The Enron Corporation Accounting Scandal and Bankruptcy

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The collapse of the Enron Corporation in December 2001 led many to believe that this could happen again to another company (Niskanen, 2005). The accounting scandals and bankruptcy by Enron and other major corporations have also undermined the popular and political support for free market policies. This effect led to increased federal regulation of accounting, auditing, and corporate governance and increased criticism of any proposal for reducing the role of government. The policy lessons that can be learned from the scandal come from the problems of conventional accounting and the limitations of the monitoring model of corporate governance. The Enron scandal and its effects have had a significant impact on the accounting industry, and the scandal has caused a need for the government to reform accounting ethics in order to restore public confidence in the integrity of the accounting system.

After reading about the collapse of Enron, one can be outraged by its many leading accounting practices. One of the accounting practices includes the booking of wash trades as revenues, in which Enron was essentially trading with itself in order to draw in investors (Niskanen, 2005). According to the United States Security and Exchange Commission (1997), a wash trade can be defined as "a securities transaction which involves no change in the beneficial ownership of the security." Wash trades are illegal and usually involve in the buying and selling of shares within a very short period of time so that there is no financial risk in the transaction. Therefore, Enron's purpose for engaging in those transactions was to defraud customers, and to manipulate prices of future contracts.

Another practice was the improper use of mark-to-market accounting to increase the reported value of existing assets when no substantive economic value had been added (Niskanen, 2005). This meant that once a long-term contract was signed, the present value of the stream of future inflows under the contract was recognized as revenues and the present value of the expected costs of fulfilling the contract were expensed (Healy & Palepu, 2003). Unrealized gains and losses in the market value of long-term contracts that were not hedged were then required to be reported later as part of annual earnings when they occurred (Healy & Palepu, 2003). This allowed Enron to report profits on the sales, and almost simultaneously increase the book value of some assets (Niskanen, 2005). Mark-to market accounting was central to Enron's income-recognition practice, and resulted in its management making forecasts of energy prices and interest rates well into the future (Healy & Palepu, 2003). In the Enron's income-recognition practice, Enron recorded current income fees for services rendered in future periods and recoded revenue from sales of forward contracts, which were in other words disguised loans (Niskanen, 2005). Therefore, Enron still owned the assets and had borrowed funds from banks, but recorded the transaction as sales and did not record the debt (Niskanen, 2005).

The most highly controversial practice was the use of some of its many special purpose entities (SPEs) as passive partners in these practices (Niskanen, 2005). For financial reporting purposes, a series of rules is used to determine whether a SPE is a separate entity from the sponsor (Healy & Palepu, 2003). These require that an independent third-party owner have a substantive equity stake that is at risk in the SPE, which has been interpreted as at least three percent of the SPE's total debt and equity (Healy & Palepu, 2003). The independent third-party owner must also have a controlling, of more than fifty percent, of financial interest in the SPE. If these rules are not satisfied, the SPE must be consolidated with the sponsor firm's business (Healy & Palepu, 2003). Enron had used hundreds of SPEs by 2001, and many of these were used to fund the purchase of forward contracts with gas producers to supply gas to utilities under long-term fixed contracts (Healy & Palepu, 2003). However, several controversial SPEs were designed primarily to achieve financial reporting objectives (Healy & Palepu, 2003). According to Niskanen (2005), "The most apparent violations of accounting rules appears to have been the failure to consolidate three of its many SPEs on the Enron books, a mistake that when acknowledged in November 2001 led to a $586 million reduction in reported earnings, and the failure to report the amount of debt of the SPEs that was effectively guaranteed by Enron" (p. 47). Enron ultimately failed to account properly for their investment in and dealings with SPEs, which were basically organizations sponsored by and benefiting Enron but owned presumably independent outside investors (Niskanen, 2005). Enron also accounted for its stock that was issued to and held by SPEs, of which the Generally Accepted Accounting Principles (GAAP) do not permit a corporation to record income from increases in the value of its own stock or to record stock as issued unless it has been paid for in cash or its equivalent (Niskanen, 2005).

