ASSIGNMENT 7

ACCOUNTING AND FINANCE (MBA 601)

Group 5:

APOORV AGARWAL (19125011)

ARUN GOYAL (19125013)

ITTI SINGH (19125023)

RUBEN JOSEPH (19125031)

VAIBHAV BAJPAI (19125048)

 Enron Scandal
Enron started out as a pipeline company and transformed into an energy trader, buying and selling power.
In just 15 years, Enron became America’s seventh largest company, employing 21,000 staff in more than
40 countries. Among other businesses, Enron was engaged in the purchase & sale of natural gas,
construction & ownership of pipelines and power facilities, provision of telecommunications services, and
trading in contracts to buy & sell various commodities. It expanded into many diverse industries for which
it had no unifying strategies and no expertise.

In April 2001 Enron disclosed it had owned $570 million by bankrupt California utility Pacific Gas & Electric
Co. While the top executives were likely aware of the debt and the illegal practices, the fraud was not
revealed to the public until October 2001 when Enron announced that the company was actually worth
$1.2 billion less than previously reported. This problem prompted an investigation by the Securities and
Exchange Commission1, which has revealed many levels of deception and illegal practices committed by
high-ranking Enron executives, investment banking partners, and the company’s accounting firm, Arthur
Anderson.

The Enron Scandal is considered to be one of the most notorious within American history. At the time of
Enron's collapse, it was the biggest corporate bankruptcy ever to hit the financial world. The Enron scandal
drew attention to accounting and corporate fraud, as its shareholders lost $74 billion in the four years
leading up to its bankruptcy, and its employees lost billions in pension benefits.

Analyzing the Fraud: Tactics used by Enron

1. Earnings Manipulation: Enron’s executives and senior managers engaged in wide-ranging

schemes to deceive the investing public about the true nature and profitability of Enron’s
businesses by manipulating Enron’s publicly reported financial results and making false and
misleading public representations.
2. Manipulating reserve accounts: They manipulated reserve accounts to maintain the appearance
of continual earnings growth and to mask volatility in earnings by concealing earnings during
highly profitable periods and releasing them for use during less profitable periods. Concealing
losses in individual business segments through fraudulent manipulation of "segment reporting,"
and deceptive use of reserved earnings to cover losses in one segment with earnings in another.
3. Manufactured earnings: Fraudulent inflation of asset values and avoiding losses through the use
of fraudulent devices designed to "hedge," or lock-in, inflated asset values.
4. Concealment of uncollectible receivables owed to Enron Energy Services by California utilities:
Enron also used reserves to conceal huge receivables (valued in the hundreds of millions of
dollars), accumulated during the California energy crisis, that California public utilities owed to
Enron and that Enron believed it would not collect. The California utilities were refusing to pay
these monies, and they likely were headed for bankruptcy. Enron concluded that it should book
a large reserve for these uncollectible receivables.
5. Concealment of EES failures by manipulating reporting: In the first quarter of 2001, new EES
managers discovered and quantified hundreds of millions of dollars in inflated valuations of EES
contracts that would have to be recorded as losses. Enron's senior management decided to
conceal these EES losses from investors by offsetting them with Enron Wholesale trading profits
earned in that quarter, as well as profits improperly reserved in prior periods. This was
 accomplished through a "reorganization" of Enron's business segments that was made effective
for the first quarter of 2001, enabling Enron to avoid reporting the losses in the EES segment. This
was explained deceptively to Enron's auditors and investors as meant to improve "efficiency”.
This maneuver helped to conceal the hundreds of millions of dollars in reserves booked within
ENA for the uncollectible California receivables owed to EES.
6. Fraudulent valuation of "merchant" assets: Enron's ENA business unit managed a large
"merchant" asset portfolio, which consisted primarily of ownership stakes in a group of energy
and related companies that Enron recorded on its quarterly financial statements at what it alleged
to be "fair value." Senior Enron and ENA commercial and accounting managers’ fraudulently
generated earnings needed to meet budget targets by artificially increasing the book value of
certain of these assets, many of which were volatile or poorly performing. Likewise, to avoid
recording losses on these assets, Enron's management fraudulently locked-in these assets' value
in improper "hedging" structures.
7. Use of Special purpose entities: SPEs are non-consolidated, off balance-sheet vehicles, used to
move assets and liabilities off the balance sheet, where substantial amounts of debt were
removed from the accounts. Through SPEs, the risk of the company can be reduced by moving
assets into separate partnerships called SPEs. Through SPEs a company can finance their activities
with a lower-cost debt which can be kept off balance sheet by using the weak accounting rules
for SPEs. Even the assets with falling value were sold to partnerships and were listed as earnings

What International Accounting Standards were violated in the Enron Scandal?

1. IFRS 10 Consolidated Financial Statements:

IAS 27 (2008) is superseded by IAS 27 Separate Financial Statements (2011) and IFRS 10
Consolidated Financial Statements effective 1 January 2013
IAS 27 has the twin objectives of setting standards to be applied:
• In the preparation and presentation of consolidated financial statements for a group of
entities under the control of a parent; and
• In accounting for investments in subsidiaries, jointly controlled entities, and associates when
an entity elects, or is required by local regulations, to present separate (non-consolidated)
financial statements.
Under this standard the Special purpose entities (SPEs) should be consolidated where the
substance of the relationship indicates that the SPE is controlled by the reporting entity. This
may arise even where the activities of the SPE are predetermined or where the majority of
voting or equity are not held by the reporting entity.
Violation of IFRS 10 in Enron Scandal:
Investment money flowing into Enron from new partnerships ended upon the books as profits, even
though it was linked to specific ventures that were not yet up and running. The main reason behind
these practices was to accomplish favorable financial statement results, not to achieve economic
objectives or transfer risk. These partnerships would have been considered legal if reported according to
present accounting rules or what is known as “applicable accounting rules”.
One of these partnership deals was to distribute Blockbuster videos by broadband connections. The
plan fell through, but Enron had posted $110 million venture capital cash as profit.
As per IFRS 10 accounting standard SPE need to be separate from the company which created it but in
case of Enron this standard was overruled. Even the assets with falling value were sold to partnerships
and were listed as earnings.

