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Investment Analysis 1

BEAM011

Lecture 7

Creative Accounting

Dr Jon Tucker

Xfi Centre for Finance and Investment

University of Exeter

Lecture Objectives

1. To introduce the concept of creative accounting

2. To examine common measurement problems in accounting

3. To examine the application of accounting standards to help to deal with these problems:

� UK context

� International context

4. To illustrate creative accounting issues using the case of Enron

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Introduction to Creative Accounting

It is fairly certain that:

• Some managers believe that firms can be shown in a better light by judicious choice of accounting policies and by applying bias to the necessary estimation procedures;

• A number of firms have failed even though their financial statements gave no indication of the impending problems.

Good text on subject of Creative Accounting:

Ian Griffiths, Creative Accounting (1987), International Thomson:-

“Every company in the country has been fiddling its profits. Every set of published accounts is based on books which have been gently cooked or completely roasted. The figures which are fed twice a year to the investing public have all been changed to protect the guilty. It is the biggest con trick since the Trojan horse.”

An Creative Accounting ExampleSource: Elton & Gruber

4.41251.975Per Share on 1,000 Shares

4,412.51,975Net Income

1,837.5525Tax Expense (11)

6,2502,500Pre-tax Income

21,000(3,000)24,000Total Costs/Expenses

(200)200Bonuses (10)

400400Base Salaries

Compensation:

(300)300Asset Impairments (9)

100(200)300Other Post-employment costs (8)

550(200)750Pension Costs (7)

650(550)1,200Exploration Costs (6)

150(250)400Amortisation Expense (5)

600(400)1,000Depreciation (4)

(900)900LIFO Effect (3)

3,5503,550Selling, General and Administrative

15,00015,000Cost of Goods Sold

Costs and Expenses:

27,25075026,500Total Revenues

1,250(250)1,500Equity/Cost Method Affiliates (2)

Other Income:

26,0001,00025,000Sales Revenue (1)

Company BAdjustments

($ in 000s)

Company A

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The example illustrates how, under current US GAAP, a firm could show earnings of $1.98or $4.41 depending on the choices made

Company A and B are the same company but have chosen different accounting methodsin reporting income and cost:

• Lives of investments

• Depreciation methods

• Pension costs

• Forms of compensation etc.


1. Revenue Recognition Methods

• Firms have considerable latitude concerning when they recognise revenue

• Example: difference in estimates of the degree of completion of long-term construction contracts, in revenue recognition of instalment sales, etc.

• Thus Company B recognises £1,000 more sales than A

2. Equity/Cost Method Affiliates

• Company A owns 20% or more of voting stock in another company, and its share of the earnings of this investment, $1,500, is reported as a component of other income

• Company B owns less than the 20% threshold and cannot use the equity method – under the cost method, it reports $1,250 as other income, received as dividends


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3. LIFO Effect

• Company A uses LIFO and B uses FIFO

• If price are increasing and inventories are stable or increasing, LIFO reports higher cost of goods sold

• LIFO effect here is $900

4. Depreciation

• Company A uses accelerated depreciation methods with shorter lives

• Company B uses straight-line depreciation with longer lives

5. Amortisation Expense

• Company B amortises goodwill, patents, and copyrights over the maximum periods allowed

• Company A uses shorter lives


6. Exploration Costs

• Company B capitalises all exploration costs

• Company A expenses dry-hole costs

7. Pension Costs

• Company B’s pension costs are $200 lower because of difference in assumptions of discount rates of return on assets

• Also different allocation to expense of the difference between actual results and actuarial assumptions

8. Other Post-Employment Contracts

• Company B recognises costs of health-care and life-insurance benefits as incurred – current accounting does not require accrual of these costs

• Company A has recorded current costs and accrued future costs

• Studies show that accrued amounts could be as much as 20 to 30 times the periodic cost


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9. Asset Impairments

• Accounting guidelines for the timing and measurement of impairments (loss in value) to long-lived assets are at best vague and inconsistently applied

• Firms also have considerable discretion with respect to reporting impairments to receivables, marketable securities, investments in affiliates, etc.

