The global socio-economic landscape is a fraught with different episodes of fraudulent activities from Europe to Asia to the United State of America. The biggest systems affected by this episode are technology, which is most commonly used to undermine financial systems.
Technology has been used to dramatically exploit systems and it appears that there is strong correlation between the surge of fraudulent activities and the advancement of technology.
A case in point is the recent financial meltdown which metamorphosed into the ongoing global recession. Simple mortgage loans were manipulated and re-modified into complex trading instruments (technology driven) which attracted attention and investment from all over the world using technology and eventually lead to a systemic collapse - that Engulfed the whole world.
The impact of this kind of fraudulent events is there for all to see. Economic systems collapse, leading to loss of jobs, weakening of institutions and ultimately pauperizing the common man. This paper examines one of such epoch making events, the collapse of Enron Corporation. Enron shall remain a watershed in the annals of corporate history and will for a long time be remembered as one major event that really turn the search light on the subject matter of financial statement fraud as well as questioned the fundamentals of the accounting profession and standards.
It is quite an interesting fact that as large and as important as Enron was, its activities were designed to defraud the society at such a grand scale eventually crashing so badly basically due to avoidable acts of fraud and dishonesty.
As at the time of liquidation in the year 2001, Enron had over 21,000 employees. Its bane however was largely due to misrepresentative and fraudulent acts of accounting practices. These manipulative tendencies were so well orchestrated that it earned Enron so much accolades and even gaining so much currency as a giant in America and a force in the global business earned scope. For example, it was rated among the top ten companies in the US with leadership in communications and power. Manu Sharma (2008) in their article titled 'The Ten Financial Frauds that Shoot the World Captured the Enron debacle succinctly
Cite
"As a result of the massive fraud at Enron, shareholders lost tens of billions of dollars. Many Enron's executives, Enron's accounting firm and certain bank officials were indicted. Andrew Fastow, Enron's former finance chief, testified that many of the banks transactions were contrived, deceptive deals done solely to create the false appearance of profits and cash flow.
Kenneth Lay, the founder of Enron whose spectacular implosion in 2001 lead to one of the biggest fraud cases in history, was convicted of fraud for duping investors over the health of Enron's finances before it plummeted into bankruptcy. Prosecutors accused Lay of pocketing over 2180 million of investors' money, and Lay was charged with counts of securities fraud".
Fraud
In recent years, fraud is gaining so much global attention and according to the institute of Internal auditors in the most comprehensive global study ever conducted on the internal audit professionthe group concluded that internal auditing is becoming more standardized throughout the world.
While internal audit is at various stages of maturity in diverse cultures, it is predicted to expand its role in organizational governance and risk management. (QUOTE SOURCE)
AAAB (2009) Assert that Fraud is a generic term, which includes unthinkable possibilities which human ingenuity can design in the determination to take undue advantage of another person using false representation.
Accordingly, it is difficult to stipulate a mechanistic definition of fraudas it includes surprise, trickery, cunning and unfair ways by which another is cheated.
Types of Fraud
As its definition fraud can also have myriad of classifications, but generally it is easy to think about it broadly from two perspectives, the victim on the one hand and the perpetrator(s) on the other and the motive behind the fraudulent actions.
The victim can be an individual or an organization while from the perspective of the perpetrator(s) the motive is the determinant of the classification.
AAAB (2009) have distinguished between employee fraud and financial statement fraud if the motive is to make the company's financials very attractive so that executives of a company can benefit. Furthermore, as reported in AAB (2009) page- The Association of Certified Fraud Examiners (ACFE) defines this type of fraud as,
"The use of one's occupation for personnel enrichment through the deliberate misuse or misapplication of the employing organization's resources or assets. Occupational fraud results from the misconduct of employees, managers, or executives. Occupational fraud can be anything from lunch break abuses to high-tech schemes. The Report to the Nation on Occupational Fraud & Abuse by the Association of Certified Fraud Examiners states that, "The key to occupational fraud is that the activity (1)is clandestine, (2) violates the employee's fiduciary duties to the organization, (3) is committed for the purpose of direct or indirect financial benefit to the employee, and (4) costs the employing organization" assets, revenues, or reserves.'
The ACFE classification provides a broad insight into the complicated intricacies of fraud and the fact that it is a branch of knowledge that should be studied carefully as it could be a multifaceted discipline requiring knowledge of accounting, human psychology, economics, and organizational behavior.
