Accounting Issues at Enron

By Alan Reinstein and Thomas R. Weirich

In Brief

Accounting Abuses Lead to Significant Structural Changes

The failure of Enron sent shock waves through the economy, resulting in a series of reforms and proposals that will significantly change accounting standards setting, auditing practice, and the legal and regulatory environment of financial reporting. The authors integrate a short history of the rise and fall of Enron with an account of the sham operations carried out and accounted for therein. They also offer a discussion of the analytical procedures that might have revealed the shams, the remedies currently proposed, and the implications of the possible changes for the accounting profession.

The accounting profession is facing a major overhaul because of a credibility crisis. Accountants’ overall image has quickly fallen from the top to near the bottom of all professionals. The profession’s self-regulatory system is in the process of replacement, and new legislation prohibits certain services to audit clients. Even the issue of who will determine accounting and auditing standards is up for debate.

Why this sudden focus on the accounting profession? The problem arose in part because many executives at Enron and Andersen focused on the “letter of the law” rather than on whether the proposed accounting appeared ethical and “fair.” This issue extends beyond Enron and Andersen, as seen in many recent articles in the popular and business press, but understanding the current crisis requires starting with what happened at Enron.

A Short History of Enron

Enron’s 2000 annual report stated 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.

This unusual business arose from a 1985 merger of Houston Natural Gas and InterNorth. In 1986, Kenneth Lay became the newly created firm’s top executive. He later became chairman of the board and hired Jeffrey Skilling as CEO. Under their leadership, Enron adopted an aggressive growth strategy. Andrew Fastow, Enron’s CFO, helped create the complex financial structure for the new Enron.

Enron rapidly changed its business 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, risky, and expensive hedging transactions. These trading operations relied mainly on very complicated financial transactions.

Enron changed its business focus from primarily delivering and brokering energy domestically to focusing on three new key business areas: water, international energy brokerage, and broadband communications. Although Enron’s stock jumped as it entered these new markets, all three of these new endeavors went sour, causing Enron’s stock to plummet. Exhibit 1 presents some basic facts concerning the Enron debacle.

Enron’s demise began when investors became aware of “off–balance sheet” partnerships that hid billions of dollars of liabilities. Many entities, like Enron, used special purpose entities (SPE) because as long as at least 3% of capital comes from outsiders, an SPE can be left off the consolidated financial statements of the parent company.

Enron apparently “cooked the books” (both in form and in substance) to make its shares financially more viable, while creating little or no real shareholder and creditor value, as was revealed when the questionable accounting and financial reporting decisions were publicly disclosed. During 2001, Sherron Watkins, an Enron vice president, reported that she believed the numbers did not add up, and informed CEO Kenneth Lay that she was “incredibly nervous that we will implode in a wave of accounting scandals.” Enron’s financial executives ignored their own corporate code of ethics, apparently with the board of directors’ acquiescence. In a few months, the corporate officers who created one of the world’s largest companies panicked as they frantically—and unsuccessfully—tried to save it. After the company’s stock collapsed, a Newsweek columnist (February 11, 2002) reported that Enron’s demise was “the biggest crisis investors have had since 1929.”

Sham Operations

Various Congressional and other federal agencies investigated what have been referred to as sham operations, whose alleged purposes were twofold: to make investors believe that debt and risk had been removed from the financial statements, and to create phony income. Exhibit 2 summarizes the major accounting issues in the Enron debacle.

The first major sham operation was Enron executives’ apparent use of SPEs to deceive shareholders and to enrich themselves. Enron used about 500 such SPEs and thousands of other questionable partnerships in order to structure transactions to achieve off–balance sheet treatment of assets and liabilities. Enron executives often held large personal interests in these partnerships and made massive personal gains in such transactions.

