Case Study: Enron Corporation Accounting Scandal - Scandal Essay Example

Case Study: Enron Corporation Accounting Scandal

1 - Case Study: Enron Corporation Accounting Scandal introduction. What is Enron Scandal?

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Formed in 1985 from a merger of Houston Natural Gas and Internorth, Enron Corp. was the first nationwide natural gas pipeline network. Over time, the firm’s business focus shifted from the regulated transportation of natural gas to unregulated energy trading markets. The guiding principle seems to have been that there was more money to be made in buying and selling financial contracts linked to the value of energy assets (and to other economic variables) than in actual ownership of physical assets. Until late 2001, nearly all observers – including Wall Street professional – regarded this transformation as an outstanding success. Enron’s reported annual revenues grew from under $10 billion in the early 1990s to $139 billion in 2001, placing it fifth on the Fortune 500. Enron’s problems did not arise in its core energy operations, but in other ventures, particularly “dot com” investments in Internet and high-tech communications businesses. Like many other firms, Enron saw an unlimited future in the Internet. [15] During the late 1990s, it purchased on-line marketers and service providers, constructed a fiber optic communications network, and attempted to create a market for trading broadband communications capacity. Enron entered these markets near the peak of the boom and paid high prices, taking on a heavy debt load to finance its purchases. When the dot com crash came in 2000, revenues from these investments dried up, but the debt remained.

Enron also recorded significant losses in certain foreign operations. The firm made major investments in public utilities in India, South America, and the U.K., hoping to profit in newly-deregulated markets. In these three cases, local politics blocked the sharp price increases that Enron anticipated. [16] By contrast, Enron’s energy trading businesses appear to have made money, although that trading was probably less extensive and profitable than the company claimed in its financial reports. Energy trading, however, did not generate sufficient cash to allow Enron to withstand major losses in its dot com and foreign portfolios. Once the Internet bubble burst, Enron’s prospects were dire. It is not unusual for businesses to fail after making bad or ill-timed investments. What turned the Enron case into a major financial scandal was the company’s response to its problems. Rather than disclose its true condition to public investors, as the law requires, Enron falsified its accounts. It assigned business losses and near-worthless assets to unconsolidated partnerships and “special purpose entities.”

In other words, the firm’s public accounting statements pretended that losses were occurring not to Enron, but to the so-called Raptor entities, which were ostensibly independent firms that had agreed to absorb Enron’s losses, but were in fact accounting contrivances created and entirely controlled by Enron’s management. In addition, Enron appears to have disguised bank loans as energy derivatives trades to conceal the extent of its indebtedness. [16] When these accounting fictions – which were sustained for nearly 18 months –came to light, and corrected accounting statements were issued, over 80% of the profits reported since 2000 vanished and Enron quickly collapsed. (For an Enron timeline, see CRS Report RL31364.) [15] The sudden collapse of such a large corporation, and the accompanying losses of jobs, investor wealth, and market confidence, suggested that there were serious flaws in the U.S. system of securities regulation, which is based on the full and accurate disclosure of all financial information that market participants need to make informed investment decisions. The central issue raised by Enron is transparency: how to improve the quality of information available about public corporations. As firms become more transparent, the ability of corporate insiders to pursue their own interests at the expense of rank-and-file employees and public stockholders diminishes. Several aspects of this issue are briefly sketched below, with reference to CRS products that provide more detail.

2. What kinds of accounting fraud were there?

From the fall of 2000 Enron began its journey into bankruptcy. Enron’s complex financial statements were confusing to shareholders and analysts. [1]. According to film “The Smartest Guys in the Room”, “The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control.” There were several accounting fraud in Enron’s practice:

