Enron Summary

Issam Chleuh Accounting 322 – Intermediate Accounting II Professor William Driscoll, Accounting Department – Suffolk University

Enron, a paper on the company’s fraud scheme In the following lines, I will discuss the Enron scandal. I will start by an introduction on “cooking the books” in order to give us an idea of why drove Enron and many other companies into fraudulent activities. I will then talk about Enron, I will start with an introduction of the company, I will then follow with a discussion of the fraudulent activities the company where involved in and I will finally present how the company got caught.

To begin with, what does “cooking the books” mean? Well, companies cook the books when they do not tell us their real earnings. Managers cook the books and present us fake earnings to improve their earnings per share (EPS) of stocks. But why do companies cook the books? Companies cook the books because they have the pressure to deliver good earnings in order to attract investors to invest in them

and most importantly to keep current investors happy. Let us note that public companies’ projects are mainly financed by public investors. Executive bonuses are also tied to the company’s earnings and managers are tempted to manipulate company’s earnings to receive these big checks (big earnings). Furthermore, let us discuss the history of Enron. Northern Natural Gas Company – the ancestor of Enron – was established in 1930. In 1979, InterNorth Inc bought Northern Natural Gas Company and placed it under a new management. In the 1980s, the United States Congress passed legislation deregulating the sale of natural gas. At the beginning of the 1990s, Congress passed a similar legislation targeted at the sale of electricity. These steps launched a new era in the energy market, allowing companies like Enron to prosper. In 1985, Kenneth Lay, CEO of Houston Natural Gas devised a new company and changed InterNorth’s name to Enron Corporation. This newly formed company was at first involved in distributing gas and electricity in the US and in selling power plants and pipelines worldwide. However, the company started to deviate into many non-energy-related fields – i.e. non-core businesses, such as weather derivatives – weather insurances for seasonal business, risk management, and internet bandwidth. Even though Enron’s core business remained gas and electricity, most of the company growth came from those non-core businesses. How fraud happens at Enron? This is going to be the topic of this paragraph. Let us start by saying that the Enron fraud case was extremely complex. People say that the roots for the Enron scandal date back to the beginning of the 1990s. In fact, in 1992, Jeff Skilling, who was the president of Enron’s trading operations, convinced federal regulators to allow Enron to use mark to market accounting. Mark to market accounting is “a measure of fair value of accounts that can change over time, such

as assets and liabilities. Mark to market aims to provide a realistic appraisal of the institution or company’s current financial situation” (source: investopedia). When market-based measurement - mark to market accounting in our case - does not accurately reflect the underlying asset’s true value, problems can arise. This is what is happening in the economy with fair value FAS 157. With FAS 157, companies like private equities for instance are forced to calculate the selling price of their assets or liabilities during this unfavorable volatile time. Investors are fearful and thus liquidity is low and makes the selling price of the asset or liability very low, which brings the value of the asset or liability to an all time low level. Conversely, companies can use mark to market accounting unethically, which is what Enron did. Enron used mark-to-market accounting for its energy segment in the 1990s and used it excessively for its trading transactions. Under this accounting rule, when companies have outstanding contracts, energy-related or derivatives ones, on their balance sheets at the end of a quarter, they must appraise them using fair value and record unrealized gains and losses to the quarterly income statement. The subtlety is that there are no quoted prices upon which to base valuations for longterm future contracts in commodities such as gas. Companies with these types of derivatives are free to value those assets or liabilities using their own models and based on their own assumptions and methods. Using mark-to-market accounting allowed Enron to count projected earnings from long-term energy contracts as current income. Those contracts represented money that might not be collected for many years. Investigators found that this accounting method was used to overestimate revenue by manipulation of future revenue. For instance, unrealized gains accounted for a little more than of Enron’s $1.1 billion reported pretax profit for 2000. The use of this accounting measure, as well as the use of other

questionable measures, made it difficult for the public to see the business model of Enron. In fact, the numbers were recorded on the books but the company was not paying equivalent taxes (unrealized gains). Moreover, we know that Enron has been buying a big number of ventures that looked promising. We know that Enron has also been creating off balance sheet entities in order to remove the risk of their financial statements. However, how did the company implement these operations? Because of the use of mark-to-market accounting explained above, Enron recorded all-time high revenues. The company thus wanted to be involved in other areas. For instance, Enron was buying or developing an asset – such as a pipeline – and then was expanding through a vertical integration (buying a retail business around that pipeline for instance). This strategy required huge amounts of initial investments and was not going to generate earning or cash flow in the short term. If Enron elected to present this strategy on its financial statements, it would have placed a big burden on the company’s ratios and credit ratings, and credit ratings investment grade was crucial for Enron energy trading business. In order to find a solution to this issue, Enron decided to look for outside investors who would like to make those deals with them. Those combined investments required Enron to present a guaranty or another form of credit proof. Because of that, Enron decided to organize these investments as Special Purpose Entities (SPE). Also, since Enron’s executives believed Enron’s longterm stock would remain high, they looked for ways to use the company’s stock to hedge its investments in these SPEs. Enron did this through a complex arrangement of special purpose entities the company called the Raptors. The Raptors were created to cover those SPEs losses if their stocks were falling. When the telecom industry experienced its first decline, Enron experienced poor financial

performance as well. In fact, when Enron stocks fell below a certain level, it caused the Raptors’ stock to collapse. This is mainly due to the fact that the Raptors’ stocks were back up by Enron’s stock (through the hedging described above). The telecom industry downturn was thus the underlying event that uncovers the fraud scheme at Enron.

Issam Chleuh