ENRON

Once the seventh largest company in America, Enron was formed in 1985 when InterNorth Natural Gas acquired Houston Natural Gas. The company branched into many non-energy-related fields over the next several years, including such areas as Internet bandwidth, risk management, and weather derivatives (a type of weather insurance for seasonal businesses). Although their core business remained in the transmission and distribution of power, their phenomenal growth was occurring through their other interests. Fortune Magazine selected Enron as "America's most innovative company" for six straight years from 1996 to 2001. Then came the investigations into their complex network of off-shore partnerships and accounting practices. In 1989, Enron started trading natural gas commodities and eventually became the world's largest buyer and seller of natural gas. In the early 1990s, Enron became the nation's premier electricity marketer and pioneered the development of trading in such commodities as weather derivatives, bandwidth, pulp, paper, and plastics. Enron invested billions in its broadband unit and water and wastewater system management unit and in hard assets overseas. In 2000, Enron reported $101 billion in revenue and a market capitalization of $63 billion. In November 1999, Enron launched EnronOnline. Conceptualized by the company's European Gas Trading team, it was the first web-based transaction system that allowed buyers and sellers to buy, sell, and trade commodity products globally. It allowed users to do business only with Enron. At its peak, over $6bn worth of commodities were transacted through EnronOnline every day. EnronOnline went live on November 29, 1999. The site allowed Enron to transact with participants in the global energy markets. The main commodities offered on Enron Online were natural gas and electricity, although there were 500 other products including credit derivatives, bankruptcy swaps, pulp, gas, plastics, paper, steel, metals, freight, and TV commercial time.

Enron Scandal
The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation. The collapse of energy giant

Enron is the largest bankruptcy and one of the most shocking failures in United States corporate history

Reasons of Default
Enron violated GAAP, through incorrect accounting for SPEs including failure to consolidate, selective use of the equity method of accounting, and failure to eliminate the impact of transactions among entities failure to provide complete disclosure unfair financial reporting Mark to Market This was a technique that was previously only used by brokerage and trading companies. With mark to market accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income. This was money that might not be collected for many years. Enron exacerbated many problems by using mark-to-market accounting. Because earnings were recognized immediately for the entire life of the contract, a short-term focus was encouraged and earnings were volatile. Additional contracts had to be sold in the immediate short-term to report any earnings. So Enron expanded mark-to-market accounting to trading in electricity, broadband, fuel additives, and other items that were not commodities, such as deferred tax benefits. For many of these commodities there was no active market, even in the short-term. Because, in many cases, it is doubtful the underlying assets existed, it appears Enron reported fictitious earnings. A major problem was that these estimated earnings did not generate liquidity; cash flow from actual execution of the contracts lagged far behind the recognition of earnings. The risk was enormous. If the market reversed, mark-to-market accounting required the recognition of losses, possibly enormous losses. A huge gap opened between realistic estimation of earnings and Enrons estimations based on aggressive assumptions about interest rates, continuing viability of other parties to contract, taxes, regulations, technology, demand, etc. When changing market conditions necessitated a mark down and the recognition of a loss, Enron hid, delayed or ignored the loss. Andersen apparently did not

question any of the values assigned to the contracts or object to tactics to hide, delay or ignore losses. Some of Enrons most abusive SPEs were created to avoid reporting mark-to-market losses. Often, the viability of these contracts and their related costs were difficult to judge. Due to the large discrepancies of attempting to match profits and cash, investors were typically given false or misleading reports. While using the method, income from projects could be recorded, this increased financial earnings. However, in future years, the profits could not be included, so new and additional income had to be included from more projects to develop additional growth to appease investors Financial reporting of Enrons SPEs SPEs are typically created for purposes such as owning and leasing real estate. Enron had over 3,000 SPEs, many times more than any other company. Initially, some SPEs were legitimate for risk management. However, the vast majority of the SPEs in the years preceding bankruptcy were used to manipulate financial reports. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt. The special purpose entities were used for more than just circumventing accounting conventions. As a result of one violation, Enron's balance sheet understated its liabilities and overstated its equity, and its earnings were overstated. Enron disclosed to its shareholders that it had hedged downside risk in its own illiquid investments using special purpose entities. However, the investors were oblivious to the fact that the special purpose entities were actually using the company's own stock and financial guarantees to finance these hedges. This setup prevented Enron from being protected from the downside risk. 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 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.

Disclosures about SPEs US GAAP specified by the FASB and SEC require disclosure of details about related-party transactions, such as those among Enron and its SPEs, including the nature of the relationship, description of transactions, dollar amounts of transactions, and amounts due to or from the related party at year end. Improper reporting of shares issued Enron issued shares of its stock to several SPEs, executives, and others. Many of the shares were in exchange for notes receivable. US GAAP does not permit recording a receivable in exchange for the issuance of shares of stock. From improper reporting, Enron overstated assets and equities by over $1.2 billion, a material amount, even for a company as large as Enron. Financial audit

Enron's auditor firm, Arthur Andersen, was accused of applying reckless standards in their audits because of a conflict of interest over the significant consulting fees generated by Enron. The auditors methods were questioned as either being completed for conflicted incentives or a lack of expertise to adequately evaluate the financial complexities Enron employed. Enron hired numerous Certified Public Accountants (CPA) as well as accountants who had worked on developing accounting rules with the Financial Accounting Standards Board (FASB). The accountants looked for new ways to save the company money, including capitalizing on loopholes found in the accounting industry's standards, Generally Accepted Accounting Principles (GAAP). One Enron accountant revealed "We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness." Audit committee Corporate audit committees usually meet for just a few times during the year, and their members typically have only a modest background in accounting and finance. Enron's audit committee had more expertise than many.. Enron's audit committee usually had short meetings that would cover large amounts of material. In one meeting on February 12, 2001, the committee met for only one hour and 25 minutes. Enron's audit committee did not have the technical knowledge to properly question the auditors on accounting questions related to the company's special purpose entities. The committee was also unable to question the management of the company due to pressures placed on the committee. The Permanent Subcommittee on Investigations of the Committee on Governmental Affairs' report accused the board members of allowing conflicts of interest to impede their duties as monitoring the company's accounting practices. When Enron fell, the audit committee's conflicts of interest were regarded with suspicion Other accounting issues Enron made a habit of booking costs of cancelled projects as assets, with the rationale that no official letter had stated that the project was cancelled. This method was known as "the snowball", and although it was initially dictated that snowballs stay under $90 million, it was later extended to $200 million.

In 1998, when analysts were given a tour of the Enron Energy Services office, they were impressed with how the employees were working so vigorously. In reality, however other employees were removed to the office from other departments (instructing them to pretend to work hard) to create the appearance that the division was bigger than it was. This ruse was used several times to fool analysts about the progress of different areas of Enron to help improve the stock price.