• Company A has recognised loss due to impairment

• Company B has not yet done so

10. Compensation

• Company B uses stock options for bonuses, whereas A pays them in cash


Smith and Hannah (1991) on Creative Accounting

Smith and Hannah (1991) discussed various methods of manipulating accounting statements (‘creative accounting’) in their publication, “Accounting for Growth”

Important results from this publication:

• They found cases where reported earnings were “flattered at the expense of the balance sheet”

• They produced a useful classification of the most common methods of accounting manipulation – these methods are explained in the following slides

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Low tax chargeForeign exchange mismatch

Earn-out commitments

Pension fund holidaysDepreciation rate changes

Brand accounting

Non-trading profits

Creative

Accounting

Techniques

Capitalised costs

Off balance sheet finance

Extraordinary itemsExcessive provisions

Creative Accounting Techniques

1. Excessive provisions

• Creation and use of significant balance sheet provisions

• Example: reduce asset values on acquisition of another firm to reduce depreciation → profits increase artificially

2. Extraordinary items

• Significant cash reorganisation/rationalisation costs which appear as extraordinary items but not against pre-tax profit

• Artificially maintains pre-tax profit

3. Off balance sheet finance

• Companies may have significant off balance sheet debt

• Example: firm raises capital in associate firms which are not fully consolidated – often where parent group has guaranteed the debt → gearing appears artificially better than it is


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4. Capitalised costs

• Capitalisation of interest and other costs when acquiring an asset

• Okay as will eventually appear as depreciation or losses on disposal

• BUT with property companies, a considerable expense may not appear as a cost on the income statement

5. Non-trading profits

• This occurs when significant non-trading profits are credited to pre-tax profits – asset disposals, sales and leasebacks, etc.

• Firms usually try to classify unusual losses below the line and unusual profits above the line

6. Brand accounting

• Include brand values as an asset on the balance sheet

• Legal in the UK, but not in most other countries

• BUT is value reliable? Will it be volatile?


7. Depreciation rate changes

• Sometimes inappropriate rates are used due to error or attempt to mislead

• Some firms will reduce the rate without good reason to produce a growth in profits

8. Pension fund holidays

• If pension funds are performing well, firms could reduce their contributions, cancel them, or even reclaim funds

• Profits are inflated as a result (but only temporarily)

9. Earn-out commitments

• Earn-outs ⇒ where a business has been acquired and important personnel are persuaded to remain by generous profit-sharing schemes

• BUT meeting these terms can become very demanding, especially where the rest of the group is doing badly


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10. Foreign exchange mismatch

• Example: UK firm deposits cash in US bank; US interest rate↑, interest income↑ from US; BUT why have interest rates increased in the US? Perhaps to tackle US inflation THUS we expect at the same time, value of dollar↓ and thus ultimate principal value of investment at redemption will decrease

• This would temporarily inflate profits BUT ultimately give rise to exchange losses

11. Low tax charge

• A low tax charge in relation to profit may indicate that the firm is not sound OR is temporarily depressing the tax charge

• Indicates possible accounting wizardry/creative accounting

• BUT tax authorities are good at spotting such cases


So how frequent are these accounting problems?

Refer to Table 2.2 in Rees (1995)

• Creative accounting procedures are common amongst the largest UK quoted firms e.g. 57.1% of firms use excessive provisions

• The use of such practices can significantly impact upon security market variables (relative P/E, abnormal returns, beta)

Feroz et al. (1992) study of creative accounting

Refer to Table 2.3 in Rees (1995)

• Shows accounts items most frequently mis-stated

• Debtors is the main culprit

• Overall working capital accounts for 2/3 of errors

• Effect can be very significant on reported income

Incidence of Creative Accounting

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US Income Statement – “Above and Below the Line”

• Revenues from the sale of goods and services• - Operating expenses• ----------------------------------------------------------------------------------------------• Operating income from continuing operations

• + Other income and revenues• ----------------------------------------------------------------------------------------------• Recurring income before interest and taxes from continuing operations

• - Financing costs• ----------------------------------------------------------------------------------------------• Recurring (pre-tax) income from continuing operations

• +/- Unusual or infrequent items• ----------------------------------------------------------------------------------------------• Pretax earnings from continuing operations – ‘The Line’

• - Income tax expense• ----------------------------------------------------------------------------------------------• Net income from continuing operations

• +/- Income from discontinued operations (reported net of tax)• +/- Extraordinary items (reported net of tax)• +/- Cumulative effect of accounting changes (reported net of tax)• ----------------------------------------------------------------------------------------------• Net income

1. They attempt to satisfy a wide readership

2. They do not always predict failure

3. Investors have different levels of interpretation skills

4. Firms disclose enough information to attract external funds, butare reluctant to disclose information which may be used adversely by competitors, regulators, etc. who may constrain their actions

