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ENRON SCANDAL
Enron’s Accounting Methods
April 30, 2015
Acct 301-d02 LUO
[Company address]
April 30, 2015
Acct 301-d02 LUO
[Company address]
Melissa Vest
Liberty University

I. Introduction: Enron used many legal accounting practices to commit fraudulent accounting activities II. The genius, or ingenious, accounting methods Enron used: 1. Special purpose entities a. Synthetic leases b. FAS 140’s 2. Hedges 3. Share trust transactions 4. Minority interests 5. Prepays 6. Mark-to-market 7. Stock Games III. Conclusion:
The beginning of the end

Enron Scandal
I have always tried to do the right thing, but where there was once great pride, now it’s gone.
—From the suicide note of JOHN CLIFFORD BAXTER,
Enron’s former vice chairman I. Enron used many legal accounting practices to commit fraudulent accounting activities:
Enron was on the road to success when only a couple bad decisions were made that seemed to cause a panic that had them hiding and covering until the hole was too deep for them to climb out of. Was it optimism or cynicism that got Enron into the mess that ultimately destroyed it? II. The genius, or ingenious, accounting methods Enron used:
“Enron executives applied for – and were subsequently granted – government deregulation. As a result 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 partake in what seemed like a profitable company.” (Yale, G. 2002)

Special Purpose Entities: Synthetic leases and FAS 140s “Part of the Enron story hinges on a corporate reliance on something called synthetic leases, a model that Enron used when creating its shaky partnerships.” Synthetic leases are complex structures that were entered into primarily for tax benefits and generally allowed corporations to set up a special purpose entity (SPE), “sell” property to the entity and then lease the property from the entity. The special purpose entities would finance the sale with bank debt and hold the properties off the corporation's balance sheet. “So, if much of the business community is resorting to the use of synthetic leases, and the regulators bless this tactic, is it fair to point the finger of blame at Enron?” (Jorion, P. Investing in a post Enron world, 2003. p. 82)
Financial Accounting Standards (FAS) section 140, governs the sale of financial assets and lists the conditions in which the transfer can be considered a sale. Enron used FAS 140 transactions to monetize liquid assets in order to remove them from the balance sheet, while still retaining control over them through SPE’s.
“Most observers have called the Special Purpose Entities a form of off-balance-sheet financing, in which Enron engages in transactions that it somehow doesn’t even record on its balance sheet. That would be illegal. Rather, Enron put them on the balance sheet, in plain sight for everyone to see, but just in a place that few people think to look. Enron had a choice in how to record the investment in and activities of the SPEs: It could consolidate them, or use the ‘equity method.’ Consolidating them meant that the assets of an SPE become the assets of Enron, its liabilities become Enron’s liabilities, and so forth. Enron certainly didn’t want to do this, since it sought to avoid the SPE liabilities in the first place. In contrast, the equity method allows a firm merely to add the shareholders’ equity of a subsidiary or affiliate (such as the SPEs) to its own. This way, Enron wouldn’t care about the revenues and expenses or assets and liabilities of the SPEs.” (Yale, G. 2002)

Hedges:
The financial dictionary defines hedge funds as “a portfolio accounting method that combines the values of both a security and its offsetting hedge instrument. A hedge experiences gains in value when the corresponding security sustains losses. Under traditional accounting practices, a security and its hedge are treated as separate components when priced. Hedge accounting treats them as a single accounting entry that reflects the combined market values of the security and the hedge.” Enron used these in an unethical way by combining transactions that were all within, or closely related to the company. “The counter-parties to the hedges were entities in which employees participated and over which they exercised managerial control; and the resources of these entities were largely Enron stock.” (Dembinski, Paul H., Lager, Carole, Cornford, Andrew. Enron and the World of Finance, 2005. Pg. 21)

Share Trust Transactions:
Using share trust transactions, Enron formed entities for the purpose of removing assets and liabilities from the balance sheet. “One of the entities issued securities for which the proceeds were received by another entity that also held assets contributed by Enron itself.” This, in effect, was only a circle of assets and liabilities being moved around so that investors couldn’t see the extent of debt it was under.