Another perspective of classification is from a victim's perspective,where a company or organization is the victim. Employee embezzlement which refers to fraud committed by a company or an organization employee.Vendor fraud, which is fraud committed by a vendor of the company or an organization, Customer fraud refers to fraud committed by a customer of the company or an organization, Management fraud occurs where the victims are shareholders and debt-holders of an organization or a company. AAB (2009)
Brief History of the Enron Collapse
Enron Corporation was a major player in energy and communications sector in the United States of America. Based in Houston, Texas it had about 21,000 people in its employment as at mid-2001. It was established in 1985 with the merger of Houston Natural Gas and Inter-North engineered by Houston Natural Gas CEO Kenneth Lay. Enron was originally involved in the transmission and distribution of electricity and gas in the United States (ENTER SOURCE). It was at some point considered the most viable candidate to help Nigeria Africa's most populous nation out of its electricity quagmire but this also turned out to be one of the biggest scandals in Nigeria's quest to develop its power sector. This was reported in forbes.com.
"The issue for the jury is whether the 1999 sale of an interest in Nigerian energy barges by an Enron was a sham that allowed Enron to illegally book about $12 million in pretax profit, when in fact there was no real sale and no real profit. The idea, announced in 1999, was that Enron would build gas-fired power plants near Lagos. Estimated costs put the project at about $500 million. Before the main plant was built, Enron would start supplying power from three 30-megawatt barge-mounted plants burning either oil or gas, according to a 1999 article in Global Power Report, citing an Enron spokesman.
Easily, Enron was recognized as the seventh largest company in corporate America. A highly innovative enterprise, it was a leader in the structuring and marketing of derivative securities related to the energy and communications power and weather securities. This feat was however achieved based on fake fundamentals and a deliberately structured fraudulent accounting practice that eventually led it to become the biggest corporate failure in the history of corporate America.At the heart of this process was its accounting firm Arthur Andersen which doctored Enron to rise through a process of manipulated accounting procedures. The biggest losers from the process were its shareholders who suffered a capital loss from during 2001 from US$85 to 30 US cents. These were clear indicators that this institution had for a long time been hiding a lot of facts. Its financial statements were clearly misrepresented over the years. -(Internet Source)
Scope
This paper aims to once again shed some light on this epoch marking event in America's corporate history. Using some analytical tools to revisit the case and to draw significant learning points that should help present and future investors take a deeper look into the activities going on in their companies. Fraud has taken such a global scale, it has become more than necessary to devise means and ways of x-raying the activities of managers and corporate governance issues.
Accordingly, that financials of Enron corporation will be re-visited from 1997-2001 when it became moribund.
What were the significant red-flags, how did these corporate boys Kenneth Lay et. al take the entire corporate America through such a fantasy ride that eventually almost lead to a systemic collapse and almost discredit the noble profession of accounting. Could the events have been avoided?
The arguments shall be first from a qualitative perspective looking closer at the case context. The second dimension will be to apply the Altman's discriminate analysis model and the Beneish model on the financials of Enron (1997 - 2001) with a view to assess its corporate health within the period and the extent to which its financial were manipulated.
Contextual Analysis
Brief survey of Enron's many subsidiaries
Subsidiaries are organizations or corporations that focus on some exclusive aspect of the parent company. The Subsidiaries of Enron are viewed as special purpose entities, limited partnerships or companies created to achieve a temporary or specific purpose, to fund or manage risk associated with specific assets. Enron established the following subsidiaries:
Joint Energy Development Investments.(JEDI). This is one of the special purpose entity founded in 1993, as a joint venture in Energy Investments with CALPERS, the California State Pension Fund. This Joint venture realized lots of losses but was kept off Enron's Balance Sheet.
Chewco Investment L.P: was formed by the Chief Financial Officer (CFO) Andrew Fastow in order to finance CALPERS stake in JEDI.
Enron was essentially not interested in acquiring CALPERS because of its enormous debt which he did not want to capture in its Balance Sheet, as such came the birth of Chewco investment, with these concept. Enron was able and confident enough not to reflect the debt in its Balance Sheet, thereby depicting a buoyant financial status.
These Accounting practice was revealed prior to the collapsed which made its revenue to reduce by $405 million(from 1997-mid 2001), and the debt increased by $628 million.
Whitewing: Whitewing Dove subsidiary was formed to finance the purchase of vehicles by Enron used for domestic and external purposes with the funding of $579 million provided by Enron and $500 million by an outsider investor called Whitewing Associate L.P.
TheIrony of transaction between Whitewing and Enron should look suspicious to an astute analyst when white wing purchases assets from Enron using Enron's stock as collateral which should instead be a loan to Whitewing.