5. Management have an incentive to manipulate reported earnings figures

General Problems with Accounting Data

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Measurement Problems in Accounting

Inflationary distortionDefinition of the firmNumber of transactions


Recognition and matching

Link between profit and cash flow

Link between economic and

accounting numbers


1. Economics vs. accounting

• Problem: no clear link between accounting measures of income and wealth and the underlying economic values

• E.g. asset values in balance sheet are not:

• Realisable value

• Replacement cost

• ALSO value of firm based on its income-generating potential may be very different from value of its constituent parts

2. Profit vs. cashflow

• No immediate link between profit and cash flow

i.e. profit → cash flows BUT link is not obvious

• Because of need for investment in:

• Working capital

• Fixed assets

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3. Recognition and matching

• Income is taken to profit and loss account when product is delivered, NOT when:

• Order is received

• Cash payment is made

• Expenses are taken to profit and loss account:

• When they are incurred

• When revenue is accounted for

• THUS matching of expenses to relevant income → AND problem with historic cost accounting (valuation of expenses involves expectations about the future)

• Problems occur with respect to: depreciation, intangible assets, extraordinary items, revalued assets, etc.



a) Depreciation

• Depreciation or amortisation of an asset over its expected life

• Balance sheet → shows residual value of an expense not yet written off, not an assessment of the declining value of an ageing asset

b) Intangible assets

• Examples of intangibles – amortisation problem is acute with:

• Goodwill

• Advertising

• Research and development expenditure

• Uncertainty regarding duration of benefits from these and THUS they tend to be written off immediately in the UK

• ALSO valuation of brands and inclusion on balance sheet is problematic because of:

• Subjectivity of attributing a market value

• Some include on balance sheet and others do not

• THIS can significantly reduce gearing ratios

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c) Extraordinary items• Firms often categorise costs (and sometimes even income) as extraordinary• THUS meaning that they do not fall within the normal activities of the firm and

are not expected to recur• BUT firms can often try to pass off recurring costs as atypical which makes

them look better to investors• This is more difficult since FRS2 (UK GAAP which makes extraordinary items

more rare)

d) Revalued assets• Certain long-lived assets may be revalued to their current valuations even

though all other items in the accounts are historically valued• Problem in degree of subjectivity here and lack of consistency across UK firms

(not accepted outside UK)

4. Definition of the firm• Which assets or liabilities should be treated as part of the firm and which

should be treated as external?

Example:• Should firm in which holding company has an investment become part of the

group with its assets and liabilities fully disclosed?• OR should the net asset figure only be recorded?


5. Inflationary distortion

• Timing difficulties – difference in dates between:

• Purchase of inputs

• Use of inputs in production process

• Products sold

• THUS original cost may no longer be meaningful

• IF high inflation ⇒ Costs are understated

Profits are inflated

Assets are understated

• Effect of this → Return on capital is multiplied

6. Number of transactions

• Given huge numbers of transactions, valuation of inventory and debtorsis extremely difficult and at times subjective


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FinancialReportingCouncil

Management Board

AccountingStandards

Board

FinancialReportingReviewPanel

ProfessionalOversightBoard for

Accountancy

AuditingPractices

Board

AccountancyInvestigation

and DisciplineBoard

AuditInspection

Unit

Accounting Standards in the UK

Financial Reporting Council

• UK firm financial statements are ultimately governed by the FRC• The Financial Reporting Council (FRC) is a unified, independent

regulator which: 1. Sets, monitors and enforces accounting and auditing standards; 2. Oversees the regulatory activities of the professional accountancy

bodies, and regulates audit; and 3. Promotes high standards of corporate governance.

• Initially established in 1990 to promote good financial reporting through its two subsidiaries, the Accounting Standards Board (ASB) and the Financial Reporting Review Panel (FRRP).

• The membership of the Council includes wide and balanced representation at the highest levels from the business, investor, professional and other communities interested in corporate reporting and governance.

• The FRC's high reputation and excellent track record was one of the factors which led the Government to decide that changes designed to strengthen further the regulatory system following the corporate collapses in the US should be taken forward through the FRC

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Financial Reporting CouncilWhat is the FRC’s remit?

• The FRC's original remit has now been enlarged so that it takes a more active role in relation to corporate governance, it seeks a proactive role in relation to compliance with company law and accounting standards and it assumes new responsibilities in relation to audit, auditing standards and the oversight of the self-regulatory professional bodies.

• Bringing these elements together in one organisation will help to increase public and investor confidence in corporate reporting and governance, and the underpinning regulatory processes.