Enron had significantly manipulated its earnings through its accounting practices, as seen through the chart below. Figure 1 presents three versions of Enron's earnings for fiscal years 1997-2000, along with the first two quarters of 2001 (Lev, 2003). Pursuant to its bankruptcy filing in December 2001, Enron did not report quarterly earnings beyond second quarter 2001 (Lev, 2003). The three bars for each year portray, from the left, financial analysts' consensus forecast of earnings per share, which was an aggregate of individual forecasts made before year-end (Lev, 2003). The corresponding earnings figures publicly reported by Enron shortly after fiscal year or quarter end, and the restatement of these earnings filed with the Securities and Exchange Commission on November 8, 2001, in the wake of Enron's collapse (Lev, 2003). From 1998 on, Enron's reported earnings similarly shows that, starting with December 1997, Enron beat analysts' forecasts in every quarter but one, being the September 1999 quarter (Lev, 2003). In addition, Enron's annual and quarterly earnings from 1997 to its demise appeared to exhibit a healthy and continuous rate of growth (Lev, 2003). However, the reality was different; the right bars in each triplet of Figure 1 present Enron's restated earnings as of November 2001, indicating substantially lower figures than both originally reported and forecasted by analysts (Lev, 2003). However, even the restated earnings are significantly overstated, as Enron's new management withdrew the restatement in April 2002 and has yet to issue an updated version (Lev, 2003). As is clear from Figure 1, the analysts that followed Enron and were supposedly capital market experts did not have a clue about Enron's problems up to its bankruptcy or were so obliged to concealed interests as to fail to warn investors (Lev, 2003). In conclusion, these earnings show how the accounting practices of Enron manipulated the earnings, and baffled many analysts and exports about Enron's true earnings.

One of the major problems in the accounting industry itself which allowed for such accounting errors to occur is the lack of competition among accounting standards. The central problem with the Financial Accounting Standards Board (FASB), which is a monopoly standard setter, is that there is no incentive to respond quickly to market forces, let alone act in a manner free from political influence (Niskanen, 2005). It is important that any monopoly that sets the accounting standards is quickly responsive to a change of business practices, such as derivatives, that calls for an amendment or addition to the common standards (Niskanen, 2005). The solution to monopoly is competition, as in private markets (Niskanen, 2005). As is the situation for private companies, governmental agencies seek acceptance of their products and modify those products to meet substitutes produced by other agencies (Niskanen, 2005). Consequently at a minimum, Congress or the Securities and Exchange Commission (SEC) should permit corporations with publicly traded stock to base their financial accounting statements on U.S. or international accounting standards (Niskanen, 2005). Therefore, a competitive system that would allow corporations to prepare their financial statements in accordance with alternative standards, such as the International Accounting Standards that have been adopted by the European Community, should be adopted in the United States (Niskanen, 2005). By doing this, the confidence in the accounting industry will improve and lead to less errors in the accounting system which lead to the Enron scandal.

The role of accounting regulation in the Enron scandal had loop-holes in the system which had allowed for some of the accounting practices. According to Eichenwald (2005), while the Enron executive team gathered to decide what to do, Jeff Skilling who was a senior executive and later became CEO was quoted saying, "If the government sets up the market, it's going to be done wrong. Just know the rules better than anybody else. Then you'll make money" (p. 116). This shows how finding and exploiting loopholes in the law was standard business practice at Enron. Enron was able to devise transactions that satisfied the law, but violated its intent such that the company's balance sheet did not reflect its financial risks (Healy & Palepu, 2003). The Financial Accounting Standards Board (FASB) had recognized for several years that problems existed with the rules for SPEs, however FASB attempts to operate by forming a consensus between affected groups, and it had not been able to reach a consensus on an alternative (Healy & Palepu, 2003). Therefore, when standards are passed as a result of intensive negotiations, they often tend to be highly detailed, mechanical, and inflexible.

In conclusion, the financial accounting of Enron was misleading, and often provided little information and adequate measurements to investors of the actual economic performance and conditions of the company (Niskanen, 2005). Niskanen (2005) suggests that GAAP should be principle-based instead of rule-based, so that investors are not to be misled by accountants finding loop-holes in a system by simply remaining in technical compliance. Such principles are clear and include concise ideas of what revenue and expenses should be, as well as trustworthy numbers to be reported in financial statements (Niskanen, 2005). By abiding to the principles, traditional income statements would be fair and consistent with the records of a company's operations, and therefore would fulfill the proper function of accounting (Niskanen, 2005). Investors should realize that there are limitations in financial information reported in accounting financial statements, and accounting therefore, cannot produce both trustworthy and completely adequate measures of the economic performance and the condition of a company.