Enron scandal – some basic analysis

By Dongfan Zhang (Zoe) Id: 1095871

And Naghmeh Malayeri Id: 1095862

Introduction

Aggressive and inappropriate accounting method

 Mark to market value

 Special purpose entity

 Failure of external auditing (SAS 82)

 False information and misleading disclosure – Manipulated financial report

Profit driven management culture

Conclusion

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Introduction
After watching the Smartest guys in the room (Enron Video) in Class, we are really shocked by
the extension of the violation of business ethics and how human being can be driven to conduct
the business so dishonestly in exchange of personal interest (money) without questioning if this
is the descent way to make money.

We all need money, but the excess greed towards those green papers will certainly lead to lies,
fraud, and manipulation. The excessive greed works like the bubble machine which creates a
certain product and inflates its price like blowing a bubble; and when the money is drained out,
the bubble blows out. Whoever invested in the bubble will suffer the eventual loss although the
bubble creator is gone with the money. They will then seek to create another bubble at a different
place with a different appearance.

Kenneth lay, Jeff Skilling, Andrew Fastow who’s names are most mentioned under the Enron
scandal are all human being like ordinary people except they are obsessed by arrogance and
performance, under this notorious band leadership, Enron was transformed from a tangible gas
energy company to kind of intangible trading company. Their performance is not the production,
but the speculation and snowball growing financial derivatives. These people in the management
can be classified as Vampire Squid which takes others’ blood relentlessly by using lies, fraud
and numerous sophisticated financial tools.

The cause of the Enron Scandal is various and complex. We believe the root cause is individual
and collective greed born in an atmosphere of market euphoria and corporate arrogance which
allowed the company unreal profit be trusted and unquestioned by shareholders, employees and
all the stakeholders; until one day such trust is shaken by more and more surfaced irregularities,
thus the stocks are sold and the company which did not have enough liquidity to settle the loss
collapses. Enron scandal was first seen as a typical accounting scandal although there are other
elements involved as well: business ethics, company culture and management bias, failure of
independent third party auditing, government intervene, deregulation of energy market etc. I will
focus on accounting problems and management culture in this paper.

Aggressive and inappropriate accounting method

Enron has been using the aggressive accounting method to record their transaction and produce
the financial reports to the public. I categorized three main fields that seem essential for me as
below:

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  Mark to market value
According the GAAP, the cost to be recorded for the transaction is the historic cost in most
cases; Although the mark to market value can be used for certain industry, there is guideline and
reasonable valuation curve to be observed.

Basically, mark-to-market is a type of accounting that enables a company to book the value of an
asset or a liability, not based on the cost of that asset, but based on current market valuations or
perceived changes in market valuations.  It differs significantly from the historical cost method
of asset. Valuation with historical cost, the cost of an asset is known whereas the market value of
an asset often is unknown until the asset is sold.

Under mark-to-market value rules, Enron was free to take a guess in their favour of the value of
assets that the company owned. Useless to say, they usually marked it up rather than marked it
down.

Most important to Enron, under mark-to-market accounting, revenue recognition is changed as

well. Under conventional accounting, revenue is recognized from a sales contract when the
product is delivered or service is performed, pretty straight forward. While under mark-to-market
accounting, the entire estimated value of a sales contract or project can be recognized as revenue
on the day the deal is completed before any work has been done or costs incurred to fulfill the
contract.  This allows Enron to record the revenue once the contract is signed while no gas is
delivered or service is not rendered yet.

For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible
that valuation estimates might have considerably overstated earnings. That is why one employee
in the video was saying that several times they felt that they were not going to make the figures
at the end of quarters, but magically the numbers finally came up looking good. That should be
the result of the magic touch of the quarterly adjustment done by the accounting team under the
mark to market value rules.

This is why Enron was looking so good for the first 7-8 years with the unreal and inflating profit
and can no longer cover their loss in the later years. Imagine, if they have recorded the entire
revenue for a contract over 20 years once the deal is done, they would inflate the revenue the
first year, but the years afterwards, there are related cost, service to be done while in the
meantime no revenue to be recorded. It is like spend the money first on the credit card and then
find the way to give back the money, if not go to bankrupt.