1. Revenue recognition. Among the companies, there is a practice in which merchants are allowed to report sale price as revenue and production costs as the cost of goods sold. A mediator who provides services to the client does not take the risks that the seller has. These intermediaries are required to indicate trading and brokerage services as a source of revenue. Enron instead elected to report the entire value of each of its trades as revenue, that resulting in a significant overstatement of the company’s revenues. 2. The use of mark-to-market accounting. Mark-to-market accounting refers to accounting for the “fair value” of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed “fair” value. Market accounting requires that once a long-term contract was signed, the revenue is measured at the present value of future cash flows. When using the method, the income from the projects can be recorded, although they may not all have the money. Enron became the first non-financial company to use the method to account for its complex long-term contracts. [6]. 3. The use of special purpose entries. Enron used special purpose entities — limited partnerships or companies created to fulfill a temporary or specific purpose — to fund or manage risks associated with specific assets. The company elected to disclose minimal details on its use of “special purpose entities”. [1] These “shell firms” were created by a sponsor, but funded by independent equity investors and debt financing. For financial reporting purposes, a series of rules dictates whether a special purpose entity is a separate entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt. [1] Enron used a number of special purpose entities, such as partnerships in its Thomas and Condor tax shelters, financial asset securitization investment trusts (FASITs) in the Apache deal, real estate mortgage investment conduits (REMICs) in the Steele deal, and REMICs and real estate investment trusts (REITs) in the Cochise deal. [3] The special purpose entities were used for more than just circumventing accounting conventions. As a result of one violation, Enron’s balance sheet understated its liabilities and overstated its equity, and its earnings were overstated.

Enron disclosed to its shareholders that it had hedged downside risk in its own illiquid investments using special purpose entities.

However, the investors were oblivious to the fact that the special purpose entities were actually using the company’s own stock and financial guarantees to finance these hedges. This prevented Enron from being protected from the downside risk. [4] Notable examples of special purpose entities that Enron employed were JEDI, Chewco, Whitewing, and LJM. 4. Executive compensation. Although Enron’s compensation and performance management system was designed to retain and reward its most valuable employees, the system contributed to a dysfunctional corporate culture that became obsessed with short-term earnings to maximize bonuses. Employees constantly tried to start deals, often disregarding the quality of cash flow or profits, in order to get a better rating for their performance review. Additionally, accounting results were recorded as soon as possible to keep up with the company’s stock price. This practice helped ensure deal-makers and executives received large cash bonuses and stock options. [5] The company was constantly emphasizing its stock price. Management was compensated extensively using stock options, similar to other U.S. companies. This policy of stock option awards caused management to create expectations of rapid growth in efforts to give the appearance of reported earnings to meet Wall Street’s expectations. The stock ticker was located in lobbies, elevators, and on company computers.

Top management believed that if employees were constantly worried about cost, it would hinder original thinking. As a result, extravagant spending was rampant throughout the company, especially among the executives. Employees had large expense accounts and many executives were paid sometimes twice as much as competitors. [6] 4. Financial Audit. Enron’s auditor firm, Arthur Andersen, was accused of applying reckless standards in its audits because of a conflict of interest over the significant consulting fees generated by Enron. During 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees (this amount accounted for roughly 27% of the audit fees of public clients for Arthur Andersen’s Houston office). The auditor’s methods were questioned as either being completed solely to receive its annual fees or for its lack of expertise in properly reviewing Enron’s revenue recognition, special entities, derivatives, and other accounting practices.

3. How Enron caught?
In order to understand the how Enron mystifications were revealed the chronology of main events that led to Enron downfall has to be tracked down. But prior to this, the main players behind the scandal has to be revealed. 1. Kenneth Lay, the CEO and chairman of Enron from 1985 until his resignation on January 23, 2002. 2. Jeffrey Skilling, Enron CEO during 2001. Skilling began advocating a novel idea: the company didn’t really need any “assets.” By promoting the company’s aggressive investment strategy, he helped make Enron the largest wholesaler of gas and electricity, with $27 billion traded in a quarter. Skilling unexpectedly resigned on August 14 2001 year, citing personal reasons, and he soon sold large amounts of his shares in the corporation. 3. Andrew Fastow, Enron CFO, resigned on October 2001. He was one of the key figures behind the complex web of off-balance-sheet special purpose entities (limited partnerships which Enron controlled) used to conceal their massive losses. [7] In November 1997 Enron buys out a partner’s stake in a company called JEDI and sells the stake to a firm it creates, called Chewco, to be run by an Enron officer. Thus begins a complex series of transactions that enable Enron to hide debts. After years of successful hiding accounting frauds Enron eventually raises suspicion of Wall Street. And on the 20th February a Fortune magazine publishes article where it calls Enron a “largely impenetrable” company that is piling on debt while keeping Wall Street in the dark. In August, 2001 CEO Jeffrey Skilling resigns, becoming the sixth senior executive to leave in a year.

