Enron Financial Reporting

Enron’s complex business model – reaching across many products, including physical

assets and trading operations, and crossing national borders – stretched the limit of

accounting. Enron took full advantage of accounting limitations in managing its earnings and

balance sheet to portray a rosy picture of its performance

2 sets of issues proved especially problematic. First, its trading business involved

complex long-term contracts. Current accounting rules use the present value framework to

record these transactions, requiring management to make forecasts of future earnings. This

approach, known as mark-to-market accounting, was central to Enron’s income recognition

and resulted in its management making forecasts of energy prices and interest rates well

into the future. Second, Enron relied extensively on structured finance transactions that

involved setting up special purpose entities. These transactions shared ownership of

specific cash flows and risks with outside investors and lenders. Traditional accounting,

which focuses on arms-length transactions between independent entities, faces challenges

in dealing with such transactions. Accounting rule-makers have been debating appropriate

accounting rules for these transactions for several years. Meanwhile, mechanical

conventions have been used to record these transactions, creating a divergence between

economic realities and accounting numbers.

Trading Business and Mark-to-Market Accounting

In Enron’s original natural gas business, the accounting had been fairly

straightforward: in each time period, the company listed actual costs of supplying the gas

and actual revenues received from selling it. However, Enron’s trading business adopted

mark-to-market accounting, which meant that once a long-term contract was signed, the

present value of the stream of future inflows under the contract was recognized as revenue

and the present value of the expected costs of fulfilling the contract were expensed.

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.

Enron’s primary challenge in using mark-to-market accounting was estimating the

market value of the contracts, which in some cases ran as long as 20 years. Income was

estimated as the present value of net future cash flows, even though in some cases there

were serious questions about the viability of these contracts and their associated costs.

For example, in July 2000 Enron signed a 20-year agreement with Blockbuster Video

to introduce entertainment on demand to multiple U.S. cities by year-end. Enron would

store the entertainment and encode and stream the entertainment over its global

broadband network. Pilot projects in Portland, Seatlle and Salt Lake City were created to

stream movies to a few dozen apartments from servers set up in the basement. Based on

these pilot projects, Enron went ahead and recognized estimated p

Enron incorporated “mark-to-market accounting” for the energy trading business in the

mid-1990s and used it on an unprecedented scale for its trading transactions. Under mark-

to-market rules, whenever companies have outstanding energy-related or other derivative

contracts (either assets or liabilities) on their balance sheets at the end of a particular

quarter, they must adjust them to fair market value, booking unrealized gains or losses to

the income statement of the period. A difficulty with application of these rules in accounting

for long-term futures contracts in commodities such as gas is that there are often no quoted

prices upon which to base valuations. Companies having these types of derivative

instruments are free to develop and use discretionary valuation models based on their own

assumptions and methods. The Financial Accounting Standards Board’s (FASB) emerging

issues task force has debated the subject of how to value and disclose energy-related

contracts for several years. It has been able to conclude only that a one-size-fits-all

approach will not work and that to require companies to disclose all of the assumptions and

estimates underlying earnings would produce disclosures that were so voluminous they

would be of little value. For a company such as Enron, under continuous pressure to beat

earnings estimates, it is possible that valuation estimates might have considerably

overstated earnings. Furthermore, unrealized trading gains accounted for slightly more than

half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its

reported pretax profit for 1999.

“Mark-to-market” accounting became acceptable and Skilling applied it to the

energy trading business. “Under mark to market rules, whenever companies have

outstanding energy-related or derivation contracts (either assets or liabilities) on their

balance sheets at the end of a particular quarter, they must adjust them to fair market

value, booking unrealized gains or losses to the income statement for the period;” however,

long term future contracts for commodities such as gas are difficult to ascertain market

values, typically no quoted prices are available. This leaves room for companies to develop

its own valuation models as well as room for manipulation.