During the 1990s, Enron needed additional capital to continue its growth despite its substantial debt load. Funding new investments by either issuing additional debt or raising capital was unattractive because such financing would dilute earnings per share. Therefore, it used SPEs to borrow funds directly from outside lenders, often supplying its own credit and stock guarantees. The use of these SPEs included many aspects of Enron’s business: synthetic lease transactions; sales to SPEs of “financial assets” (i.e., debt or equity interests that Enron owned); sales of Enron stock and contracts to “hedging” SPEs in return for Enron stock; and transfers of other assets to entities that had limited outside equity. Exhibit 3 presents one example of how Enron used SPEs.

Enron created the Chewco SPE to help identify a new limited partner for the buy-out of the California Public Employees’ Retirement System’s share of an Enron joint venture. Chewco would maintain the joint venture (JEDI) as an unconsolidated entity. Initially, the Chewco structure did not meet the SPE consolidation rules. The three basic rules for nonconsolidation of an SPE require that the independent equity investor—

In order to meet the SPE nonconsolidated equity, Enron created a new capital structure, which included an unsecured subordinated loan to Chewco from Barclays Bank guaranteed by Enron. With this cash collateral, however, Barclays’ equity was not at risk, and therefore both Chewco and JEDI transactions should have been consolidated in Enron’s financial statements.

At first, Enron apparently set up these SPEs correctly, with Andersen’s help. When Enron met difficulty in finding replacement independent investors, however, it utilized key management personnel for this purpose. Therefore, the issue of “control” of the SPE became suspect. In addition, as Enron needed to increase the number of SPEs to keep moving debt off the balance sheet, it began using its own stock as collateral. As a result, the SPE would record an increase in Enron’s stock as income, which would thereby allow Enron to increase income by utilizing the equity method of accounting.

In the Chewco transaction, Enron appointed employee Michael Kopper, who reported to Fastow, as Chewco’s manager. This raised the question of control for consolidation purposes: Did Kopper control Chewco, or did Enron control Chewco by virtue of Kopper’s position at Enron? If Enron controlled Chewco, accounting standards required consolidating Chewco and JEDI. This and other SPEs raised the question of the proper disclosure of related-party transactions. Fastow allegedly realized $30 million in profits on investments in Enron SPEs that he oversaw at the same time he served as Enron’s CFO. With other transactions also using SPEs in accounting hedges, one can recognize the complexity of the accounting issues within Enron.

The unraveling. Enron’s November 8, 2001, Form 8-K filing reported that it intended to restate previously issued financial statements that dated back as far as 1997. It also disclosed that Enron should have consolidated three previously unconsolidated SPEs not included in Enron’s consolidated financial statements.

A second questionable accounting transaction was the improper recording of a note receivable from Enron’s equity partners in various limited partnerships. These notes were the apparent promises to pay for the equity claims in the limited partnerships, which Enron recorded as assets even though GAAP requires subscribed equity to be reported as a contra–stockholders’ equity account, rather than as a note receivable. Once it was accused of GAAP violations, Enron announced it would restate the previous 4 As years of financial statements by recording a $1.2 billion reduction in stockholders’ equity, adjusting its income statements and balance sheets for the unconsolidated SPEs, and making prior-period proposed audit adjustments and reclassifications that had originally been considered as immaterial. Enron’s restatement reduced previously reported net income by $569 million and reduced shareholders’ equity by $1.2 billion.

Shortly after these announcements, several rating agencies lowered Enron’s long-term debt to below-investment grade, and Dynegy terminated its proposed merger agreement with Enron. In December 2001, Enron filed for Chapter 11 bankruptcy protection. In June 2002, a federal jury convicted Andersen, Enron’s independent auditor, of obstruction of justice, prohibiting the firm from practicing before the SEC and ending its audit practice. Andersen also allegedly played a major role in the improper recording of the creative accounting related to SPEs.

The aftermath. Congressman John Dingell, ranking member of the House Energy and Commerce Committee, blasted federal and industry watchdogs’ inactions as Enron dissolved. He said:

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?

Enron’s collapse has brought attention to deficiencies in several accounting and auditing areas. The most commonly cited issues include treatment of off–balance sheet and related-party transactions, auditor independence, retention of audit records, and clarification of disclosure rules.