For many people, both inside and outside Enron, that was when it became clear something was seriously wrong. Enron’s stock fell 6 percent the next day, to $40.25. [8] In October Arthur Andersen, Enron’s audit company, legal counsel instructs workers who audit Enron’s books to destroy all but the most basic documents in the attempt to hide most accounting frauds. Later the same month Enron reports $638m third quarter loss and $1.2bn fall in shareholder equity Securities and Exchange Commission begins inquiry into firm. Moody’s investors Service indicates that it is considering lowering its credit rating on Enron debt securities. On the 24th October Chief financial officer Andrew Fastow, who ran some of Enron’s stealth partnerships, is replaced. Later Ken Lay claimed that the CFO’s larcenous behavior sank the company. [9] Meanwhile The Wall Street Journal reports the existence of the Chewco partnerships run by an Enron manager. Ken Lay calls Fed Chairman Alan Greenspan to alert him of the company’s problems. On November Enron shares sink to 10-year lows as buyout deal falls through and further losses are revealed at the firm. All these led to Enron admitting accounting errors, inflating income by $586 million since 1997. During following months the SEC investigation is taken further and includes auditor Arthur Andersen. [10] Finally, Enron filed for bankruptcy on December 2001, company stock price fell to 26 cents. After this, criminal investigation was launched and it lasted till 2006 and concluded with a verdict for Jeffrey Skilling (was sentenced to 24 years and 4 months in prison, and fined $45 million.), Andrew Fastow (sentenced to 6 years in prison) and Kenneth Lay (was charged with 11 counts of securities fraud, wire fraud, and making false and misleading statement, died in 2006 before his sentence). [11]

4. What changes were made after that?

The Enron scandal is one of the most famous in the world and the changes that have been made after it, are being made, and will be made, all will have a positive impact on the accounting industry. The changes implemented by accounting companies and different accounting agencies affect only the companies making the changes and the American companies, and subsidiaries. The three new Statement of Accounting Standards (SAS) are presented in order to help to expose fraud and deception if it exists in a company. The move by many businesses to hire new auditors allows the public to see companies do care that they do not misrepresent their position to the public. It also creates more work for the accounting industry, which creates job security for accountants. These changes allow companies to show that even though their auditors were corrupt; the company itself was fine. The governmental changes had the strongest effect of all the changes that would result from the Enron scandal. The Sarbanes-Oxley Act, which was adopted as a response to famous financial scandals, improves the accounting industry in two ways. First, it creates a lot more work for many companies.

This additional work means more job opportunities for many accountants and job opportunity means freedom to tell a client when they are wrong, which in turn makes audits more reliable. The second way is that “it requires tougher restrictions on internal audits and in judging how well the internal audit is conducted. If the internal audit is functioning effectively, it cuts down on the volume of work that the auditors have to do, thus making it easier for auditors to do audits.” [17] Another positive effect is the separation of auditing and consulting. This decreases the occurrence of non-independence by auditors. At the same time, it allows companies to reap the benefits of having both auditors and consultants. The accounting industry should again flourish, and businesses will see that once the consulting firm gets used to working with a company they will work just as well as the company that they use for audits. The changes in education are connected with new type of accountants. These accountants have more training in ethics that increases the public’s confidence in accountants. In addition, accountants are better prepared to deal with special-purpose entities which will allow more meaningful and correct accounting procedures to prevail where bad or antiquated procedures may have been used in the past.

5. What is SOX? What provisions were made and what do they stand for? July 30, 2002 President George W. Bush signed the Sarbanes – Oxley Act (SOX), which is one of the most significant events to change federal law with the U.S. Securities over the last 60 years. [18] The law is much stricter financial reporting requirements and the process for its preparation – the result of numerous corporate scandals involving unscrupulous managers of large corporations. In accordance with the Law for the Public Corporation:

a new regime for the control and regulation of financial activities was created; there are significant changes in the management and disclosure requirements. The law, known by their first names – Senator Paul Sarbanes (Democratic Party Pieces. Maryland) and Rep. Michael Oxley (Republican Party Pieces. Ohio) – consists of 11 sections. [19] We would like to consider our attention on the main patterns of SOS: Sections 302 and 404 have the greatest business impact in terms of ongoing compliance obligations. Section 302 pertains to corporate responsibility for financial reporting, and requires that the CEO and CFO personally stand behind the accuracy of their company’s quarterly and annual financial statements. In order for the CEO and CFO to certify that the financial statements are 100% correct, systems must be developed and in place to pull together all of the business performance data from all across the company – even if that data resides in various departments, business units, in separate data centers or on different networks and in different countries. At the end of each quarter, all of the business information must unite into one comprehensive and accurate financial view of the business. Section 404 requires that annual reports contain a discussion of the effectiveness of internal controls. These places major responsibility on the CFO, the company’s Chief Compliance Officer, and the company’s external auditors who must provide a public opinion about the reliability and effectiveness of the company’s internal controls. Internal control not only include policies and processes but also the company’s IT systems and record retention. [24] Section 409 mandates significantly expanded disclosure requirements, with disclosures made as quickly and completely as possible after an event affects the company’s performance. [http://www.soxlaw.com/] SOX makes the assumption that companies have almost real-time visibility into their company’s data, including all sorts of situations and business transactions that are outside the direct control of the accounting or finance functions. Sections 103, 801(a) and 802 are the core of SOX’s record retention rules. Section 103 relates to audit work papers and evidence.

Sections 103 (a) and 801 (a) require public companies and registered public accounting firms to maintain audit work papers, documents that form the basis of an audit or review, and all information supporting conclusions for at least 7 years. Section 802 addresses the retention and destruction of records, with implied penalties. Under Section 802, it is a crime for anyone to intentionally destroy, alter, mutilate, conceal, cover up, or falsify any records, documents, or tangible objects that are involved in or could be involved in, a US government investigation or prosecution of any matter, or in a Chapter 11 bankruptcy filing. Section 802 stresses the importance of record retention and destruction policies that affect all of a company’s e-mail, e-mail attachments, and documents retained on computers, servers, auxiliary drives, e-data, web-sites, as well as hard copies of all company records. The rules state that any employee who knows their company is under investigation, or suspects that it might me, must stop all document destruction and alteration immediately. And, the employee must create a company record showing that they have ordered a halt to all automatic e-data destruction practices. Section 906 provides for signing the heads of all the issuer’s periodic reports to the Commission, including the financial statements. Directors are required to confirm that the submitted reports “fully comply” with the requirements SEC. The same article provides for violation of criminal responsibility – a fine of 1 to 5 million and imprisonment from 10 to 20 years. Confirmation of the correctness of the management company can not be momentary and requires considerable effort of all company, not just the units responsible for preparing the financial statements. From our point of view, SOX is not just an act, it is a process that requires a “putting in order” all areas of business of the company that are relevant to the preparation of the financial statements.

6. In addition to Enron Scandal, which companies committed accounting frauds and what technics they use? (e.g., WorldCom, Tyco International, etc.) Among the most notable accounting scandals are such companies as WorldCom, Tyco International etc.

1. WolrdCom. On June 25, 2002, WorldCom, the Nation’s second largest long distance telecommunications company, announced that it had overstated earnings in 2001 and the first quarter of 2002 by more than $3.8 billion. The announcement stunned financial analysts and, coming on top of accounting problems at other corporations, had a noticeable effect on the financial markets. The accounting maneuver responsible for the overstatement – classifying payments for using other companies’ communications networks as capital expenditures – was characterized by the press as scandalous, and it was immediately asked why Arthur Andersen, the company’s outside auditor at the time, had not detected it. WorldCom filed for bankruptcy protection on July 21St . On August 8th , the company announced that it had also manipulated its reserve accounts in recent years, affecting an additional $3.8 billion. [12]

2. Tyco International. It’s an international manufacturing company with diversified product lines (safety products, fire protection, electrical products etc). The company indicted the former executives, Kozlowski and Schwartz, on charges of civil fraud and theft. They are accused of giving themselves interest-free or low interest loans for personal purchases of property, jewelry, and other frivolities.