With debt still visible, financial analysis’ rating for Enron were lower than the

company desired. Andy Fastow, Enron’s CFO, led the company in the use of special purpose

entities (SPEs) to increase the capital and improve Enron’s rating. SPEs are partnerships with

an outside party that allow the company to increase its ROA and leverage without required

reporting of debt on the company’s financial statements. Thus, Fastow was able to hide

Enron’s debt through approximately 500 SPEs, including “troubled” hard assets such as

overseas energy plants and broadband operations. These entities are required to have at

last a 3% interest from an independent party to qualify for the off balance sheet

requirement; if the interest requirement is not reached, the entity must be reported as a

subsidiary to the parent company. Moreover, related party transactions hindered

transparent financial statement. Risk for these entities was assumed by Enron and not the

outside party, yet were not completely independent.

Enron wasn't actually doing very well financially, but the executives illegally changed their financial

records to make it look like they were doing great. 

So everyone thought it was good, and people kept on buying shares, and share prices kept on rising.

All the while, the executives of Enron were slowly selling off their shares at a high price, because only

they knew that the reality was that the shares were worthless. The crime is called "Insider Trading".

It's also what Martha Stewartwas arrested for.

They got caught, and went to jail. The share prices plummeted, and all of the shareholders lost their

investment money. For many innocent Enron employees, their pensions were guaranteed in Enron

stock, so when they share prices died, so did their pension funds. Thousands of innocent people lost

huge amounts of money.

Enron evolved from a legitimate pipeline gas trader into what is known in business as a "black box" --

an enterprise that reports but cannot verify its profits. Jeff Skilling, the company's leader, instituted

"mark to market" accounting, where projected profits from any of the company's deals were registered

on the books as real, even if over time they turned out to be losses. So Enron appeared to be

successful despite losing money, a fact carefully hidden from investors whose purchase of Enron

stock provided the capital to keep the charade going. Other corporate entities were established by

Enron to help disguise its deficits from Wall Street. With the collusion of a bribed accounting firm and

number of prominent banks, the deceit lasted until the collapse of the 1990s tech boom.

As bad as that fraud was, the worst part of the scandal occurred when Enron used its control of a

West Coast electric company to extort billions of dollars from California by creating artificial blackouts.

If the state did not pay Enron's outrageous rates, the power was shut off. Consequently, people were

stuck in elevators, and cars crashed because traffic signals went dead. For a company to bring a state

to its knees like that is one of the most despicable acts perpetrated in American business history.

Disgraced CEO Kenneth Lay escaped punishment by dying before sentencing, but Jeff Skilling will rot

in prison, a curious fate for a graduate of the prestigious Harvard Business School.

The Enron scandal was a financial scandal that was revealed in late 2001. After a series of

revelations involving irregular accounting procedures bordering on fraud, perpetrated throughout the

1990s, involving Enron and its accounting firm Arthur Andersen, it stood at the verge of undergoing

the largest bankruptcy in history by mid-November 2001. A white knight rescue attempt by a similar,

smaller energy company, Dynegy, was not viable. Enron filed for bankruptcy on December 2, 2001.

As the scandal was revealed, Enron shares dropped from over US$90.00 to just pennies. As Enron

had been considered a blue chip stock, this was an unprecedented and disastrous event in the

financial world. Enron's plunge occurred after it was revealed that much of its profits and revenue

were the result of deals with special purpose entities (limited partnerships which it controlled). The

result was that many of Enron's debts and the losses that it suffered were not reported in its financial

statements.

In addition, the scandal caused the dissolution of Arthur Andersen, which at the time was one of the

world's top five accounting firms.

The CEO and members of the Board of Director's lied to the investors about the real worth of the

company. The company was losing money, but numbers were fudeged, and details not given in an

attempt to inflate the value of the stock. Then the CEO and others sold the inflated stock to make

some quick money and let the bottom fall out for the rest. Employees at Enron were lied to, and they

had all there life savings wiped out.

No love loss for any of the bigwigs. May they rot in jail where they belong.

Pretty much in simple terms the CEO's of Enron knew that things were going bad and hid the true

figures from everyone, including their employees, and pretty much left them to hang while the

company went bankrupt. They had all sold their shares of the company before the crash and made

out like bandits. It's America mang.