The analyses connotes that white wing became an entity on its own two years after its establishment and should have provided its own collateral to purchasing their assets from Enron worth $2 billion.
L J M and Raptor: These were run by Andrew Fastows, one of the key perpetrators of Enron's fraud. Being the Chief Financial Officer, he had to seek for an exemption clause in order to execute these concepts. L J M Cayman served a purpose of buying the stock which was not performing in order to improve its financial status. The sum of $1.2 billion was used to purchased shares and $150 million of notes payable. This is an investment fund used in hedging against risk in any decline in stock prices.
TheAuditor Arthur Anderson was aware of this but turned a deaf ear and blind eye- composure due to selfish reasons and endangering the core concept of its shareholders equity. (source for this page)
Capital Market Indicators
Enron needed support from the securities analyst in order to raise funds from the financial markets. Any recommendation is widely circulated to investors to "buy", "sell' or hold their shares. On November 2001, after its stock price fell to 99% from its high, only two of the major analyst rated its stock as a "sell". The market rated its stock price based on results placed on its board. The Securities and Exchange Commission was suspicious of Enron's trade deals. This was depicted in the conference call Lay participated in October 23 where David Leischer, the analyst at Goldman told Lay "there is an appearance that you are hiding something". The Securities and Exchange announced that it will investigate into the dubious transactions of Enron.
Some analyst predicted the explanations to Enron's transaction would be made difficult when Lay removed Fastow from his position in October 25. Though they still went ahead to recommend the stock as viable believing that accountants and auditors would not allow any dubious act. Enron stock was traded at $16.41 after losing its value in over a week. Enron's credit rating was lowered below investment -grade standard and poor(S&P) that it would have rated it to BB if not for the intending buyout by Dynergy. This was later not possible as things kept fluctuating for Enron. (QUOTE SOURCE)
Business Activities
Enron is an organization with diverse business activities, electricity and natural gas. It traded in other product and service ranging from petro-chemical, pulp and paper, derivative trading such as futures trader including sugar and coffee, Broad band services, energy and commodity services, risk management, commercial and industrial service to name but a few.
Looking at the various business unit activities of Enron, it could be an organization channeled with pursuing different aims or goals at different time which would not achieve efficiency, thus indicating that some segments would record or show a poor performance in its activities. It is this scenario that lead to the establishment of various subsidiaries in - other to carter for its losses.
Market Perception
Enron was named by fortune magazine as the "Most Innovative Company" for six-years. It continued to grow in its reported earnings. Up to 2001 Enron was able to manipulate its earnings and gain favorable ratings from rating agencies.As early as the 1st quarter in 2001, eyebrows were raised as to Enron's ability to maintain high stock value which traded at 55ce its revenue. This whistle blower action created a decline in investors' confidence.The earnings growth of Enron always triple similar industries despite the downturn in the financial market and the 9/11 incidence.The investors confidential status also decline when their stock prices was falling. The market saw the company as being intricate and very dubious in deciphering their financial statement.One analyst stated "it's really hard for analysts to determine where Enron was making money in a quarter and when they are losing money."The CEO accepted that their business was very complex, but accepted the fact that analysts would "never get all information they want" to satisfy their curiosity. Despite this, a hedge fund manager noted that Enron stock was traded under a shadow of its real value. (INTERNET SOURCE)
The discrete nature of Enron accounting practice made Wall Street unable to perform a proper assessment of Enron. Analyst were skeptical of the worth of some of 'Enron's asset as reported in October 16, when Enron's planned to restructure its losses from 1997 to 1998, this was claimed as a result of a claim by Lay that its broadband unit was worth $35billion. As at October 2000, Enron's management had lost its creditability and it was in the effort to regain such and assure investors that all is well, things started falling apart with the resignation of Jeffery Skilling as the Chief Operating Officers. (QUOTE SOURCE)
Red Flags
Share Price
Enron's share price dropped from $90 to pennies prior to its final collapse. It was $70 in August 23, 2000 and dropped to $0.12 in January, 2002.
Why so many subsidiaries?
Enron created these subsidiaries in order to shift debt and losses from business activities from their balance sheet to these entities. These entities financial statement were not consolidated to reflect the true position of the parent company, other transactions between Enron and other related companies that turnout as a loss were used to shift unprofitable entities off the balance sheet. These subsidiaries were also used as a hedge fund. They refused to disclose details of the use of these subsidiaries.
Integrity of the board and management
The Management Board lack the experience of questioning any idea brought in by the managers. They resulted in skyrocketing of innovations to meet the compensation bonus the company was dishing out to employees.
