ENRON Case study

1. FINANCIAL ACCOUNTING
PROGRAMME: MBA – HIBA
COURSE: Financial Accounting
TUTOR: DR. . ELIE SALAMEH
SEMESTER: January 2011
Unit Financial Accounting
Assignment ID Financial Accounting
Assignment Title Business Research Report
Author Dr. ELIE SALAMEH
Verifier
Publishing date 17/1/2012
Deadline 15/2/2012
Student name: RAWED ALMIDANI
GROUP NUMBER: MBA 6 – Group 1
Background: Core area of Interest Law / Hotel Management
Case Study: This case about the Enron group offers An opportunity to explore many
accounting 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: 10/2/2012
Name: Rawed Al-Medani
Date Submitted: 12/2/2012
Statement 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:
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2. History
Enron was founded in the mid 80s of last century from the merger of Houston Natural Gas and InterNorth. In
the process of the merger, Enron incurred massive debt.
Kenneth Lay, CEO, hired McKinsey & Co. to assist in developing Enron’s business strategy, and Skilling, a
prominent financial analyst was hired in the financial department at that time to propose solutions to Enron’s
credit, cash and profit.
Skilling proposed revolutionary solutions. One of them was to create a “gas bank” in which Enron would buy
gas from a network of suppliers and sell it to a network of consumers, contractually guaranteeing both the
supply 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 natural
gas contracts, with more contacts, more access to supplies and more customers than any of its competitors. With
its market power, Enron could predict future prices with great accuracy, thereby guaranteeing superior profits.
The People and Culture Impact
Enron set out on a quest to hire the best and brightest traders. It rewarded its employees and associates
generously with a long list of benefits.
The internal culture started to take aggressive and darker sides. Despite trying to mask it, associates came to feel
that the only real performance measure was the amount of profits they could produce. Everyone started to focus
on doing deals and get short term result by different means rather than looking on the long term impact. Skilling
was encouraging such business approach. Gradually, most Enron employees and associates were in fierce
internal and external competition for result.
Growing Business and Expansion
Enron’s business expanded and became fragmented after entering the electricity business. Revenue grew to $7
billion from $2 billion, and the number of employees in the electricity division increased to more than 2,000
from 200.
The surprising and more exciting development was the creation of Enron Online (EOL) in October 1999. In
January 2000 Enron diversified its business even more by starting a plan to build a high-speed broadband
telecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricity
or natural gas.
Despite having a very little return on the telecommunication investment, Wall Street rewarded the strategy with
an increase of $40 on the stock price!
As a result of the propaganda and publicity surrounding all of Enron activities and business expansion, Enron’s
stock hit an all-time high of $90.56 in August 2000, and the company was being touted by Fortune and other
business publications as one of the most admired and innovative companies in the world.
The Role of Mark-to-Market Accounting
The concept of mark-to-market accounting is that the price or value of a security is recorded on a daily basis to
calculate profits and losses. Using this method allows a company to count projected earnings from long-term
contracts as current income. This was money that might not be collected for many years. This technique is
used to inflate revenue numbers by manipulating projections for future revenue
Mark-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
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3. valuations. Mark-to-market accounting allows companies to use discretionary valuation models based on their
own assumptions and methods.
Due to the nature of Enron’s business, that is supplying energy, Enron benefited from the debate on how to
value and disclose energy-related contracts. It started to incorporate “mark-to-market accounting” for the
energy 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 fair
market 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 system
to considerably overstate its earnings. In addition, this accounting method allowed Enron to make money and
grow without bringing in a lot of taxable cash.
Role of Special Purpose Entities
Enron had to make sure the company’s leverage ratios were within acceptable ranges. Reducing hard assets
while earning increasing paper profits served to increase Enron’s return on assets (ROA) and reduce its
debt-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) to
move debt off of the balance sheet and transfer risk for their other business ventures. These SPEs were also
established to keep Enron's 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 then
borrows large sums of money from a financial institution to purchase assets or conduct other business without
the debt or assets showing up on the company’s financial statements. The company can also sell leveraged
assets to the SPE and book a profit.
Role of Accounting Firms
Enron hired Arthur Andersen LLP as its accounting auditor. To Arthur Andersen Enron was the second largest
client and it was doing internal and external auditing for them and had staff permanently present in Enron’s
offices.
Many of Enron’s internal accountants, CFOs and controllers were former Andersen executives. Because of
these relationships, as well as Andersen’s extensive concurrent consulting practice, members of Congress, the
press 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 of
guidance on accounting policy issues as the reasons. Andersen countered with the contention that in its mind
the relationship had terminated on December 2, 2001, the day the firm filed for Chapter 11 bankruptcy
protection.
Andersen admitted it destroyed perhaps thousands of documents and electronic files related to the engagement, in
accordance with “firm policy,” supposedly before the SEC issued a subpoena for them. The firm’s lawyers issued an
internal 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 and
replaced the entire management team of the Houston office.
Impact on other Accounting Firms
The CEOs of the Big Five accounting firms made a joint statement on December 4 committing to develop improved
guidance on disclosure of related party transactions, SPEs and market risks for derivatives including energy contracts
for the 2001 reporting period. In addition, the Big Five called for modernization of the financial reporting system in the
United States to make it more timely and relevant, including more nonfinancial information on entity performance. They
also vowed to streamline the accounting standard-setting process to make it more responsive to the rapid changes that occur
in a technology-driven economy.
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4. Chronology of Events
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.
February 20, 2001
• A FORTUNE story calls Enron a "largely impenetrable" company that is piling on debt while keeping Wall Street in the
dark.
Stock Close: $75.09
April 17
• Enron chairman Ken Lay meets with Vice President Dick Cheney and other energy-policy officials; it's one of six such
visits.
August 14
• CEO Jeffrey Skilling resigns, becoming the sixth senior executive to leave in a year. Lay says in a conference call with
stock analysts, "I never felt better about the company." He deflects analysts' pleas for more disclosure. They lower their
ratings on Enron stock, which drops in after-hours trading to a 52-week low.
Stock Close: $39.55
October 12
• Arthur Andersen legal counsel instructs workers who audit Enron's books to destroy all but the most basic documents.
October 16
• Enron reports a third-quarter loss of $618 million. Moody's investors Service indicates that it is considering lowering its
credit rating on Enron debt securities.
Stock Close: $33.84
October 22
• Enron discloses that the Securities Exchange Commission has opened an inquiry.
October 24
• Chief financial officer Andrew Fastow, who ran some of Enron's 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 Fed
Chairman Alan Greenspan to alert him of the company's problems.
Stock Close: $15.40
October 28
• Lay calls Treasury Secretary Paul O'Neill. In October and November, Enron's president phones an O'Neill deputy at least
six 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 Treasury's O'Neill.
November 29
• The SEC expands its investigation to include auditor Arthur Andersen.
December 2
• Enron files for bankruptcy.
Stock Close: 26 cents
December 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.
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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
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