Mark to market value is an accounting practice that should be used in caution and with objective
evaluation. But in Enron’s case this was purposely abused to hide the company’s true financial
situation and the miss-leading financial reports. Jeff Skilling properly already had a plan to abuse
it while he was celebrating the SEC no objection to using the mark to market value with his
colleagues in the office. Actually this can be considered as a milestone of the Enron fraud
history. Before Skilling’s arrival, Enron was using the historic cost rule for the transactions. And
after Skilling, Enron changed to mark to market value, another era starts and the nightmare is on
the way.

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  Special purpose entity (SPE)
Another aspect of Enron’s aggressive accounting practice is the special purpose entity which was
directly manipulated and organized by CFO Andrew Fastow. The definition of special purpose is
a legal entity created to fulfill narrow, specific or temporary objectives. Special Purpose Entities
(SPEs) have a useful role in business financing when used appropriately. However, there must be
transparency, and all parties must understand the risks.

Fastow has used this financial tool to such grandiose scale by creating numerous SPEs and thus
transfer Enron’s loss to those SPE and at the meantime book the revenue of the assets sales into
the income statement. Fastow himself has earned more than 30 million from the deals inside
SPEs. Two most important SPEs have to be mentioned here are Raptor & Condors. Which Mrs.
Sherron Watkins was working on and she noticed those weird figures and wrote the internal
memo to Lay right after Skilling’s resignation.

Enron was able to avoid consolidating the SPEs on its balance sheet. Therefor fulfilled the
purpose of keeping the loss off the balance sheet and mark the revenue of asset sales. While the
SPE’s loan lenders were backed by the Enron stock, if the stock price goes down to a certain
level, Enron either has to pay out the debt right way or issue more stocks. When the stocks went
down, Enron didn’t have the money to pay back his creditors, and this leads to his direct
bankruptcy.

This is also like the bad circle: transfers loss to SPEs, borrows money from SPEs; when stock
cannot be boosted, then all the negative effects fall off like the dominos.

Because of these aggressive accounting methods, Enron is facing the pressure constantly to
produce more and more profits on the papers to maintain its stock price. This is result of the
speculation and manipulation. Still, time prove any indecent practice cannot last long. Enron’s
stakeholder became the ultimate victims of those Vampire Squids once the bubble blew out in
2001.

 Failure of external auditing (SAS 82)

Arthur Anderson, Enron’s independent auditor and consultant failed to detect wrong numbers in
the financial reports of Enron and ignored the internal memo from Mrs. Sherron Watkins. They
absolutely did not carry their duty as watch dog of the public but traded the responsibility with
money. Let’s take a look at some of the classic risk factors associated with management fraud
outlined in SAS no. 82; which are evident in the Enron case.

o Unduly aggressive earnings targets and management bonus compensation based on those
targets.

o Excessive interest by management in maintaining stock price or earnings trend through

the use of unusually aggressive accounting practices.

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 o Management setting unduly aggressive financial targets and expectations for operating
personnel.

o Inability to generate sufficient cash flow from operations while reporting earnings and
earnings growth.

o Assets, liabilities, revenues or expenses based on significant estimates that involve

unusually subjective judgments such as…reliability of financial instruments.

o Significant related party transactions.

o These factors are common threads in the tapestry that is described of the environment
leading to fraud. They were incorporated into SAS no. 82 on the basis of research into
fraud cases of the 1970s and 1980s in the hope that auditors would learn from the past.
Andersen will have to explain when and how it identified these factors, as well as how it
responded and how it communicated with Enron’s board about them.

We truly believe AA had all the evidence and the knowledge to make the judgement and
discovery, however they couldn’t take a firm position due to the interest conflict as AA was
offering also consulting service and collecting huge amount of service fees from Enron. AA’s
downfall is an excellent lesson for the ethics as well. One has to carry the business ethically and
there are rules to follow. We cannot break the rules forever.