• In addition, the Companies Bill, currently with Parliament, will give the subsidiary bodies of the FRC new powers to exercise statutory functions in relation to accounting and auditing on behalf of the Secretary of State for Trade and Industry.

Financial Reporting Council

New structure

• The FRC now has five subsidiary boards. The three new additions are:

1. Auditing Practices Board (APB)

2. Accountancy Investigation and Discipline Board (AIDB)

3. Professional Oversight Board For Accountancy for Accountancy, which will encompass the Audit Inspection Unit (AIU).

• In addition a new Management Board will co-ordinate the key policy and resource issues that impact on the organisation as a whole and a new post of Chief Executive to the FRC has been established.

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Auditing Practices BoardAims• Aims of setting high quality standards and guidance:

1. For the performance of external audit and other activities undertaken by accountants that result in reports or other output that is published, required by law or otherwise relied upon in the operation of the financial markets ('assurance services'); and

2. In relation to the independence, objectivity and integrity of external auditors and the providers of assurance services.

Objectives• The Board intends to achieve its aims by:

• Establishing Auditing Standards which set out the basic principles and essential procedures with which external auditors in the United Kingdom and the Republic of Ireland are required to comply;

• Issuing guidance on the application of Auditing Standards in particular circumstances and industries and timely guidance on new and emerging issues;

• Establishing Standards and related guidance for accountants providing assurance services;

• Establishing Ethical Standards in relation to the independence, objectivity and integrity of external auditors and those providing assurance services;

• Taking an appropriate role in the development of statutes, regulations and accounting standards which affect the conduct of auditing and assurance services, both domestically and internationally

• Contributing to efforts to advance public understanding of the roles and responsibilities of external auditors and the providers of assurance services including the sponsorship of research.

Accounting Standards BoardAims• Aims of establishing and improving standards of financial accounting and

reporting, for the benefit of users, preparers, and auditors of financialinformation.

Objectives• The Board intends to achieve its aims by: 1. Developing principles to guide it in establishing standards and to provide a

framework within which others can exercise judgement in resolving accounting issues.

2. Issuing new accounting standards, or amending existing ones, in response to evolving business practices, new economic developments and deficiencies being identified in current practice.

3. Addressing urgent issues promptly. 4. Working with the International Accounting Standards Board (IASB), with

national standards-setters and relevant European Union (EU) institutions to encourage high quality in the IASB's standards and their adoption in the EU.

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Accounting Standards BoardOperating guidelines:• In carrying out its work the Board will

1. Be objective and ensure that the information resulting from the application of accounting standards faithfully represents the underlying commercial activity. Such information should be neutral in the sense that it is free from any form of bias intended to influence users in a particular direction and should not be designed to favour any group of users or preparers.

2. Ensure that accounting standards are clearly expressed and supported by a reasoned analysis of the issues.

3. Determine what should be incorporated in accounting standards based on research, public consultation and careful deliberation about the usefulness of the resulting information.

4. Ensure that there is consistency both from one accounting standard to another and between accounting standards and company law.

5. Issue accounting standards only when the expected benefits exceed the perceived costs. The Board recognises that reliable cost/benefit calculations are seldom possible. However, it will always assess the need for standards in terms of the significance and extent of the problem being addressed and will choose the standard which appears to be most effective in cost/benefit terms.

6. Take account of the desire of the financial community for evolutionary rather than revolutionary change in the reporting process where this is consistent with the objectives outlined above.

7. Follow best practice in its own governance and processes, deploy resources effectively and liaise with the Council's other Boards to promote and benefit from operating synergies wherever possible.

Financial Reporting Review PanelAims• Aim of playing its part with directors, auditors and other regulators in the enforcement regime.

The Panel seeks to ensure that the provision of financial information by public and large private companies complies with relevant reporting requirements, while having due regard to international best practice standards for effective regulation.

Objectives• The Panel intends to achieve its aim by:

1. Carrying out its formal responsibilities on behalf of the Secretary of State in relation to annual accounts and other documents falling within its remit.

2. Maintaining a Panel body that includes a wide and balanced representation, at the most senior level, of businesspeople, accountants, lawyers and preparers and users of accounts such that those who come before the Panel know that they are judged by their peers within the financial reporting community.

3. Developing and operating a selective programme of proactive review of annual accounts and other documents falling within its remit and which is based primarily on risk assessment.

4. Enquiring appropriately into specific sets of published financial statements and other documents falling within its remit which come to its attention, whether through proactive review, through complaints, or otherwise.