Jeffrey Skilling(1996-2001): cannot be forgotten on the major role he played in the scandal. He concentrated on revenue recognition. He pushed the company's strategy in investment by proposing that, the company didn't really need any "assets". He introduced the mark-to market accounting model where profit were recognized before being materializes. This was in the effort to meet favorable ranking from Wall Street. Skilling was also shown to be insulted in public statement when Grubman complained of Enron's inability to publish financial statement along with its earnings and CEO replied in an abusive language "well, thank you very much, we appreciate that, asshole". This later became an in-house joke among the employees.
The Chief Financial Officer, Andrew Fastow:initiated the special purpose entities, he manipulated the deals to enrich himself, family and friends with hundreds of millions in guaranteed revenue. He created the complex accounting models that can only be understood by a few professionals.
Kenneth Lay: Known for assuring investors that all is well, thus coercing investors to buy more of the shares. He well knew that all was not well, but kept deceiving and misplacing the trust they repose in him. He sold over $70m stock at the time when the company was gradually falling, employees where selling off their shares because of the inside knowledge of the impending doom.
Arthur Andersen: The audit firm that failed to question the financial practices of the corporation. They were also found to have destroyed documents and e-mails in connection to the reports of the corporation.
Red flags
Corporate Governance
Enron corporations detailed from the ethnics it established. Shareholders are supposed to elect board members but management of Enron elected the board members. The culture also waived its rule by granting Fastow exemption rule to create special purpose entities to do business with the organization.The issue also revolves around board's inability to question the practices used by the organization. The policy of compensation (stock options) also created a dysfunctional culture. The managements were not cost-centered, spending extravagantly. They had large expense accounts (all employees). The executive were paid more than what is obtainable in competitors. It was reported that the top 200 highest paid employees earned $193m from salaries, bonuses and stock annually.Audited committee members were not stringent on the selection of auditor neither in reviewing the activities of the auditors.
Share Price Trends
It was considered a blue-chip company. As such its stock where highly priced. These stock prices were always an indication of its position from the earnings. Enron tried to lobby in order to sell its products at market prices. Its stock was priced at $80 - 90 in late 1990s, from 1990s to late 1998 rose by 311%, which was far above the S&P 500 index. It further increased by 56% in 1999 and 87% in 2000. Compared to 20% increase and 105 decreases in the index by December 2000, its stock price was priced at $83.13.
Table of share price
Year
Jan 2001
July 2001
November 2001
Price.
$40 - $70
$65 - $45
$0.0
March 1999
Dec. 1999
Nov. 2000
Price.
$30 - $40
$35 - $60
$60 - $80
Enron Failed the Beneish Test
The Beneish model constructed from financial statement variables measures the extent to which the financial could have been manipulated. A table of the Beniesh manipulation mean is reported below.
Measure
Manipulation Mean
Non Manipulation Mean
Difference
% Difference
Days sales in receivables Index
1.46
1.03
0.43
42
Gross margin Index
1.19
1.01
0.18
16
Asset Quality Index
1.25
1.04
0.21
21
Sales Growth Index
1.61
1.13
0.48
42
Total Accruals to Total Assets
0.031
0.018
0.013
72
The Beneish algorithm is applied to Enron below
BENEISH RATIO
2000
1999
1998
1997
Sales growth index = Sales Current Year
Sales Prior Year
100789
40112
= 2.513
40112
31260
=1.283
31260
20273
=1.542
20273
13289
=1.526
Gross Margin Index =
(Sales - Cost of goods sold prior year)
Sales prior year - cost of goods sold
Sales prior year
Sales current year - cost of goods sold current year
Sales current year
40112
-34761
5351
5351
40112
=0.133
100789
- 94517
6272
6272
10078
=0.062
...=0.133
0.062
=2.145
31260
-26381
4879
4879
31260
=0.156
40112
-34761
5351
5351
40112
=0.133
...=0.156
0.133
=1.173
20273
-17311
2962
2962
20273
=0.146
31260
-26381
4879
4879
31260
=0.156
... = 0.146
0.156
=0.935
13289
-10478
2811
2811
13289
=0.212
20273
-17311
2962
2962
20273
=0.146
... 0.212
0.146
-1.448
Days sales in Rec
Receivables
Sales
Receivables current year/sales current year
Receivables prior year/sales prior year
12270/100787
3548/40112
=0.122
0.088
=1.386
3548/40112
2893/31260
=0.088
0.093
=0.946
2893/31260
1826/20273
=0.093
0.90
=1.033
1826/20273
917/13289
=0.090
0.069
=1.308
Sales general and admin exp. Index
SGAI current year/sales current year
SGAI prior year/sales prior year
3184/100789
3045/40112
=0.032
0.076
=0.421
3045/40112
2473/31260
=0.076
0.079
=0.962
2473/31260
1508/20273
=0.079
0.074
=1.068
1508/20273
1510/13289
=0.074
0.114
=0.649
Results
Applying the Beneish algorithm to Enron financials shows clearly that in the four years in question, Enron consistently manipulated its accounts. For example, Beneish, reports a gross margin manipulation mean of 1.19. This was consistently overshot except in the year 1998 when the figure was 1.
