Inside the Enron debacle

RMA Journal, The, May, 2002 by Thomas R. Weirich, Alan Reinstein

This article surveys what happened at Enron, the egregious accounting errors that were made, and future mitigants to this operational risk now under consideration.

Enron's annual report states that its business is: ...to create value and opportunity for your business by combining financial resources, access to physical commodities, and market knowledge to create innovative solutions to challenging industrial problems.

Formed from a merger in 1985 of Houston Natural Gas and InterNorth, Enron shortly transformed from a regulated natural gas company into one of the world's largest energy traders. Enron was, in large measure, an unregulated derivative-trading company. It generated funds by entering into extremely volatile and expensive hedging transactions that relied on very complicated financial transactions.

Enron had recently changed its business focus from that of primarily delivering and brokering energy domestically to focusing on three new business areas: water, international brokerage of energy, and broadband transmission of communications. Enron's stock jumped initially when it entered these new markets, but all three endeavors soured, causing the stock value to plummet. To maintain its reported profitability and buttress its stock price, Enron began to "cook the books."

Sham Operations

Federal investigations have largely focused on sham operations that were performed to allegedly keep debt and risk out of the financial statements and create phony income. Table 1 summarizes many of the major accounting issues at Enron.

Enron's November 8, 2001 Form 8-K filing reported that it intended to restate previously issued financial statements dating back as far as 1997. This filing disclosed that the company should have consolidated three previously unconsolidated special-purpose entities (SPEs), whose basic purpose was to structure transaction(s) to achieve off-balance-sheet treatment of assets and liabilities so that they would not appear on the transferor's financial statements. Enron had about 500 such SPEs and thousands of other questionable partnerships. Enron executives also frequently held large personal interests and made massive personal gains in these transactions.

After reported violations of generally accepted accounting principles (GAAP), Enron announced its intentions to restate its financial statements for the prior four-and-a-half years, taking into account the effects of the unconsolidated SPEs. The restatement would remove about $1.2 billion of stockholders' equity and about $569 million of previously reported net income. Enron's prior audits had called these prior-period audit adjustments and reclassifications "immaterial."

Shortly after these announcements, several rating agencies lowered Enron's long-term debt to below investment grade, and Dynegy terminated its merger agreement with Enron. On December 2, 2001, Enron filed for Chapter 11 bankruptcy protection. Its independent auditor, Arthur Andersen, was implicated in the improper recording of the SPEs.

Congressman John Dingell, ranking member on the House Energy and Commerce Committee, blasted federal and industry watchdogs for the Enron debacle, saying:

Enron went from the number seven company on the Fortune 400 to a penny stock in a stunning three weeks because it apparently lied for years in its financial statements. Where was the Securities and Exchange Commission? Where was the Financial Accounting Standards Board? Where was Enron's audit committee? Where were the accountants? Where were the lawyers? Where were the investment bankers? Where were the analysts? Where were the institutional investors? Where was common sense?

Suspect was not only Enron's accounting, but also the adequacy of its financial disclosures. Accounting issues related to the Enron debacle include the treatment of off-balance-sheet and related-party transactions, independence for external auditors, guidance relating to retention of audit records, and clarification of rules pertaining to disclosures. Some of the issues relate directly to the client, some to the audit firm, and some to the SEC and the AICPA.

Analytics as Prevention

Use of analytical procedures or rigorous financial analysis could have uncovered the problems at Enron or at least have implied to Andersen, the SEC, and savvy analysts that major financial relationships did not make sense. All such parties should then have investigated the issues much more carefully and in greater detail. Table 2 presents selected Enron financial information reported in its 2000 annual report, with key analytical issues highlighted.

Questionable financial ratios and analytical relationships seemed to indicate a problem in Enron's 2000 financial statements long before the firm declared bankruptcy.

* If 2000 revenues had increased 151% and the cost of sales 172%, how could the stock price increase 100%?

* What caused revenues to increase significantly? Was the company "pushing the envelope" by using highly favorable assumptions or aggressive accounting?