An Examination Of The Collapse Of Enron Corporation Accounting Essay

Category: Accounting

The global socio-economic landscape is a fraught with different episodes of fraudulent activities. Technology has been used to dramatically exploit systems and it appears that there is some correlation between the surge of fraudulent activities and the advancement of technology. The power of bits and bytes has to be acknowledged in today's business world, and this has expanded the possibilities of fraud. 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 key events trends and developments within the defunct Enron Corporation that eventually led to it collapse in the year 2001. Enron was one of the giants of corporate America. Enron was loved and envied at the same time for their innovative exploits which challenged most competitive incursions and their ability to deliver handsome returns to their investors. Eventually, Enron turned out to be a fairy tale that did not live happily ever after. Enron had enlisted the support of their auditors Arthur Anderson to employ numerous accounting antics that would present Enron as a corporate giant. These unscrupulous acts, engineered its own devastating demise mid-2001, leading to the greatest corporate collapse in history and virtually discredited the noble profession of accounting.

A number of qualitative and quantitative avenues will be explored to show that how Enron charted its own demise.

Introduction

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 for a long time is remembered as one of the major events that really turned the search light on the subject matter of financial statement fraud as well as questioned the fundamentals of the accounting profession and standards.

As at the time of liquidation in the year 2001, Enron had about 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 great accolades and respect as a giant in America and a force in the global business land scape. For example, it was rated among the top ten companies in America with leadership in communications and power. Sharma (2008) captured the Enron debacle succinctly;

"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 (p4).

This reveals the extent of damage that these dishonest men caused and the extent of the damage they suffered consequently.

Fraud

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 fraud as it includes surprise, trickery, cunning and unfair ways by which another is cheated. (Albrecht, Albrecht & Albrecht, 2009)

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.

Albrecht, et al, (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 Albrecht et al (2009), 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'' (p.10)

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 and management fraud which occurs where the victims are shareholders and debt-holders of an organization or a company. (Albrecht, et al 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. 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.

Scope

This paper aims to 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.

In determining the significant red-flags, the governance culture that allowed how did these corporate boys Lay et al to 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.

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, a number of business ratios are then considered to substantiate the facts that would have been established above.

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, this was one of the special purpose entity founded in 1993, as a joint venture in Energy Investments with the California State Pension Fund. This Joint venture realized lots of losses but was kept off Enron's Balance Sheet. Chewco Investments, was formed by the Chief Financial Officer (CFO) Andrew Fastow in order to finance CALPERS stake in JEDI. However, 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, accordingly depicting a healthy 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.

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 Fastow, 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.

The Auditors Arthur Anderson were aware of this but turned a deaf ear and blind eye composure due to selfish reasons.

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.

Too 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.

Innovation or Integrity

The Management and subsequently the Board rarely questioned ideas brought in by the managers. This resulted in skyrocketing of innovations to meet the compensation bonus the company was dishing out to employees.

Revenue Recognition

Jeffrey Skilling, CEO (1996-2001), 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 materialized.

Special Purpose Entities (SPEs)

The Chief Financial Officer, Andrew Fastow, initiated the special purpose entities; he manipulated the deals to enrich his, 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.

Compromised Audit

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 ethics 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 the board's inability to question the practices used by the organization. The policy of compensation (stock options) also created a dysfunctional culture. The management was not cost-centered, spending extravagantly. They had large expense accounts (all employees). The executive were paid more than what is obtainable in the completive range. 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 auditors neither in reviewing the activities of the auditors.

Share Price Trends

It was considered a blue-chip company. As such its stock was highly priced. As the stock prices was 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

Source: John Nugent Class Notes SMC University Residency Programme, Vienna (2010)

The Beneish algorithm is applied to Enron below

BENEISH RATIO

2000' $000

1999 $000

1998 $000

1997 $000

Sales growth index = Sales Current Year

Sales Prior Year

100,789

40112

= 2.513

40,112

31260

=1.283

31,260

20273

=1.542

20,273

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.