These loans were never approved or repaid. Kozlowski and Schwartz are also accused of issuing bonuses to themselves and other employees without approval of Tyco’s board of directors. It is alleged that these bonuses acted as de facto loan forgiveness for employees who had borrowed company money or were used to buy the silence of those who suspected the former CEO and CFO of fraud. Kozlowski, Schwartz, and Belnick are also being indicted on charges of selling their company stock without telling investors, despite their obligation to do so under SEC rules. In sum, the three are accused of stealing $600 million dollars from Tyco International. [13]

3. Parmalat SpA. It’san Italian dairy and food company and Europe’s biggest dairy company, was declared bankrupt in late 2003, when a 8 billion euro hole was discovered in Parmalat’s accounting records. The company went under for a variety of reasons: investment disasters; non-existent cash in bank; fake transactions; hidden debts and the use of derivatives and accounting fraud to hide these facts. These illegal acts were carried out worldwide, and they affected not only the company and its people but international financial institutions, as well. (http://emievil.hubpages.com/hub/10-Scandals-That-Rocked-the-Accounting-World)

4. Satyam Computer Services. a leading Indian information technology services company. Ithas a network in 67 countries with 53,000 employees. On 7th January, 2009 the accounting scandal came into exposure. Company inflated cash and bank balances of more than $1.5 billion (INR 7,000 crore), overstated debtors’ position of $100 million and understated liability of $250 million. [15].

References

1. Healy, Paul M.; Krishna G. Palepu (Spring 2003). “The Fall of Enron” (PDF). Journal of Economic Perspectives 17 (2): 11. 2. Healy, Paul M.; Krishna G. Palepu (Spring 2003). “The Fall of Enron” (PDF). Journal of Economic Perspectives 17 (2): 10 3. Niskanen, William A. (2007). After Enron: Lessons for Public Policy. Rowman & Littlefield. pp. 306–307. ISBN 978-0-7425-4434-5. 4. Healy, Paul M.; Krishna G. Palepu (Spring 2003). “The Fall of Enron” (PDF). Journal of Economic Perspectives 17 (2): 11. 5. Dharan, Bala G.; William R. Bufkins (July 2008). Red Flags in Enron’s Reporting of Revenues and Key Financial Measures. Social Science Research Network. p. 112. Retrieved from: http://www.ruf.rice.edu/~bala/files/dharan-bufkins_enron_red_flags.pdf. PDF file 6. McLean, Bethany; Peter Elkind. The Smartest Guys in the Room. p. 119. ISBN 1-59184-008-2 7. Eric Roston, The Enron Players. Time Magazine. Jan. 27, 2002. Retrieved from: http://www.time.com/time/magazine/article/0,9171,1101020204-197668,00.html 8. Peter Elkind and Beth McLean, Enron Exposed: how the house of cards fell apart. Fortune, Nov.3, 2005 Retrieved from: http://www.crawfordsworld.com/rob/AP%20Macro%20Year/Enron/EnronTrial.htm 9. Behind the Enron Scandal. Cronology of a collapse. Time Lists. Retreieved from: http://www.time.com/time/specials/packages/article/0,28804,2021097_2023262,00.html 10. Enron scandal at a glance. BBC news. Aug.22. 2002. Retrieved from: http://news.bbc.co.uk/1/hi/business/1780075.stm 11. Peter Elkind and Beth McLean, Judgment day: guilty, guilty, guilty. Fortune. Jan.13, 2006. Retrieved from: http://www.crawfordsworld.com/rob/AP%20Macro%20Year/Enron/EnronVerdict.htm 12. Bob Lyke, Mark Jickling, CRS Report for Congress. WorldCom: the accounting scandal.PDF file. Retrieved from: http://www.law.umaryland.edu/marshall/crsreports/crsdocuments/RS21253_08292002.pdf 13. The

14. Heather Tmmons. Satyam Chief Admits Huge Fraud. The New York Times. Jan. 7, 2009. Retrieved from: http://www.nytimes.com/2009/01/08/business/worldbusiness/08satyam.html?_r=0 15. Mark Jickling, CRS Report RS21401, Regulation of Energy Derivatives. Apr. 21, 2006. PDF file. Retrieved from http://www.policyarchive.org/handle/10207/bitstreams/3682.pdf 16. Mark Jickling, CRS Report RS20560, Derivatives Regulation: Legislation in the 106th Congress. Oct. 10, 2000. PDF file. Retrieved from: http://digital.library.unt.edu/ark:/67531/metacrs1223/m1/1/high_res_d/RS20560_2000Oct10.html 17. Kleckner, P.K., & C. Jackson (2005) Sarbanes-Oxley Creates a New Beginning for Accountants. CPA Journal, 75, 14. 18. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (to be

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