ENRON AND ARTHUR ADNDERSEN: THE CASE OF THE CROOKED E AND THE FALLEN A

Global Perspectives on Accounting Education, 2006 by Cunningham, Gary M, Harris, Jean E

Many of the financial reporting issues at Enron related to the concept of entity - failure to consolidate entities, selective use of the equity method of accounting for entities, and failure to eliminate the effects of transactions among the entities. As a result of these irregularities, Enron manipulated its financial reports in several ways, including the following:

* Enron did not report debt on its balance sheet. Through collaboration with major banks, SPEs borrowed money, often with direct or indirect guarantees from Enron. The cash was used to benefit Enron, but was not necessarily transferred to Enron. Enron did not report debt on its financial reports. It did not disclose the contingent liability for the debt as required by GAAP. Various methods described next were used to transfer the cash and further manipulate financial reports.

* Enron had investments in companies (which were not SPEs) that it consolidated or reported on the equity method. When the investments began to show losses, they were transferred to SPEs so Enron would not reflect the losses. Enron did not consolidate or report the SPEs on the equity method, and thus avoided reporting the loss. Often the "sale" of the investment to the SPE generated a reported gain, and a cash payment from the SPE to Enron to pay for the investment could be used to transfer borrowed cash. This process allowed Enron to manipulate its reported cash flow by disguising cash from borrowing as cash flow from sale of investments.

* Enron sold services to SPEs for large amounts in order to inflate its sales revenue and income. Because Enron did not use the equity method of accounting, the cost to the SPE was not reflected by Enron. The cash payment from the SPE to Enron for the "services" could be borrowed cash. Thus Enron would report cash flow from operations rather than from borrowing.

* One Enron unit would sell energy to a SPE that would then resell the energy to another Enron unit. The SPE would borrow money to pay for the energy; banks often collaborated by helping to set up offshore SPEs to disguise the transaction. The cash was transferred to the selling unit of Enron that reported an increase in revenues, although not necessarily in profits. In addition, by doing this, Enron manipulated cash flow to report positive cash flow from operations.

Enron and Andersen sought a position from the SEC staff on circumstances under which Enron could avoid consolidating its SPEs. The SEC staff position response, consistent with the EITF statement, stated consolidation could be avoided only if there were a substantial outside equity ownership interest in the SPE and if the SPE were independently managed and not controlled by Enron. The response stated it would not specify what constituted "substantial outside equity ownership"; it emphasized that the three percent amount in the EITF statement was a guideline and should be viewed as an absolute minimum. In all cases, Enron managed the activities of its SPEs directly or indirectly. Many of the transactions between Enron and the SPEs would not have been conducted with independent outside entities. In all cases, Enron owned a majority interest either directly or indirectly through Fastow, Gilsan, Kopper, and other Enron employees.