5. Ensuring that any published findings of the Panel concerning any case considered by it are brought to the attention of relevant regulatory bodies so that they can determine whether disciplinary or other sanctions should be applied, and to co-operate with and provide information to such regulatory bodies so far as permissible.

6. Liaising with FSA and other enforcement agencies in the UK and internationally to foster consistent application of accounting requirements and generally to improve the compliance of financial information with relevant reporting requirements.

7. Contributing to and seeking to sustain an EU approach to enforcement that, recognising the effectiveness of the UK arrangement, is vigorous, consistent and cost-effective.

8. Seeking an appropriate level of knowledge, understanding and public recognition within the financial reporting community to maximise the Panel's deterrent effect.

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Accountancy Investigation and Discipline BoardAims

1. Safeguarding the public interest by maintaining and enhancing the standards of conduct of members and member firms of the accountancy profession, as represented by the participating members of the Consultative Committee of Accountancy Bodies (the Participants);

2. Providing a demonstrably fair, independent and expert system forinvestigating and, where appropriate, hearing significant public interest disciplinary cases;

3. Proceeding expeditiously with a view to sanctions being imposed on those found guilty of misconduct, including removal of their eligibility to audit;

4. Seeking to deter future acts of misconduct through its work.

Objectives1. Operating an independent investigation and discipline Scheme

• For the investigation of cases, involving members and/or member firms of the Participants, which raise or appear to raise serious issues affecting the public interest in the United Kingdom;

• For bringing appropriate disciplinary proceedings against those whose conduct appears to fall short of the standard reasonably to be expected of a member or member firm and, where appropriate, to impose penalties.

2. Keeping under review the working of the Scheme and the supporting Regulations to ensure that they are operating effectively.

3. Regular, high profile publicity for the Board's activities and achievements.

Professional Oversight Board For Accountancy

Aims & Objectives

• To provide:

• Independent oversight of the regulation of the auditing profession by the recognised supervisory and qualifying bodies

• Monitoring of the quality of the auditing function in relation to economically significant entities

• Independent oversight of the regulation of the accountancy professionby the professional accountancy bodies.

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What are Accounting Standards?What are accounting standards?• Accounting standards are authoritative statements of how particular types

of transaction and other events should be reflected in financial statements. Accordingly, compliance with accounting standards will normally be necessary for financial statements to give a true and fair view.

• Accounting standards issued by the Accounting Standards Board are designated “Financial Reporting Standards” (or FRSs). Those issued by its predecessor bodies, and adopted by the Board when it was created in 1990, are designated "Statements of Standard Accounting Practice" (or SSAPs).

Are Accounting Standards Mandatory?

Are accounting standards mandatory?

• Companies legislation does not directly require compliance with accounting standards. However, the Companies Act 1985 requires accounts (other than those prepared by small or medium-sized companies) to state whether they have been prepared in accordance with applicable accounting standards and to give particulars of any material departure from those standards and the reasons for it.

• Directors of companies are required by the Act to prepare accounts that give a true and fair view of the state of affairs of the company and of its financial position at the end of the financial year. The accountancy profession (as represented in the Consultative Committee of Accountancy Bodies) is committed to promoting and supporting compliance with accounting standards by its members, whether as preparers or auditors of financial information.

• Under the Companies Act, both the Financial Reporting Review Panel and the Department of Trade and Industry have procedures for receiving and investigating complaints regarding the annual accounts of companies in respect of apparent departures from the accounting requirements of the Act, including the requirement to give a true and fair view.

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Accounting Standards and Creative Accounting

It is sometimes suggested that accounting standards are not necessary, because the market can decide what accounting principles to demand. What are the views of the ASB on this?

• Most of the accounting scams of the 1980s, such as off balance sheet finance, window dressing, the presentation of debt as equity and the abuse of reorganisation provisions, were practised in areas of accounting that were not the subject of accounting standards.

• Experience shows therefore that, in the absence of regulation, financial reporting may not give the information that users need to make informed assessments of companies.

• Accounting standards aim to promote comparability, consistency and transparency, in the interests of users of financial statements.

• Good financial reporting not only promotes healthy markets, it also helps to reduce the cost of capital because investors can have faith in companies' reports.

Taken from ASB website

What has the ASB done about "creative accounting"?

• "Creative accounting" is primarily a journalistic term; it has no official standing and no agreed definition.