In the same vein, the sales growth index also reveals huge inconsistencies overshooting the manipulation mean in the year 2000 by almost 70 %. This algorithm holds true it also reveals some serious inflection points.
The sales growth index between 1999 and 2000, shot up astronomically from 1.2 to 2.5 this represents an inflection point and between the three years 1998, 1999, 2000 one can spot some gross margin proposing.
Enron Failed the Altman Z- Score Corporate Health Check
ALTMANS RATIOS
STANDARD
2000
1999
1998
1997
X1
1.2
0.030151291
0.01
(0.01)
0.011395885
X2
1.4
0.049249653
0.08
0.08
0.08212132
X3
3.3
0.037891394
0.06
0.05
0.02505321
X4
0.6
0.454248128
0.50
0.02
0.00292657
X5
1
1.538692884
1.20
1.07
0.898944661
Z-Score
2.04
1.83
1.35
1.11
Financial Statement
Company Name:
Enron
2000
1999
1998
1997
Assets
000
000
000
000
Current Assets
30,381.00
7,255.00
5,933.00
4,113.00
Total Investment
23,379.00
15,445.00
12,760.00
9,269.00
Long term Assets
11,743.00
10,681.00
10,657.00
9,170.00
Total Assets
65,503.00
33,381.00
29,350.00
22,552.00
Liabilities
Current Liabilities
28,406
6,759.00
6,107.00
3,856.00
Long Term Liabilities
8,550
7,151.00
7,357.00
6,254.00
Deferred Credit
13,759
6,471.00
5,694.00
4,684.00
Commitment and Contingencies
3,318
3,430.00
3,144.00
2,140.00
Equity
Retained Earning
3,226
2,698.00
2,226.00
1,852.00
Cumulative preferred stock
8,348
6,637.00
5,117.00
4,224.00
Gross Revenue
100,789
40,112.00
31,260.00
20,273.00
Cost of Goods Sold
94,517
34,761.00
26,381.00
17,311.00
Gross Margin
1,953
802.00
1,378.00
15.00
Sales Gen &Admin Exp
3184
3,045.00
2,473.00
1,508.00
Net Income After Tax
979
893.00
703.00
105.00
EBITDA
2,482
1,995.00
1,582.00
565.00
Market Value
6,250
3,210.00
95.00
66.00
Working Capital/Total Assets
0.030151291
0.01
(0.01)
0.01
Retained Earnings/Total Assets
0.049249653
0.08
0.08
0.08
EBITDA /Total Assets
0.037891394
0.06
0.05
0.03
Mkt Value of Equity/Bk Value of Total Debt
0.454248128
0.50
0.02
0.00
Net Sales/Total Assets
1.538692884
1.20
1.07
0.90
Total liability to shareholder
Total liability
Shareholder fund
54,033
11,470
=4,71
23,811
33,381
=0.71
22,302
29,350
=0.76
16,934
22,552
=0.75
Cash flow ratio
Cash from operations
Total Debt: Total current liability
Long term debt
Other liability
4779
28,406
8,550
13,759
50,715
=4,779
50,715
=0.09
1,228
6,759
7,151
6,471
20,381
=1,228
20,381
=0.06
1,640
6,107
7,357
5,694
19,158
=1,640
19,158
=0.09
211
3,856
6,254
4,684
14,794
=211
14,794
=0.614
Results
Altman's Z score model stipulates a Z score of 2.99 for manufacturing companies and if a company's score falls below 1.81 it could spell doom in the near future for the company. Nugent (2006). Using Altman's parameters Enron failed all the Z score tests from 1997-200 as follows. In 1997 (1.11), 1998 (1.35), 1999 (1.83), 2000 (2.04). This goes to show that the signal had been there to put investors and shareholders on notice that something was wrong or something was about to happen.
