Enron’s financial reporting problems

The core of the controversy about Enron’s financial reporting problems is its use and accounting treatment of so-called Special Purpose Vehicle (SPE). Enron’s strategy in the late 1990s was to buy an asset, usually energy related, and expand it by building a business around the asset. In carrying out the strategy, however, Enron faced a number of problems. First each of their investments required a large outlay now, but payback would come only in the long term. Funding the investments consequently involved two choices, each of which had its disadvantages. Enron could fund the investments by issuing new equity, but doing so would dilute the equity of current shareholders. Alternatively, Enron could borrow to finance the investments. But Enron had already borrowed a great deal and more debt might endanger the investment grade credit rating necessary to its energy trading and derivatives business.

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Given its choices, Enron developed the following way to implement its strategy. First, it would find outside investors to help finance its investments. Second, it would seek ways to retain the risks it believed it could manage well and profit from doing so. At the same time, it would create a joint venture or a special purpose entity (SPE), to which outside and investors could contribute resources; the entities could also borrow in the credit markets, possibly with guaranties or other credit support

from Enron. Enron sought outside investors that would jointly create separate ventures (structured as SPEs) to which Enron and the other investors would contribute assets or other consideration. These SPEs borrowed directly from outside lenders and, because they were not consolidated with Enron, the debt of these entities never appeared on Enron’s balance sheet. Thus, Enron had accomplished its accounting objective of recognizing the asset but not he related debt to acquire it, even though, in some cases, Enron had guaranteed the SPE’s debt.7

Non – Consolidation

One of the most significant accounting issues that Enron faced was the consolidation of SPE’s, in which it entered into a number of transactions and did not need to be consolidated. This made Enron present a more favorable picture of its operation results and financial condition than would otherwise. In forming a joint venture or SPE, Enron faced the choice between consolidating the entity into its balance sheet or moving it off their balance sheet.

Given Enron’s indebtedness and its desire to retain its investment grade rating, senior management chose off-balance sheet treatment. In order to avoid consolidating the entities into its balance sheet, however, the entities had to meet two conditions. First, outside owners must make a ‘substantial’ investment (normally 3% of total capital), and their investment must actually be at risk. Second, the outside owners must have some control over the investment. Both the existence of outside risk capital and of outside control was at issue in the following transactions.

Despite the risks, SPEs remain very appealing to companies. And any attempt to curb them or abolish the 3% rule will run into furious opposition. Since the early ’90s, an army of accountants, lawyers, and bankers built a huge industry to concoct ever more creative ways to evade consolidated reporting. So reform won’t come easily. Revenue Recognition Though the amounts under the different ways in which Enron recognized revenue is less material, Enron recognized revenue from certain questionable transactions with some of the SPEs. As noted above that Enron guaranteed outside debt of one of the SPEs for which Enron was paid an up-front fee. Enron immediately recorded the entire amount of the up-front fees as income, even though the appropriate treatment should be to spread it over the guaranteed period.

Further Enron received management fee from it SPE’s, at some point of time it was re-characterized as “required fees”. The main purpose of this change apparently was to accelerate revenue recognition. But under GAAP, a management fee is to be recorded as income when the related services are rendered. Another way that Enron was recognizing revenue was when one of the SPEs in question held as an asset a substantial number of Enron’s common shares whose market price increased dramatically during the period from 1993 through 2000. Hence, in applying the equity method, Enron, in effect, recorded as “other revenue” the appreciation in its own stock. Although the issue is not clear in this case, under GAAP, a company may not recognize gains from increases in the value of its own shares.

Variability in Accounting Standards adopted in the Industry

Enron at its peak accounted for more than 70% of the energy trading business in the global markets. Its competitors were small in comparison, only managing to achieve a combined 30%. Hence the magnitude of the off balance sheet transactions entered into by Enron would have been much larger than any of its main competitors. In addition, Enron’s strategy of turning itself into a energy trading business is very much different from its competitors, who in large still focused and relied on their core business of producing and wholesaling energy products whereas Enron was heavily trading on derivatives and hedging risk in billions of dollars.