• The ASB's task is to improve the quality of financial statements, a task that obviously took as its starting point the standards of financial reporting that existed when the Board was established in 1990. In its Statement of Aims (1991), the ASB adopted certain guidelines for conducting its affairs. The first was:

"To be objective and to ensure that the information resulting from the application of accounting standards faithfully represents the underlying commercial activity. Such information should be neutral in the sense that it is free from any form of bias intended to influence users in a particular direction and should not be designed to favour any group of users or preparers."

• If, for convenience, it is assumed that 'creative' accounting is the opposite of what the ASB favours - i.e. accounting that does not faithfully represent the underlying commercial activity and is not neutral-then it would be correct to say that the ASB aims to eliminate 'creative' accounting.


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In developing accounting standards, the ASB set itself five principal objectives:

1. Exclude from the balance sheet-the statement of assets and liabilities-items that are neither assets nor liabilities;

2. Make 'off balance sheet' assets and liabilities more visible by putting them on the balance sheet whenever practicable;

3. Ensure that all gains and losses are reported prominently so that nothing can be overlooked;

4. Reverse the 'bottom line' mentality by focusing performance reporting on the components of income;

5. Use up-to-date measures, when appropriate, if other measures such as historical costs are ineffective.


Mission Statement

• The International Accounting Standards Board is an independent, privately-funded accounting standard-setter based in London, UK.

• The Board members come from nine countries and have a variety of functional backgrounds.

• The IASB is committed to developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial statements.

• In addition, the IASB co-operates with national accounting standard-setters to achieve convergence in accounting standards around the world.

International Accounting Standards Board

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The world importance of the IASB

• The IASB, based in London, began operations in 2001. The 14 IASB members have a variety of professional backgrounds throughout the world.

• At present, some 35 countries require the use of international standards for all domestic listed companies, six other countries require the use of international standards for some companies, and many countries base their national practices on international standards.

• In 2002, several jurisdictions, including Australia, the European Union, and Russia, announced that they would require the application of international standards on or before 1 January 2005 for some or all domestic issuers of securities.



Structure

The structure achieves its purpose by a balance of the functions of the various parts of the organisation, through the operational relationship shown in the diagram. The composition of the oversight body (the Trustees of the International Accounting Standards Committee Foundation), the advisory body (the Standards Advisory Council) and the interpretative body (the International Financial Reporting Interpretations Committee) represents the wider community by reflecting a diversity of geographical or professional backgrounds and membership of the standard-setting body (the International Accounting Standards Board) is based on the principles of technical competence and independence.

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The collapse of energy giant Enron is the largest bankruptcy and one of the most shocking failures in United States corporate history.

In just a little over 15 years, Enron grew into one of the US’s largest companies. It embraced new technologies, established new methods of trading in energy and seemed to be a shining example of successful corporate America.

But the company’s success was based on artificially inflated profits, dubious accounting practices, and fraud.

The Enron Story

The Enron Story

1985: Founding years

Enron's dramatic expansion and rise to international prominence

• Enron was born in July 1985 when Houston Natural Gas merged with Omaha-based InterNorth. Kenneth Lay, an energy economist who had held academic and government positions throughout his career, became chairman and chief executive.

• His ambitions for the new company he had helped form went beyond the business of piping gas.

• He wanted to see an energy trading revolution and place Enron at the heart of it.

• By 2001 he appeared to be succeeding in his goal, having created a multinational corporation employing thousands with a turnover of billions of dollars.

• But suddenly, as if from nowhere, the company unravelled and collapsed. How could a company worth billions come crashing down, destroying the livelihoods of thousands?

1980s: Energy deregulation

How the power business became big business

• In the 1980s, energy corporations lobbied Washington to deregulate the business. Companies including Enron said the extra competition would benefit both companies and consumers. Washington began to lift controls on who could produce energy and how it was sold.

• New suppliers came to the market and competition increased. But the price of energy became more volatile in the free market.

• Enron saw its chance to make money out of these fluctuations. It decided to act as middle man and guarantee stable prices - taking its own cut along the way.

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1980s: Trading futures:

How Enron took a bet on energy

Kenneth Lay had been anxious to expand the business right from the word go. Jeff Skilling, an ambitious thinker from the world famous consultancy firm McKinsey, offered a way to do it.

Skilling believed that Enron could profit from trading futures in gas contracts between suppliers and consumers - effectively betting against future movements in the price of gas-generated energy.

Buyers and sellers use futures markets to get what they hope will be a better deal on commodity prices than they would do on the open market.

