Issam Chleuh

Accounting 322 – Intermediate Accounting II

Professor William Driscoll, Accounting Department – Suffolk
University

Enron, a paper on the company’s

fraud scheme

In the following lines, I will discuss the Enron scandal. I will start by an

introduction on “cooking the books” in order to give us an idea of why drove Enron

and many other companies into fraudulent activities. I will then talk about Enron, I

will start with an introduction of the company, I will then follow with a discussion of

the fraudulent activities the company where involved in and I will finally present

how the company got caught.

To begin with, what does “cooking the books” mean? Well, companies cook

the books when they do not tell us their real earnings. Managers cook the books and

present us fake earnings to improve their earnings per share (EPS) of stocks. But

why do companies cook the books? Companies cook the books because they have

the pressure to deliver good earnings in order to attract investors to invest in them
and most importantly to keep current investors happy. Let us note that public

companies’ projects are mainly financed by public investors. Executive bonuses are

also tied to the company’s earnings and managers are tempted to manipulate

company’s earnings to receive these big checks (big earnings).

Furthermore, let us discuss the history of Enron. Northern Natural Gas

Company – the ancestor of Enron – was established in 1930. In 1979, InterNorth Inc

bought Northern Natural Gas Company and placed it under a new management. In

the 1980s, the United States Congress passed legislation deregulating the sale of

natural gas. At the beginning of the 1990s, Congress passed a similar legislation

targeted at the sale of electricity. These steps launched a new era in the energy

market, allowing companies like Enron to prosper. In 1985, Kenneth Lay, CEO of

Houston Natural Gas devised a new company and changed InterNorth’s name to

Enron Corporation. This newly formed company was at first involved in distributing

gas and electricity in the US and in selling power plants and pipelines worldwide.

However, the company started to deviate into many non-energy-related fields – i.e.

non-core businesses, such as weather derivatives – weather insurances for seasonal

business, risk management, and internet bandwidth. Even though Enron’s core

business remained gas and electricity, most of the company growth came from

those non-core businesses.

How fraud happens at Enron? This is going to be the topic of this paragraph.

Let us start by saying that the Enron fraud case was extremely complex. People say

that the roots for the Enron scandal date back to the beginning of the 1990s. In fact,

in 1992, Jeff Skilling, who was the president of Enron’s trading operations, convinced

federal regulators to allow Enron to use mark to market accounting. Mark to market

accounting is “a measure of fair value of accounts that can change over time, such
as assets and liabilities. Mark to market aims to provide a realistic appraisal of the

institution or company’s current financial situation” (source: investopedia). When

market-based measurement - mark to market accounting in our case - does not

accurately reflect the underlying asset’s true value, problems can arise. This is what

is happening in the economy with fair value FAS 157. With FAS 157, companies like

private equities for instance are forced to calculate the selling price of their assets

or liabilities during this unfavorable volatile time. Investors are fearful and thus

liquidity is low and makes the selling price of the asset or liability very low, which

brings the value of the asset or liability to an all time low level. Conversely,

companies can use mark to market accounting unethically, which is what Enron did.

Enron used mark-to-market accounting for its energy segment in the 1990s and

used it excessively for its trading transactions. Under this accounting rule, when

companies have outstanding contracts, energy-related or derivatives ones, on their

balance sheets at the end of a quarter, they must appraise them using fair value

and record unrealized gains and losses to the quarterly income statement. The

subtlety is that there are no quoted prices upon which to base valuations for long-

term future contracts in commodities such as gas. Companies with these types of

derivatives are free to value those assets or liabilities using their own models and

based on their own assumptions and methods. Using mark-to-market accounting

allowed Enron to count projected earnings from long-term energy contracts as

current income. Those contracts represented money that might not be collected for

many years. Investigators found that this accounting method was used to

overestimate revenue by manipulation of future revenue. For instance, unrealized

gains accounted for a little more than of Enron’s $1.1 billion reported pretax profit

for 2000. The use of this accounting measure, as well as the use of other
questionable measures, made it difficult for the public to see the business model of

Enron. In fact, the numbers were recorded on the books but the company was not

paying equivalent taxes (unrealized gains).

Moreover, we know that Enron has been buying a big number of ventures

that looked promising. We know that Enron has also been creating off balance sheet

entities in order to remove the risk of their financial statements. However, how did

the company implement these operations? Because of the use of mark-to-market

accounting explained above, Enron recorded all-time high revenues. The company

thus wanted to be involved in other areas. For instance, Enron was buying or

developing an asset – such as a pipeline – and then was expanding through a

vertical integration (buying a retail business around that pipeline for instance). This

strategy required huge amounts of initial investments and was not going to

generate earning or cash flow in the short term. If Enron elected to present this

strategy on its financial statements, it would have placed a big burden on the

company’s ratios and credit ratings, and credit ratings investment grade was crucial

for Enron energy trading business. In order to find a solution to this issue, Enron

decided to look for outside investors who would like to make those deals with them.

Those combined investments required Enron to present a guaranty or another form

of credit proof. Because of that, Enron decided to organize these investments as

Special Purpose Entities (SPE). Also, since Enron’s executives believed Enron’s long-

term stock would remain high, they looked for ways to use the company’s stock to

hedge its investments in these SPEs. Enron did this through a complex

arrangement of special purpose entities the company called the Raptors. The

Raptors were created to cover those SPEs losses if their stocks were falling. When

the telecom industry experienced its first decline, Enron experienced poor financial
performance as well. In fact, when Enron stocks fell below a certain level, it caused

the Raptors’ stock to collapse. This is mainly due to the fact that the Raptors’ stocks

were back up by Enron’s stock (through the hedging described above). The telecom

industry downturn was thus the underlying event that uncovers the fraud scheme at

Enron.

Issam Chleuh