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Enron files for Bankruptcy (December 2, 2001)
The company was founded by Kenneth Lay in 1985. He was the Chairman of the company when Enron filed for bankruptcy. Two other top executives, Jeffery Skilling and Andrew Fastow were the key players that contributed to the downfall of Enron.
Enron, America's seventh largest company filed for Chapter 11 bankruptcy protection under the United States bankruptcy code. Shares plunged to less than $1 by the end of November 2001. They were charged with wire fraud, money laundering, security fraud, mail fraud and conspiracy.
Financial & Accounting Aspects:
The main cause of the Enron downfall was attributed to their complex accounting practices. The company was concealing losses by setting up shell companies overseas. These offshore entities were used for planning and avoidance of taxes, hence raising the profitability of the business. Enron's financial statements were "portrayed" to hide the losses made by the company and instead they built a façade surrounding their public image which led to investors and shareholders believing that the company was doing well and were very profitable. This concept was called the Special Purpose Entity (SPE). "These companies or limited partnerships were created to bypass the accounting issues faced by Enron."
Examples of these SPEs that were created by Enron are JEDI and Chewco, Whitewing, and LJM.
Enron accounting practice of Revenue Recognition was widely used for its trading operations. According to the books, Enron reported the complete value of each of its trading transactions as revenue hence creating fictitious income.
At the time of bankruptcy, Enron's assets on its balance sheets profit were overstated by $586 million.
Enron was also the first non-financial company to adopt the mark-to-market/fair value accounting concept. It was introduced when Skilling joined the company. Presently, accounting rules use the current value framework to record these transactions, requiring management to make a prediction of future earnings.
Skilling's reason was that the concept would reflect "true economic value" of the company. The company did not foresee future losses or profits due to the inconsistent market or take into consideration the depreciation value. Fair values concept are commonly obtained from estimates rather than the actual market value.
Mark-to-market accounting works in a way that once a long-term contract was signed, income was estimated as the present value of net future cash flows. It resulted in a large amount of discrepancy and they were having a hard time to match profits and cash.
Prices were not hedged hence revenues from these projects were not recorded in the books. This resulted in their inability to balance their books at the end of the financial year. To keep the investors happy, Enron had to source out new projects and "eat" into the new projects revenue in order to keep the profits flowing.
Although the mark-to-market style brought in substantial profits to Enron, it did not bring in any cash flow to the company. The company also announced massive write-offs and restatements in October and November 2001.
Enron's auditing firm Arthur Andersen also played a major role in the downfall. Andersen auditors were trying to work around the FASB and GAAP guidelines in order to create a profitable financial statement for Enron and not create any suspicions that would alert the Securities and Exchange Commission (SEB). Enron related documents and emails that contained vital information of Enron financial statements and their connections with Andersen were destroyed when Enron filed for bankruptcy.
Briefly explain the cause of the financial failure or distress and the area of accounting where there were irregularities.
Role of External Auditors:
Arthur Anderson's firm auditing practice on Enron was the question on everyone's mouth during the trial. Did the company simply overlooked Enron's off balance sheets or did Andersen and a number of his employees purposely hid the truth from its investors and the rest of the world.
Enron paid Andersen $25 million in audit fees and $27 million in consulting fees in 2000. This financial incentive might have impaired the firm's auditing process. Enron's audit fees accounted for roughly 27% of the audit fees of public clients for Arthur Andersen's Houston office.
Anderson would have overlooked the financial irregularities in order to maintain Enron as its audit client. Audit reports should also be standardized and external auditors should keep an objective view on their client's accounts. In addition, the audit committee should have some financial background or at least select someone who is knowledgeable on the accounting side.
Use of SPEs to deceive shareholders:
Enron used about 500 such SPEs and thousands of other questionable partnerships in order to structure transactions to achieve off-balance sheet treatment of assets and liabilities. The company also made several bad investments and "new economy" ventures. Instead of writing off these bad debts, Enron chose to withhold the information for its own benefit than informing the various shareholders and creditors.
Enron's management were allowed to establish SPEs in which "outsiders" control were 3%. Hence, Enron stock would be recorded as revenue by the SPE thus allowing an increase in revenue by utilizing the equity method in accounting. The key players bought Enron's stock on credit as the source of many "independent" partnerships causing an increase in assets and equity. However, these credits were never repaid by any of them.
GAAP and FASB Rulings
Were the GAAP rules inadequate? Enron's failure tapped on the flaw of the GAAP. One of the questionable transactions was an improper recording of a note receivable from Enron's equity partner in various limited partnership.
"These notes were the apparent promises to pay for the equity claims in the limited partnerships, which Enron recorded as assets even though GAAP requires subscribed equity to be reported as a contra-stockholders' equity account, rather than as a note receivable."
Enron adjusted its income statements and balance sheets for the unconsolidated SPEs. Enron's restatement reduced previously reported net income by $569 million and reduced shareholders' equity by $1.2 billion. Enron's net income and cash flow were off balance and this should have set off questions of the company's accounting irregularities.
Restatements of assets and liabilities were allowed on the basis that the numbers were realistic and trustworthy replacing the U.S. rules-based with a principles-based traditional "matching concept" system, and allowing publicly traded corporations to use international accounting standards as an alternative to U.S.GAAP-are proposed to restore value to corporate accounting reports.
Suggest what could have been done differently to avoid the unfortunate consequences in the case, emphasizing the importance of accurate and reliable accounting information.
Enron Accounting Practice
Enron's external auditing firm did not raise any suspicious issues to the SEB or the accounting boards on the irregularities of Enron's financial statements. The auditors should have probed into the complex and complicated SPEs transactions which were adopted by Enron. They could have obtained information from the company through reviewing the board minutes, analysing the transactions statements, audit review notes and memorandum, etc.
Role of Key Executives
Enron's key management did not declare the real value of their losses to the company. Instead they kept covering it up by setting up shell companies and writing off the bad debts. The management did not separate their entities from the company, often buying stocks on credit and never repaid the debts. This could have been prevented if the investors and shareholders were not given a rosy picture of Enron's actual financial status. What could have been done was to exercise control on the power of these executives and keep track of all the SPE transactions and perform regular auditing. Any irregularities have to be reported to the auditing committee and discussed during board meeting. Information disseminated to the company's shareholders should be supported with relevant documents and proof of transactions. Revenue should not be recorded unless the company had fulfilled its full obligation to the purchaser, partly or wholly.
Questions should also be raised when in doubt during these meetings. The shareholders should keep themselves abreast of recent accounting changes by the GAAP and they should at least have some basic knowledge on accounting.
The use of Special Purpose Entity (SPE) hid losses incurred by the shell companies or failed business ventures. Hence, most of the transactions were not consolidated in Enron financial statement. Therefor the numbers reported on the balance sheets were not on par with the company's expenses, liabilities and cash flow.
Enron's income recognition practice of recording as current revenue fees for services rendered in future periods and recording revenue from sales of forward contracts which were in fact disguised loans. Enron recorded millions of dollars of up-front payment as current revenue. These transactions should not have been recorded as incomes. These misstatements were never corrected hence the profits on sales increased. In fact several transactions were not recorded in the books and often treated as write offs.
To avoid this problem from occurring, the company should make proper recording of each transactions and adhere to the various accounting principles and guidelines set by the GAAP and FASB. Violations of such guidelines will prove inconsistency in future financial statements of the company.