis of Enron's Water subsidiary “Azurix”. But a year later, when about one third of the Azurix was sold to public, the company problem became visible as the price of the shares fell extremely after an early rise. Enron started operating its online commodity trading service “Enron Online” by 1999.
In 2000, Enron's revenue reached $100 billion; double than the previous year which reflects the continuous growth of Enron. By the middle of 2001, 30,000 people in 20 different countries were employed by Enron. The energy financial Group ranked Enron as sixth largest company in the world based on market capitalization.
However, the problem with Azurix shares continued. Things got worsened when Enron disclosed that it had owned $570 million from California utility Pacific Gas & Electric Co which got bankrupted. The fraud was not revealed to public until October 2001 when Enron announced it worth $1.2 billion less compared to what it reported earlier. This resulted investigation by Securities Exchange Commission which found several illegal practice in Enron's balance sheet for so many years by high ranking executives along with their auditing firm Arthur Anderson.
Analyzing the Fraud
Timeline and Financial Highlights:
Enron appeared very strong until October 2001 when it disclosed that it was having huge overstated balance. The critical dates of Enron scandal are from October to December 2001.
* On October 16, 2001, is the first major public sign of trouble when Enron announces a huge third-quarter loss of $618 million.
* On October 22, 2001, the Securities and Exchange Commission (SEC) begins an inquiry for this sudden huge loss and investigates Enron's accounting practices.
* On December 2, 2001, when Enron files for bankruptcy.
Findings- Accounting Fraud Technic:
Enron used different kinds of fraud technics to over shadow their financial statements. These technics are presented below-
1. Market to Market Accounting:
When Skilling joined Enron, he made the company follow the market to market accounting. Enron was the first non-financial company to use this accounting method for its long term contracts. According to the market to market model, whenever the company signs a long-term contract, income is estimated as the present value of net future cash flows resulting from the contract. The feasibility and related costs of these projects were very difficult to measure and because of these differences in profit and cash, investors were given false and misleading reports. However, the profits could not be recorded in future years, so additional income had to be included from more projects to develop additional growth. In 1992 the SEC approved the accounting method for Enron to use in its trading of natural gas contracts. Later on Enron expanded its use to other divisions of the company. In July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities. Enron estimated profits of over $110 million from the deal but the project failed to work and Blockbuster pulled out the contract. The deal resulted in a loss but still Enron continued to recognize future profits.
Implementing the market to market accounting method on the group 2 company, the company gets into a five year contract with firm xyz. The managers recognize the present value of net future cash flows from the project to be $10 million. After a year, xyz pulls out the contract but the managers of group 2 company continue recording the future profits from the deal, whereas the deal does not exist anymore.
2. Special Purpose Entities:
Now talking about another tactic that Enron used in manipulating their books was the use of SPE's (Special purpose entities) also known as ghost companies. Special purpose entities are limited partnerships or companies that are created to fulfill a temporary or a specific purpose mostly they are used to fund, manage or transfer risks associated with specific assets. In lay man's term we can say that if our group(no.2) is running a company on our own and our company owns a plastic product factory that is causing a lot of losses and it's a mere bad mark on the financial reports so what we can do is we can register a new independent company and at the end of the year transfer that asset(plastic factory) to the newly created company this will allow us not to show the losses from the plastic factory on our statements rather they will be shown on the statements of the newly created company.
* By 2001 in total, Enron had used hundreds of special purpose entities to hide its debt.
* Notable special purpose entities that Enron employed were JEDI, Chewco, Whitewing, and
* Main purpose of SPE's was to transfer:
- Assets resulting in losses
- Shares of Enron's common stock
- Long term rights to purchase millions of more shares of Enron.
- Enron's notes payable.
Enron used EITF (Emerging Issues Task Force) resolution 90-15, which was created in the year 1990, and allowed Enron to create and maintain the SPEs which help them in concealing the frauds and transferring assets and shares to special purpose entities or ghost companies.
EITF 90-15 only requires 3% of capital/assets to be contributed by independent external sources in order for an SPE to exist. According to some experts this 90-15 resolution was a license to create imaginary profits and hide genuine losses. In our group (no.2) example we just in order to create a separate independent SPE we just have to bring 3% of external financing and the rest 97% can be financed through our own Group 2 corporation and in this Way we can keep away the losses from our statements and show them on the books of the newly created company. FAS 57 require disclosure of these types of relationships (FAS 57 was proposed and implemented after the Enron Scandal) which will be discussed later.
3. Arthur Anderson:
It was the job of Andersen Consulting , that was among the nation's top five auditing companies, to make sure that the accounting practices followed at Enron are in accord with GAAP and the local regulations so that all the shareholders who have invested their hard earned money in Enron do not face any major losses. Among Arthur Anderson clients Enron was one of the largest and it had close relationships with Enron as well and because of these relationships Enron was able to cover up huge financial losses and debts and to pull off one of the world's largest frauds. Top executives at Enron ordered the shredding of Enron audit related documents that would have helped in disclosing the truth of Enron which is still a mystery. When the large energy giant collapsed in 2002 government authorities and other concerned agencies started an investigation in the accounting practices of the firm and discovered that Anderson was completely involved with Enron in carrying out the illegal and unethical accounting practices. As a result, the US Department of Justice brought obstruction of justice charges against Andersen which ultimately ran Andersen out of business. With such charges Andersen found them in unfamiliar territory, and filed for bankruptcy shortly thereafter.
4. The Snowball:
Snowball was a method used by Enron where it used to treat the costs of cancelled projects as assets on the books, with the justification that no official letter had stated that the project was cancelled. It was initially decided that the snowballs should stay under $90 million, but it was later extended to $200 million.
Solutions and aftermath:
The Enron collapse was one of the biggest scandals that damaged the reputations of corporations in United States. Soon after the incident, the Congress passed a law called the Sarbanes-Oxley Act which imposed stricter rules on auditors and made corporate executives criminally liable for lying about their accounts. The Enron scandal moved the balance of power away from the company boards towards the investors. After the scandal, there is more caution among corporate executives about spinning off accounts that might be inaccurate, as now they face criminal liability. In a nutshell, it was the fault of high level management of Enron's to hide the truth and continue by unethical practice of accounting which results tremendous financial losses.