2. IAS 39 Financial Instruments: Recognition and Measurement:

IAS 39 was reissued in December 2003, applies to annual periods beginning on or after 1
January 2005, and will be largely replaced by IFRS 9 Financial Instruments for annual periods
beginning on or after 1 January 2018.
IAS 39 establishes principles for recognizing and measuring financial assets, financial liabilities
and some contracts to buy or sell non-financial items. It also prescribes principles for
derecognizing financial instruments and for hedge accounting.
Recognition and derecognition
A financial instrument is recognized in the financial statements when the entity becomes a party
to the financial instrument contract. An entity removes a financial liability from its statement of
financial position when its obligation is extinguished.
Measurement
A financial asset or financial liability is measured initially at fair value. Subsequent measurement
depends on the category of financial instrument. Some categories are measured at amortised
cost, and some at fair value. In limited circumstances other measurement bases apply, for
example, certain financial guarantee contracts.
Violation of IAS 39 in Enron Scandal:
Enron's ENA business unit managed a large "merchant" asset portfolio, which consisted primarily of
ownership stakes in a group of energy and related companies that Enron recorded on its quarterly
financial statements at what it alleged to be "fair value." Senior Enron and ENA commercial and
accounting managers’ fraudulently generated earnings needed to meet budget targets by artificially
increasing the book value of certain of these assets, many of which were volatile or poorly performing.
Likewise, to avoid recording losses on these assets, Enron's management fraudulently locked-in these
assets' value in improper "hedging" structures.

ENA's largest merchant asset was an oil and gas exploration company known as Mariner Energy
(Mariner), which Enron was required to book at "fair value" every quarter. During the fourth quarter of
2000, there was a shortfall of approximately $200 million in Enron's quarterly earnings objectives. Senior
Enron and ENA managers decided to increase artificially the value of the Mariner asset by approximately
$100 million in order to close half of this gap.

The consequences of Enron Collapse

• 4500 employees lost their jobs.
• Investors lost some 60 billion dollars within a few days.
• The pension fund for the company's employees was obliterated.
• Losses on the financial market amounted to the worst stock value loss in peaceful times.
• Banks were suspected of collusion.
• The auditing firm Arthur Anderson lost its accreditation.
• The rules for company financial reporting were drastically sharpened: Sarbanes-Oxley Act
(2002).
 • Enron filed for Chapter 11 bankruptcy, allowing it to reorganize while protected from creditors.
• Enron has sought to salvage its business by spinning off various assets.
• Enron's core business, the energy trading arm, has been tied up in a complex deal with UBS
Warburg. The bank has not paid for the trading unit, but will share some of the profits with
Enron.

Creation of Sarbanes-Oxley Act

In response to the auditing and accounting problems laid bare by Enron and other corporate scandals,
Congress enacted the Sarbanes-Oxley Act of 2002 (P.L. 107-204), containing perhaps the most far-
reaching amendments to the securities laws since the 1930s.The Act does the following:

• Creates a new oversight board to regulate independent auditors of publicly traded companies –
a private sector entity operating under the oversight of the Securities and Exchange
Commission.
• Raises standards of auditor independence by prohibiting auditors from providing certain
consulting services to their audit clients and requiring preapproval by the client’s board of
directors for other non-audit services.
• Requires top corporate management and audit committees to assume more direct responsibility
for the accuracy of financial statements.
• Enhances disclosure requirements for certain transactions, such as stock sales by corporate
insiders, transactions with unconsolidated subsidiaries, and other significant events that may
require “real-time” disclosure.
• Establishes and/or increases criminal penalties for a variety of offenses related to securities
fraud, including misleading an auditor, mail and wire fraud, and destruction of records.

Creative Accounting V/S Violation of Accounting Standards.

Creative accounting is a process by which the professional accountants use their knowledge to
manipulate the figures in the annual financial statement and take advantage of the numerous options
available to solve various accounting problems. It refers to accounting practices that follows the rules of
standard practices but certainly deviates of those rules, characterized by excessive compliance and the
use of novel ways of exhibiting income, assets or liabilities with an intention to influence the reader
towards the interpretation of the desired result.

It is unethical but not illegal because creative accounting practices are used by the company without
violating the rules. Various creative accounting techniques are used by the companies to distort the true
and fair view of the financial position of the company resulting in serious corporate failure. The main
reason for creative accounting is the choice available with the companies to use any of the accounting
methods which are laid down in the system. The companies adopt different inventory pricing – FIFO
(first in first out), LIFO (last in first out), and average pricing method to take advantage of the different
market conditions. Even the methods of charging depreciation-WDM (written down method) and SLM
(Straight line method) gives different results of valuation of assets. The system itself authorizes the
companies to adopt any method without any accountability to the stakeholders.
Accounting scams are political and business scams which arise with the disclosure of misdeeds by
trusted executives of large public corporations. Such misdeeds typically involve complex methods for
misusing funds, overstating revenues, understating expenses, overstating the value of corporate assets
or underreporting the existence of liabilities, sometimes with the cooperation of officials in other
corporations or affiliates all the while violating the established accounting standards.

References:
• ifrs.org: issued-standards, list-of-standards
• iasplus.com: standards
• academia.edu: Enron Corporation A Case Study
• Investopedia
• indiainfoline.com