Key Ratio Tests

PROFITABILITY RATIOS

2000

$000

1999

$000

1998

$000

1997

$000

Gross Margin % = Gross Profit x 100

Sales 1

100,789

-94517

6272

6272 x 100

100789 1

= 6.2%

40,112

-34210

5351

5351 x 100

40112 1

=13.3%

31,260

-26381

4879

4879 x 100

31260 1

=15.6%

20,273

-17311

2962

2962 x 100

20273 1

=14.6%

Profit to sales % - Net Profit After Tax x 100

Sales 1

979 x 100

100789 1

=0.97 = 1%

893 x 100

40112 1

=2.2%

703 x 100

31260 1

= 2.2%

105 x 100

20273 1

=0.5%

Individual expenses to sales =

Individual expenses x 100

Sales

Operating expense

Depreciation, depletion

Taxes/other income tax

Contract charge

Impairment of long lived asset

3184 x 100

100,789 1

=3.16%

855 x 100

100789 1

=0.84%

280 x 100

100789 1

=0.28%

-

3045

40,112

7.59%

870

40112

=2.16%

193

40112

=048%

441

40112

=1.10%

2473

31260

=7.91%

827

31260

=2.65%

201

31260

=0.64

-

-

1508

20273

=7.43%

600

20273

=2.96%

164

20273

=0.81%

675

20273

=3.33%

Total Asset Turnover

Sales

Total asset

100,789

65,503

=1.5 times

40,112

33,381

=1.2 times

31,260

29,350

=1.1times

20,273

22,552

=0.9 times

B. LIQUIDITY RATIO

Working capital ratio or current ratio

Current Asset

Current Liability

30,381

28,406

=1.07:1

7,255

6,759

=1.07:1

5,933

6,107

=0.97:1

4,113

3,856

=1.07:1

Quick asset ratio

Liquidity asset Current Asset Stock

Current liability Current liability

30,381 - 953

=29428

28,406

=1.04:1

72255 - 598

=6657

6759

= 0.98

5933 - 514

=5419

6107

=0.89

4113 - 136

3977

3856

=1.03

C. LONG TERM SOLVENCY/STABILITY RATIO

Fixed dividend cover

Profit after tax

Preference dividend

979

77

=12.7

=13 times

893

76

=11.8

=12 times

703

77

=9.13

=9 times

105

69

=1.5

2 times

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

Revenue and Profitability Challenge

So much earnings too little to show it was very clear, that the management of Enron had spearheaded their strategy from the earning/revenue perspective. Between 1998 and 2000 earnings grew by over 200% from $30B to $101Billion. Even a rocket scientist will search for answers to explain how this feat was achieved in a space of 2 years without any major mergers or acquisition activities going on. This already has been revealed by Beneish manipulation test.

It is also very interesting that with this type of turnover for example in the year 2000, they were only able to report gross margin of 6% and net margin of about 1%. This tells even the untrained eye, that there was something really wrong either the organization lacked the control mechanisms or expenses were definitely on the high side. It could also have been a strategy to curtail profitability. In view of the nefarious activities that were going on within the system.

Dharan and Bufkins (2005) in a study of the profitability of major global companies from the perspective of net profits reveal as follows;

"Enron's financial performance was at the lowest end for this group only El Paso

Corporation had worse profitability and return ratios"

Cash Flow

Turning the analytical light on cash flow, a key element of solvency was not properly managed it is also very obvious that cash flow was ignored a cash flow ratio of just about 6% to 9% between 1998 and 2000 speaks volumes and it was clear that they will not be able to cover their debt portfolio. This leaves the casual observer wondering how Enron was able to pull this off. Clearly, their rapid expansion and investment in subsidiaries made investors confident that the future was bright. This could also have been compounded by the favorable ratings they enjoyed from rating organizations.

Conclusion

There is probably some part of the makeup of human beings that is prone to and enjoys acts of dishonesty. The ever increasing rate of financial, economic and technological crime growing all over the world is alarming.

The case of Enron is simply derives from the point of view that an opportunity presented itself and the management of Enron capitalized on it. A good point was the approval it received to apply the MTM accounting principle in its reporting. Enron was given too much leeway to manipulate and recognize its revenues.

While there is no doubt that they recorded some initial success, governance structure of the company failed to check the excesses of the Chief Executive who was opening subsidiaries for virtually any innovation and committing huge investments in the subsidiary without doing any thorough investigation.

What is more? The compromised audit firm Arthur Anderson, did not help matters because they gave their seal of approval to the financial statements, authenticating the fraud they were supposed to guard against and led the investing public on. The Enron debacle remains a landmark school both for investors and practitioners. The lessons will continue to impact the world in three important respects. Firstly it has extended the frontiers of knowledge for in forensic accounting and allied disciplines. Secondly the investment community is more discerning and finally managers those charged with oversight responsibility have a solid reference to benchmark their behaviors.