ENRON’s ACCOUNTING SCANDAL
INTRODUCTION: Northern Natural Gas Company (the ancestor of ENRON) was established in 1930. In 1979, Inter North Inc. bought Northern Natural Gas Company and placed it under a new management. In the 1980s, the United States Congress passed legislation deregulating the sale of natural gas. At the beginning of the 1990s, Congress passed a similar legislation targeted at the sales of electricity.
These steps launched a new era in the energy market, allowing companies like ENRON to prosper. In 1985, Kenneth Lay, CEO of Houston Natural Gas devised a new company and changed Inter North’s name to ENRON Corporation. This newly formed company was at first involved in distributing gas and electricity in the US and in selling power plants and pipelines worldwide. However, the company started to deviate into many non-energy-related fields i. e. non-core businesses, such as weather derivatives – weather insurances for seasonal business, risk management, and internet bandwidth.
Even though ENRON’s core business remained gas and electricity, most of the company growth came from those non-core businesses. ENRON was involved in the following fraudulent activities:
- Fraud to Shareholders
- Fraudulent Accounting Practices
- Creating off Balance Sheet Entities to Cover-up Losses
- Fake Energy Crisis
- Deregulation of ENRON
Fraud to Shareholders: When the employees of a corporation deliberately deceive the company’s shareholders by misrepresenting information. ENRON was involved in the phenomenon named “cook the books”, companies cook the books when they don’t tell us their real earnings.
Managers cook the books and present us fake earnings to improve their earnings per share (EPS) of stocks. Companies cook the books because they have the pressure to present good earnings in order to attract investors to invest in them and most importantly to keep current investors happy. By misrepresenting earnings reports, the executives of ENRON misused funds directed from investments while reporting fraudulent earnings to the investors; this not only proliferated more investments from current stockholders, but also attracted new investors desiring the enjoy the apparent financial gains enjoyed by the ENRON corporation.
Since, Executive bonuses are tied to the company’s earnings so managers are tempted to manipulate company’s earnings to receive these large earnings. During 2001, ENRON shares fell from US$ 85 to US$ 0. 30. The result of this accounting scandal was that many of the losses that ENRON encountered were not reported in its financial statements. Fraudulent Accounting Practices: The ENRON fraud case was extremely complex. The roots for the ENRON scandal lie in the beginning of the 1990s.
In fact, in 1992, Jeff Skilling, who was the president of ENRON’s trading operations, convinced federal regulators to allow ENRON to use market-based accounting. Companies can use market-based accounting unethically i-e one party deliberately misinforms another party during the trading of stocks, bonds, and other securities, which is what ENRON did. ENRON used market-based accounting for its energy segment in the 1990s and used it excessively for its trading transactions.
Under this accounting rule, when companies have outstanding contracts or energy-related contracts on their balance sheets at the end of a quarter, they must appraise them using fair value and record unrealized gains and losses to the quarterly income statement. The point is that there are no quoted prices upon which to base valuations for long-term future contracts in commodities such as gas. Using market-based accounting allowed ENRON to count projected earnings from long-term energy contracts as current income. Those contracts represented money that might not be collected for many years.
Investigators found that this accounting method was used to overestimate revenue by manipulation of future revenue. For instance, unrealized gains accounted for a little more than of ENRON’s $1. 1 billion reported income before taxes for 2000. The use of this accounting measure, as well as the use of other questionable measures, made it difficult for the public to see the business model of ENRON. In fact, the numbers were recorded on the books but the company was not paying equivalent taxes. Creating off Balance Sheet Entities to Cover-up losses:
Moreover, we know that ENRON has been buying a big number of ventures that looked promising. We know that ENRON has also been creating off balance sheet entities in order to remove the risk of their financial statements. Because of market-based accounting explained above, ENRON recorded all time high revenues. The company thus wanted to be involved in other areas. For instance, ENRON was buying or developing an asset – such as a pipeline – and then was expanding through a vertical integration (buying a retail business around that pipeline).
This strategy required huge amounts of initial investments and was not going to generate earning or cash flow in the short term. If ENRON elected to present this strategy on its financial statements, it would have placed a big burden on the company’s ratios and credit ratings, and credit ratings investment grade was crucial for ENRON energy trading business. In order to find a solution to this issue, ENRON decided to look for outside investors who would like to make those deals with them. Those combined investments required ENRON to present a guaranty or another form of credit proof.
Because of that, ENRON decided to organize these investments as Special Purpose Entities (SPE). ENRON did this through a complex arrangement of special purpose entities the company called the Raptors. The Raptors were created to cover those SPEs losses if their stocks were falling. When the telecom industry experienced its first decline, ENRON experienced poor financial performance as well. In fact, when ENRON stocks fell below a certain level, it caused the Raptor’s stock to collapse. This is mainly because the Raptors’ stocks were backed up by ENRON’s stock.
The telecom industry downturn was thus the underlying event that uncovers the fraud scheme at ENRON. Fake Energy Crisis: Timothy Belden, the head of ENRON's energy-trading operation, committed wire fraud by playing his part in the manipulation of California's energy market that would cause the increase of power prices. He contributed to this fraud by buying California's power at cheap, capped prices. They would then route them outside of California and then sell it back into California at a very highly inflated price.
However, upon retroactive review, many historians and economists suspect that the ENRON executives manufactured this crisis in preparation of the discovery of the fraud they had committed, although the executives of ENRON were enjoying the funds rendered from investments, the corporation itself was approaching bankruptcy.
Deregulation of ENRON: While the term regulation within a commercial and corporate setting typically applied to the government’s ability to regulate and authorize commercial activity and behavior with regard to individual businesses, the ENRON executives applied for, and were subsequently granted, government deregulation.
Because of this declaration of deregulation, ENRON executives were permitted to maintain agency over the earnings reports that were released to investors and employees alike. This agency allowed for ENRON’s earning reports to be extremely skewed in nature, losses were not illustrated in their entirety, prompting more and more investments on the part of investors wishing to participate in what seemed like a profitable company.
Consequences Faced by ENRON: Due to the actions of the ENRON’s executives, the ENRON Company went bankrupt. The losses sustained by investors exceeded $70 billion. Furthermore, these actions cost both trustees and employees an amount of $2 billion, this is because of misappropriated investments, pension funds, stock options, and savings plans, and due to the government regulations and the limited liability status of the ENRON Corporation, only a small amount of the money lost was returned.