Minority Interests:
Enron raised money that was classified on the balance sheet as ‘minority interests’, which is a category in financing that credit rating agencies treat as hybrid equity rather than debt. “A majority-owned subsidiary was established by Enron with a minority interest being taken by another entity, financed by debt and equity in the proportions of 97 per cent and 3 per cent, respectively. The minority shareholder in the subsidiary was not consolidated with Enron for accounting purposes, and the financing for Enron from this source was not counted as debt.” (Dembinski, P. et al:, 2005. Pg. 23) Using this technique enabled Enron to improve their credit ratios, giving them a stronger standing for investors to see.

Prepays:
Prepaid swaps were used to disguise the nature of financial transactions between the firm and banks. Enron was paid a fixed sum in advance in return for a stream of future payments (from the oil revenues) made through an offshore SPE to the bank. The cash flows of prepays can be counted as hedge funds (explained previously), which will boost operating cash flows, while also keeping down debt.

Mark-to-Market / Mark-to-Model Accounting:
Mark-to-market accounting involves the revaluation of assets on a regular basis. Enron used this technique to value some of its longer-term and more complex contracts. “This accounting is not so straightforward when applied to non-standardized, over-the-counter transactions and to complex, long-term contracts. In that instance, a process known as mark-to-model is used, which depend on judgements for an uncertain future.” (Dembinski, P. et al:, 2005. Pg. 24) Such accounting was a major generator of reported earnings for Enron.
Stock Games:
A firm is forbidden to capitalize on its own stock—period. “This was a prohibition that Sherron Watkins, Enron’s whistleblower, would remind legislators of pointedly and repeatedly throughout the Senate hearings. “Under generally accepted accounting principles,” the Powers Report agreed, “a company is generally precluded from recognizing an increase in value of its own stock (including forward contracts) as income. Enron sought to use what it viewed as this ‘trapped’ or ‘embedded’ value.” However, there is a back-door tactic. Instruments known as derivatives provide a way to evade such prohibitions as long as some distance is maintained between the derivative and its underlying product. Treating Enron’s stock as the underlying product rather than the product itself allowed the company to take advantage of the fact that its stock was still rising in a nose-diving market.” (Yale, G. 2002) III. The beginning of the end:
Thousands of employees and hundreds of thousands more people affiliated with Enron, a multibillion dollar company, were caught up in a catastrophe of huge proportions when the fraudulent, unethical business and accounting practices were uncovered in 2001. Enron used creative accounting maneuvers to cover up losses and appear to have a lot of rapidly growing revenue by claiming future contracts would be worth more than they actually were. Their biggest fraud was hidden through their Special Purpose Entities, also known as SPE’s. They hid their losses in these SPE’s so that many of their debts and losses were not reported in their financial statements. “Financial statements are the primary means of communicating financial information to external parties.” (Spiceland, J., Sepe, J., & Nelson, M., 2013) With the ‘external parties’ seeing a much better future for Enron than what was true, there were many investments made under false pretenses and millions of dollars lost by these parties.
“On October 16, 2001, Enron announced a $1 billion pretax charge largely relating to the unwinding of SPEs that had served as the counter-party to some of Enron’s largest hedge transactions. In addition, the company announced that $1.2 billion of net worth recorded in connection with sales of Enron’s stock to its SPEs would be reversed. In one fell swoop, roughly 20% of Enron’s capital simply disappeared. Moreover, the $1 billion charge produced a third quarter loss of $618 million, an amount that represented roughly 60% of earnings for all of 2000.” (Yale, G. Enron: An Accounting Analysis of How SPEs Were Used to Conceal Debt and Avoid Losses. FEI Research Foundation, 2002)

References

Dembinski, P. H., Lager, C., & Cornford, A. (Eds.). (2005). Enron and the World of Finance : A Case Study in Ethics. Basingstoke, Hampshire, GBR: Palgrave Macmillan. Retrieved from http://www.ebrary.com

Financial definitions retrieved on April 23, 2015 from http://www.financialdictionary.net/define/Hedge+Funds/

Jorion, P. (2003). Investing in a Post Enron World. New York: McGraw-Hill.

Spiceland, J., Sepe, J., & Nelson, M. Intermediate accounting (7th Ed.). (2013) New York: McGraw-Hill/Irwin.

Yale, G. Enron: An Accounting Analysis of How SPEs Were Used to Conceal Debt and Avoid Losses. Morristown, NJ. FEI Research Foundation, (2002)