Enron offered to do the same with gas by buying and selling tomorrow's gas at a fixed price today.

In the deregulated energy world, it appeared to make sense to many suppliers and industry consumers who took up the offer. The new Enron was emerging.

The Enron Story

The Enron Story

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1990s: Market making

Creating a commodities business on Energy Alley

In a few short years, Enron became a massive player in the US energy market, controlling at its height a quarter of all gas business. Buoyed by the success, the company went on to create markets in myriad energy-related products.

Enron began to offer companies the chance to hedge against the risk of adverse price movements in a range of commodities including steel and coal. By the end of the decade it had expanded its trading arm to include hedging against external factors such as weather risk.

Enron was not the only company in the game but through its Enrononline trading arm it was becoming the biggest on what was dubbed Energy Alley - 90% of its income came from trades.

Jeff Skilling wanted to rid Enron of its last physical assets but the company was also expanding internationally, moving into water in the UK and power generation in India.

The Enron Story

The Enron Story

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1989 - 2001: Enron and Washington

Lobbying and donations on Capitol Hill

One question that was already being asked before Enron crashed was this: how much influence did it have on Capitol Hill? Enron certainly wasn't the only company lobbying for energy deregulation, but deregulation helped Enron establish the trading markets that became its core business.

Directors built relationships with both Democrats and Republicans. Kenneth Lay himself had strong personal ties to two Republican presidents, George Bush Snr and his son George W Bush.

As Enron expanded, there was little scrutiny of how it was managing the expansion. But when it began to unravel, the questions began to pour in.

The Enron Story

Early 2000: Dot.com boom

Enron invests in the dot.com boom but are its profits all they seem?

Enron began 2000 with a plan to move into broadband internet networks and trade bandwidth capacity as the dot.com economy prospered. Enron's dynamic ideas, coupled with its stable old-economy energy background, appealed to investors and the share price soared.

It was one of the first amongst energy companies to begin trading through the internet, offering a free service that attracted a vast amount of custom.

But while Enron boasted about the value of products that it bought and sold online – a mind-boggling $880bn (£618bn) in just two years – the company remained silent about whether these trading operations were actually making any money.

At about this time, it is believed that Enron began to use sophisticated accounting techniques to keep its share price high, raise investment against it own assets and stock and maintain the impression of a highly successful company.

Enron could also legally remove losses from its books if it passed these “assets” to an independent partnership.

Equally, investment money flowing into Enron from new partnerships ended up on the books as profits, even though it was linked to specific ventures that were not yet up and running.

One of these partnership deals was to distribute Blockbuster videos by broadband connections. The plan fell through, but Enron had already posted some $110m venture capital cash as profit.

The Enron Story

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Late 2000: Trouble brewingEnron continues to expand but problems loom

By the summer, Enron's shares had hit an all time high of more than $90. But there was also controversy. California was suffering an energy crisis, blamed by many on its poor handling of deregulation.

Some claimed Enron had profiteered by buying futures in electricity supplies and passing them on at higher costs. Enron dismissed the allegation saying it was merely the market-maker.

Enron's 2000 annual report reported global revenues of $100bn. Income had risen by 40% in three years.

In reality, real revenue would have been far lower had it not been for the special partnerships established by chief finance officer Andrew Fastow.

Enron's growth was increasingly dependent on these accounting tools. Enron made investments and then shifted the debt off its books to theoretically independent partnerships, in return for potential income that provided a buffer against future losses. Meanwhile, Enron kept up it political donations. Chief among the individual donors was Kenneth Lay himself.

The Enron Story

Early 2001: Stock heading south

Enron remains bullish but stock begins to slide

Enron and Kenneth Lay each donated $100,000 to incoming President Bush's inaugural committee fund, early in 2001. The incoming president invited Mr Lay to become and advisor to his transition team. A prime concern for Enron was the new president's planned energy policy review, headed by Vice-President Dick Cheney.

Mr Lay and other Enron directors met Mr Cheney and others three times in the first half of the year, the last meeting a month before he published his conclusions on 17 May 2001.

The review, as predicted, was favourable to the energy industry. It advocated more power stations, more exploration and a national grid. While it did not meet all of Enron's wishes, it nevertheless was good news.

The Enron Story

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August 2001: Crisis revealed

Jeff Skilling quits and an insider gets suspicious

On 14 August 2001, seemingly from nowhere, Jeff Skilling resigned as chief executive, citing personal reasons. Kenneth Lay became chief executive once again. The developmentwas a shock to investors who suddenly began to fear that all was not well in Houston.