Recently, FASB has proposed new standards to ensure that unconsolidated SPEs are truly independent of their sponsoring entity. Its new chair, Robert Herz, has also outlined a new approach to principles-based standards as well as the restructuring of the standards-setting process to make it more independent of preparers and auditors.

Analytical Procedures

Using analytical procedures or rigorous financial analysis could have uncovered many of Enron’s problems, or at least pointed Andersen, the SEC, and analysts in the right direction. All such parties could then have investigated the dubious financial relationships much more carefully and in greater detail.

Questionable financial ratios and analytical relationships would have indicated problems with Enron’s 2000 financial statements long before the firm declared bankruptcy. The following questions could have been raised and investigated further:

Deregulation of the utility industry in many states, especially California, helped to cause huge price increases in the “spot price” for electricity, natural gas, and other utilities. Enron took advantage of this opportunity, to help increase its sales by 151% in 2000. This success should have raised the question of how long Enron would be allowed to retain such price increases. State and federal energy regulators have subsequently concluded that Enron traders manipulated supply and prices in California, and certain Enron traders have been indicted.

Lenders or financial analysts reviewing the numbers should have looked beyond earnings to the entity’s cash flow, which was a warning sign. In 2000, Enron reported $979 million in net income, which included $1.4 billion in noncash items. Earnings do not service a company’s debt, but cash does. A careful review of Enron’s cash flow should have set off an alarm. Another alarm would have been the combination of high leverage and rapid growth. When the management of a highly leveraged company routinely makes imprudent decisions to meet projected numbers, financial debacles can ensue.

The Enron debacle underscores the importance of professional skepticism in evaluating financial statements. Auditors and analysts carefully performing analytical procedures would have detected or identified certain items that did not make financial sense, and could have initiated additional investigations.

Other Culpable Participants

Why would anyone in 2001 have bought Enron stock based upon public information available when in fact the stock was declining to worthlessness? Many investors bought because financial analysts rated Enron stock as a buy. As late as November 8, 2001, 10 of 15 financial analysts that followed Enron still rated its stock as a buy or a strong buy, even after a Wall Street Journal article reported the hidden losses within Enron and after the SEC’s investigation of Enron became public.

Why didn’t the financial analysts question these red flags, when they knew that Enron had off-the-books partnerships and that key executives were selling their personal shares of Enron stock as they encouraged employees to buy? Undoubtedly, a major reason is the conflict of interests between the investment bankers and the financial analysts. Congress has enacted legislation that prevents analysts’ compensation from being tied to their company’s investment-banking revenues.

Enron’s failure has also raised the issue of the role of corporate boards, especially audit committees, as well as corporate governance in general. Where were the internal auditors and the audit committee? As a result, the stock exchanges and the SEC are now increasing the financial literacy requirements and strengthening independence standards for audit committee members.

Avoiding “Another” Enron

Congressional hearings have highlighted the many ways that Enron’s management cooked the books. If corporate reporting is not made more credible, there is little hope of restoring public confidence in the markets.

Former SEC Chair Harvey Pitt suggested the following measures:

Financial analysts and investors can also spot early warning signs by carefully evaluating a company’s accounting policies, analyzing key ratios and benchmarks, reviewing insider trading activities, comparing management’s projections with industry trends, and being on the alert for declining relationships with business customers and partners.

Accounting and Auditing Implications

The Sarbanes-Oxley Act of 2002 will change the processes for creating and adopting auditing, accounting, independence, ethics, and quality standards for CPAs that audit SEC registrants. There is every reason to believe that some of these standards will ultimately apply to audits of nonregistrants simply because they will be good standards. In addition, the operation of the new Public Company Accounting Oversight Board (PCAOB) will encompass discipline and inspections (peer reviews for auditors of SEC registrants). The Sarbanes-Oxley Act covers many items that will affect accounting principles and auditing standards for years into the future.