 False information and misleading disclosure – Manipulating financial report

The ultimate purpose of the abnormal accounting practice is to present public (stakeholders) the
false illusion of the profitability of the company. Enron’s many years financial reports were
based on false information and purposely hid the debt or loss in unconsolidated SPEs.

Enron violated another fundamental rule in accounting report that is to disclosure transparently
the financial status to the concerned parties. Regarding Enron’s SPEs, ordinary investor had no
clue about it by reading the footnote mentioned the transaction of SPEs in an ambiguous way.

Here below is a partial extract from the memo of Mrs. Sherron Watkins which stated the unclear
footnote of the SPEs’ transactions.

``My Concern is that the footnotes don’t adequately explain the transactions. If adequately
explained, the investor would know that the ``entities`` described in our related party footnote
are thinly capitalized, the equity holders have no skin in the game, and all the value in the
entities comes from the underlying value of the derivatives (unfortunately in this case, a big loss)
and Enron stock and N/P….``

Profit driven management culture

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Enron’s disaster was facilitated by a corporate culture that encouraged greed and fraud, as
exemplified by the energy traders who extorted California energy consumers. Rather than focus
on creating real value, management's only goal was in maintaining the appearance of value, and
therefore a rising stock price. This was exacerbated by a fiercely competitive corporate culture
that rewarded results at any cost. Some divisions of Enron replaced as much as 15 percent of its
work force annually; leaving employees to scramble for any advantage they could find to justify
their continued employment.
If I were employee of Enron, maybe at the beginning the greed would dominate but eventually
the inner conscious will wake me up by asking the question about this company’s conspicuous
culture and its super profit push strategy. Therefore I probably will quit the company once I
figure out the truth.
Finally Enron’s executives were working only for their own profit and totally omit the
shareholders’ rights.

Conclusion
The Truth behind the Enron phenomenon is that Enron was not creating the true value by
production or sales; most of their so called profit is just piles of papers, miss reported assets
value, over-valued stocks, and overstated future gain and so on. Enron’s collapse is the
beginning of the series economic crisis which started in US and peaked in 2006-2007 in terms of
the housing bubble bursting and the 2007 global financial crisis. That’s the effects of global
contagion since the effects of bubbles will be carried on from continent to continent, from
country to country.

From Enron to the later on financial crisis, there are always the bubble machines and the
vampire squid behind those machines. A typical example is the US subprime home mortgage:
banks originate the loan with any prospective home buyer; banks then sell those highly risky
mortgages to investors in disguise of bundled securities which is mortgage-backed securities
(MBS) and collateralized debt obligations (CDO)to export their risks to un-knowing investors.
When the housing prices went down, lots of the mortgages’ value became higher than the house
price and the borrower is facing to pay more to cover that loss, then when the loan taker cannot
make the payment as scheduled, a foreclosure is initiated by bank. The bank takes back most of
their money from resale of the property, and furthermore they already sold the value in the
securities, therefore the true losers are the borrower and the investor: one lost home, the other
one only had the paper money that the value decreased enormously. The crisis spread through
other country since the MBS and CDO was put into international market and bought by foreign
pension funds, government as well. Overall, the mechanisms of the downfall of financial market
is really complex, I am not able to explain in detail in this paper due to my insufficient
knowledge, however one thing is clear that money certainly went to some place, and if the greed
and new financial innovation makes the bubbles, those bubbles will eventually burst when time
goes on. Unfortunately we are still going to see bubbles come out and burst. Somehow, we have

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to be aware of this and take measures to protect ourselves either for our own or for the company
we are working for.

We are grateful that Mr. Gordon Spicer gave us an opportunity to examine this issue which
became a classic for accounting and business students. For us, whatever the profession is, remain
honest and to be fair is the very essential which should never be taken over by profit.

At the end of day we need to be able to sleep without nightmare and wake up without guiltiness.