Investors sold millions of shares, knocking some $4 off the price by the end of the week. As the price dropped below $40, Mr Lay insisted that there were "no issues".

But there was a very large issue - perhaps one that the board was not fully aware of.

In May of that year, Enron executive Clifford Baxter left the company, apparently in uncontroversial circumstances.

But there were rumours among executives that Mr Baxter - soon to become a tragic figure in the affair when he took his own life - had clashed with Jeff Skilling over the propriety of some of the partnership transactions.

When Mr Skilling resigned, one executive who knew of Mr Baxter's concerns decided to act, and warned Mr Lay that Enron was on the verge of "imploding".

The Enron Story

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October 2001: Enron crashes

Stock market panic as a giant falls

12 October:

Meanwhile, the depth of Enron’s problems were beginning to dawn on Andersen. Because Enron had hedged against its own stock, it could never recover its losses while its share price was falling.

Andersen told Enron that it had no other choice but to change the way it was accounting for its special partnerships.

On 12 October, an Andersen lawyer contacted a senior partner in Houston to remind him that company policy was not to retain documents that were no longer needed.

At some point after this, staff in Andersen’s Houston office began shredding documents relating to Enron.

Around the same time, Enron's internal legal examination of Sherron Watkin's concerns concluded that the partnerships in question, Raptor and Condor, had been approved by Andersen.

The Enron Story

November 2001: The final days

Enron struggles to stay afloat and scrambles for a merger

1 - 9 November:Despite the air of impending doom, Kenneth Lay found two banks willing to extend credit. But the worst of revelations was to come. On 8 November, the company took the highly unusual move of restating its profits for the past four years. It effectively admitted that it had inflated its profits by concealing debts in the complicated partnership arrangements.

The following day, the humiliation of Enron appeared complete as it entered negotiations to be taken over by its much smaller rival, Dynegy.

December 2001: Bankrupt

Kenneth Lay's empire falls, leaving investors and employees stranded

2 Dec:No longer able to cope with its debt, Enron filed for bankruptcy protection in a New York court on 2 December 2001, simultaneously launching a legal action against Dynegy for pulling out of the merger. In three months Enron had gone from being a company claiming assets worth almost £62bn to bankruptcy. Its share price collapsed from about $95 to below $1.

"Uncertainty has severely impacted the market's confidence in Enron and its trading operations," Kenneth Lay commented as he saw his company implode.

"We are taking the steps announced today to help preserve capital, stabilise our business and enhance our confidence to pay our creditors."

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The Enron Story

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January 2002: Investigation

America demands answers as a former executive takes his own life

9 - 10 Jan:

While America reeled from the bankruptcy and Enron employees, past and present, worked out what they had left, the Justice Dept announced a criminal investigation. Attorney General John Ashcroft, who had received campaign funds from the company in 2000, excluded himself from the investigation along with the 100 federal investigators in Houston.

The following day, Andersen, its role increasingly in the spotlight, admitted that employees had disposed of Enron documents.

The White House also confirmed speculation that Kenneth Lay had appealed to members of the administration for help.

The Enron Story

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February 2002: Hearings

The Enron affair takes centre stage on Capitol Hill

The shockwaves of a corporate crash are always keenly felt - but few failures have led to the kind of investigations Enron and its managers now face. February opened with the publication of the company's own internal investigation into the crash.

William Powers, the academic who chaired the report, didn't pull any punches when he pinned the blame firmly on executives who had personally benefited from the partnerships to the tune of millions of dollars.

"There was a fundamental default of leadership and management," he said.

"We found a systematic and pervasive attempt by Enron's management to misrepresent the company's financial condition."

Congress continued hearings began in December as America and investors around the world demanded answers.

Four of Enron's most senior executives pleaded Fifth Amendment protection against self-incrimination and refused to testify: Andrew Fastow, chief risk officer Richard Buy, finance executive Michael Kopper and Kenneth Lay himself.

Jeff Skilling did testify but insisted that he knew nothing of the complex web of intra-company deals that are almost impossible for ordinary investors to unravel.

On Valentine's Day, the woman who originally raised fears of an "implosion", took the stand.

Sherron Watkins said that Ken Lay and the board had been "duped" by Mr Fastow and Mr Skilling. Mr Lay had never really understood the gravity of the situation, she said.

The Enron Story

February 2002: HearingsThe Enron affair takes centre stage on Capitol Hill

The Enron Story

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