Enron assignment rouad_final

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ENRON Case study

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Enron assignment rouad_final

  1. 1. FINANCIAL ACCOUNTINGPROGRAMME: MBA – HIBACOURSE: Financial AccountingTUTOR: DR. . ELIE SALAMEHSEMESTER: January 2011Unit Financial AccountingAssignment ID Financial AccountingAssignment Title Business Research ReportAuthor Dr. ELIE SALAMEHVerifierPublishing date 17/1/2012Deadline 15/2/2012Student name: RAWED ALMIDANIGROUP NUMBER: MBA 6 – Group 1Background: Core area of Interest Law / Hotel ManagementCase Study: This case about the Enron group offers An opportunity to explore manyaccounting and reporting issues such as: Accounting practices. “quality” of accounting information, Independence of external auditors, In addition it creates opportunities to discuss ethical issues in business.Tutor: Dr. Elie Salameh Publish Date: 10/2/2012Name: Rawed Al-MedaniDate Submitted: 12/2/2012Statement of Authenticity: I certify that the work submitted for this assignment is my own. Where the work of others has been used to support or inform my work, then credit has been acknowledged Signed: Date: 1
  2. 2. HistoryEnron was founded in the mid 80s of last century from the merger of Houston Natural Gas and InterNorth. Inthe process of the merger, Enron incurred massive debt.Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron’s business strategy, and Skilling, aprominent financial analyst was hired in the financial department at that time to propose solutions to Enron’scredit, cash and profit.Skilling proposed revolutionary solutions. One of them was to create a “gas bank” in which Enron would buygas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both thesupply and the price, charging fees for the transactions and assuming the associated risks.Lay was so impressed with Skilling’s genius that he created a new division in 1990 called Enron Finance Corp.and hired Skilling to run it. Under Skilling’s leadership, Enron Finance Corp. dominated the market for naturalgas contracts, with more contacts, more access to supplies and more customers than any of its competitors. Withits market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits.The People and Culture ImpactEnron set out on a quest to hire the best and brightest traders. It rewarded its employees and associatesgenerously with a long list of benefits.The internal culture started to take aggressive and darker sides. Despite trying to mask it, associates came to feelthat the only real performance measure was the amount of profits they could produce. Everyone started to focuson doing deals and get short term result by different means rather than looking on the long term impact. Skillingwas encouraging such business approach. Gradually, most Enron employees and associates were in fierceinternal and external competition for result.Growing Business and ExpansionEnron’s business expanded and became fragmented after entering the electricity business. Revenue grew to $7billion from $2 billion, and the number of employees in the electricity division increased to more than 2,000from 200.The surprising and more exciting development was the creation of Enron Online (EOL) in October 1999. InJanuary 2000 Enron diversified its business even more by starting a plan to build a high-speed broadbandtelecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricityor natural gas.Despite having a very little return on the telecommunication investment, Wall Street rewarded the strategy withan increase of $40 on the stock price!As a result of the propaganda and publicity surrounding all of Enron activities and business expansion, Enron’sstock hit an all-time high of $90.56 in August 2000, and the company was being touted by Fortune and otherbusiness publications as one of the most admired and innovative companies in the world.The Role of Mark-to-Market AccountingThe concept of mark-to-market accounting is that the price or value of a security is recorded on a daily basis tocalculate profits and losses. Using this method allows a company to count projected earnings from long-termcontracts as current income. This was money that might not be collected for many years. This technique isused to inflate revenue numbers by manipulating projections for future revenueMark-to-market accounting arises due to the difficulty with application of standard accounting rules for long-term futures contracts in commodities such as gas is that there are often no quoted prices upon which to base 2
  3. 3. valuations. Mark-to-market accounting allows companies to use discretionary valuation models based on theirown assumptions and methods.Due to the nature of Enron’s business, that is supplying energy, Enron benefited from the debate on how tovalue and disclose energy-related contracts. It started to incorporate “mark-to-market accounting” for theenergy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions.Under mark-to-market rules, whenever companies have outstanding energy-related or other derivative contracts(either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fairmarket value. Booking don’t realized gains or losses to the income statement of the period.Being continuously under pressure to beat expectations, Enron abused the mark-to-market accounting systemto considerably overstate its earnings. In addition, this accounting method allowed Enron to make money andgrow without bringing in a lot of taxable cash.Role of Special Purpose EntitiesEnron had to make sure the