It is hard to determine how common Enron’s competitors’ accounting practices are to Enron’s as the sole purpose of entering into transactions with SPEs is to remove liabilities from the balance sheet, and out of the scrutiny of people. Although the sheer magnitude of Enron’s trading business would suggest that it used a far larger amount of off balance sheet transactions than its competitors. Enron’s main competitors, such as Dynergy and Duke energy were not subject to such conundrums because they did not have the same business model and corporate strategy as an Enron. In that they were more plain vanilla companies concentrating on their core energy businesses. They did not enter into many off balance sheet transactions requiring SPEs, had significantly smaller energy trading businesses aimed mainly at hedging price risk. Hence they did not have to restate earnings, shareholder’s equity, mark to market their energy trading contracts and consolidate their SPEs as such.

Overview of the U.S. accounting standards (Comparison between IAS and U.S. GAAP) Before we look into the differences between the U.S GAAP and IASB accounting standard differences we clearly need to understand that Enron used the U.S GAAP over the IASB, and though U.S GAAP accounting standards are exhaustive and detailed, Enron found ways to get past it and exploit the loopholes that existed with the U.S GAAP. Many of the standards set by the IASB are similar to the US’ generally accepted accounting principles (GAAP) in that they strive to be principle based. But they differ in one important respect. While the US rules tends to be more detailed and exhaustive, the IASB-rules favor the approach commonly described as “substance over form”.

Comparing US standards with the IASB-standards the emphasis tends to be on compliance with the rules rather than on the spirit of the accounting standard. The IASB tends to favor an approach that requires the company and its auditor to take a step back and consider whether the accounting suggested is consistent with the underlying principle.

There are many differences between the accounting standards used in the U.S (GAAP) and other standards used across the world, in particular IAS. These standards can differ in magnitude and importance in many instances, from minor interpretation differences to great discrepancies between the policies set forth by these standards. These differences include: At Enron debt avoidance wasn’t merely a strategy for managing its own balance sheet.

It was a way of life that pervaded the company’s deal making culture. Consider Enron Energy Services, which managed energy needs and equipment for big corporate customers. The company held regular seminars to teach employees how to use complex financial vehicles to woo customers, manage earnings, and, naturally, keep debt off balance sheets at Enron and its clients. These deals gave tax and other benefits to customers who outsourced their energy management to Enron. But they certainly highlight Enron’s aggressive philosophy of leveraging its financial acumen.

No doubt Enron was very good at generating the illusion of growth. Its primary tool for this purpose was an accounting technique, much favored by the energy sector, known as “mark-to-market” accounting. Mark-to-market accounting (MTM) allowed Enron to count profits it expected to earn from future energy-related contracts as current earnings profits which meant it was able to boost its earnings and demonstrate quarter by quarter growth. Enron therefore created the illusion of a rapidly expanding, highly liquid and eminently credit-worthy market for natural gas, electrical power, coal and a multitude of other commodity contracts. And not just forward sales of the commodities themselves. The apparent liquidity extended to puts, calls, swaps, collars and other exotic derivative products.

MTM accounting is a standard practice in the US but it is intended for 2-3 years applications and not for 10-20 years. Most authorities now agree that Enron’s use of the technique could be better defined as misuse or abuse but it was not the only energy company using it. In the case of OTC derivatives, MTM value must be reported quarterly on even very far-dated contracts, so long as there can be shown to be liquidity to unwind the deal at any time. Enron expanded the use of MTM to all kinds of forward contracts. The US GAAP rules contrast with the more subjective rules, IASB and others that apply in countries such as Britain. Companies there are required to publish details of subsidiaries over which they have a significant influence. Such a broad definition would arguably have forced Enron to disclose the off-balance-sheet interests as soon as they were set up.

Enron used ’embedded value’ of its own stock, increases in which could not reflect on its own balance sheet under GAAP. The problem with GAAP is it consists of highly prescriptive rules and they can encourage companies to concentrate on complying with the letter of the law rather than its spirit. The controversy over Enron’s off-balance-sheet financial interests is a case in point. The company had to restate its income by $500m after it emerged that the activities of two “special purpose entities” – finance vehicles used to keep debt off the balance sheet – should have appeared in the company’s main accounts.

They should have been included because the stakes held by other parties were less than 3 per cent of the entities’ net assets. The problems highlight a fundamental shortcoming in the rules applied, GAAP. By defining 3 per cent as the benchmark, standard-setters encourage companies to make sure they fall just the right side of the line. The ownership structures of the entities can be convoluted, which means miscalculations or deliberate attempts to mislead may remain unexposed.

Source: www.chron.com