company’s leverage ratios were within acceptable ranges. Reducing hard assetswhile earning increasing paper profits served to increase Enron’s return on assets (ROA) and reduce itsdebt-to-total-assets ratio, making the company more attractive to credit rating agencies and investors.Enron had also been forming Special Purpose Entities (off balance sheet entities LJM, LJM2, and others) tomove debt off of the balance sheet and transfer risk for their other business ventures. These SPEs were alsoestablished to keep Enrons credit rating high, which was very important in their fields of business.The company contributes hard assets and related debt to an SPE in exchange for an interest. The SPE thenborrows large sums of money from a financial institution to purchase assets or conduct other business withoutthe debt or assets showing up on the company’s financial statements. The company can also sell leveragedassets to the SPE and book a profit.Role of Accounting FirmsEnron hired Arthur Andersen LLP as its accounting auditor. To Arthur Andersen Enron was the second largestclient and it was doing internal and external auditing for them and had staff permanently present in Enron’soffices.Many of Enron’s internal accountants, CFOs and controllers were former Andersen executives. Because ofthese relationships, as well as Andersen’s extensive concurrent consulting practice, members of Congress, thepress and others are calling Andersen’s audit independence into question.Enron dismissed Andersen as its auditor on January 17, 2002, citing document destruction and lack ofguidance on accounting policy issues as the reasons. Andersen countered with the contention that in its mindthe relationship had terminated on December 2, 2001, the day the firm filed for Chapter 11 bankruptcyprotection.Andersen admitted it destroyed perhaps thousands of documents and electronic files related to the engagement, inaccordance with “firm policy,” supposedly before the SEC issued a subpoena for them. The firm’s lawyers issued aninternal memorandum on October 12 reminding employees of the firm’s document retention and destruction policies.The firm fired David B. Duncan, partner in charge of the Enron engagement, placed four other partners on leave andreplaced the entire management team of the Houston office.Impact on other Accounting FirmsThe CEOs of the Big Five accounting firms made a joint statement on December 4 committing to develop improvedguidance on disclosure of related party transactions, SPEs and market risks for derivatives including energy contractsfor the 2001 reporting period. In addition, the Big Five called for modernization of the financial reporting system in theUnited States to make it more timely and relevant, including more nonfinancial information on entity performance. Theyalso vowed to streamline the accounting standard-setting process to make it more responsive to the rapid changes that occurin a technology-driven economy. 3
  4. 4. Chronology of EventsNovember 1997• Enron buys out a partners stake in a company called JEDI and sells the stake to a firm it creates, called Chewco, to be runby an Enron officer. Thus begins a complex series of transactions that enable Enron to hide debts.February 20, 2001• A FORTUNE story calls Enron a "largely impenetrable" company that is piling on debt while keeping Wall Street in thedark.Stock Close: $75.09April 17• Enron chairman Ken Lay meets with Vice President Dick Cheney and other energy-policy officials; its one of six suchvisits.August 14• CEO Jeffrey Skilling resigns, becoming the sixth senior executive to leave in a year. Lay says in a conference call withstock analysts, "I never felt better about the company." He deflects analysts pleas for more disclosure. They lower theirratings on Enron stock, which drops in after-hours trading to a 52-week low.Stock Close: $39.55October 12• Arthur Andersen legal counsel instructs workers who audit Enrons books to destroy all but the most basic documents.October 16• Enron reports a third-quarter loss of $618 million. Moodys investors Service indicates that it is considering lowering itscredit rating on Enron debt securities.Stock Close: $33.84October 22• Enron discloses that the Securities Exchange Commission has opened an inquiry.October 24• Chief financial officer Andrew Fastow, who ran some of Enrons stealth partnerships, is replaced.October 26• The Wall Street Journal reports the existence of the Chewco partnerships run by an Enron manager. Ken Lay calls FedChairman Alan Greenspan to alert him of the companys problems.Stock Close: $15.40October 28• Lay calls Treasury Secretary Paul ONeill. In October and November, Enrons president phones an ONeill deputy at leastsix times, seeking help.October 29• Lay calls Commerce Secretary Donald Evans, suggesting he help Enron.November 8• Enron admits accounting errors, infalting income by $586 million since 1997.November 9• Lay again talks to Treasurys ONeill.November 29• The SEC expands its investigation to include auditor Arthur Andersen.December 2• Enron files for bankruptcy.Stock Close: 26 centsDecember 12• Andersen CEO Joseph Berardino testifies his firm discovered "possible illegal acts" committed by Enron.January 9, 2002• The Justice Department launches a criminal investigation. 4
  5. 5. January 10• Attorney General John Ashcroft rescues himself from the investigation because of contributions he received from Enron.Andersen acknowledges destroying Enron files.Enron’s Share Price Rocketing and Decline 5

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