Identification of Financial Fraud in Enron

INVESTMENT, TAXATION AND FRAUD EXAMINATION: ASSIGNMENT 3
5523S1531: Investment, Taxation, and Fraud Examination
Assignment 3: Identification of financial fraud in Enron Corp.
Submitted To: Dr. John H. Nugent

Submitted By: Arif Ahmed
This paper is submitted in partial fulfilment of the requirements of course on Investment,

Taxation, and Fraud Examination
SMC University
March 25, 2012
2
Contents
Abstract.............................................................................................................................................3
Background Rise and fall of Enron...............................................................................................4
Financial frauds................................................................................................................................5
Fraud and Audit................................................................................................................................7
Detecting financial distress...............................................................................................................7
Detecting financial fraud................................................................................................................14
Study of financial performance of Enron.......................................................................................16
Study of incomplete disclosures of Enron......................................................................................30
Conclusions....................................................................................................................................31
Reference........................................................................................................................................32
Table I: Common Size Statement Balance Sheet........................................................................35
Table II: Statement of Cash Flow...................................................................................................38
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Abstract
Fraud detection is one of major challenges to financial community. Failures of large
corporation like Enron only highlighted the ability of the large corporate to misguide investing
community and finance professionals. There is no shortage of appropriate tools that can identify
such fraud before they reach alarming proportion. This study reviewed various tools available for
fraud detection and employed them on Enron. The study found that majority of the tools could
have easily identified the wrong doing of Enron at early stages of such commitment.
4
Background Rise and fall of Enron

On 2nd October, 2002, Andrew Fastow, former Chief Finance Officer of Enron voluntarily
surrendered to FBI. He was charged with securities fraud, mail fraud, wire fraud, money
laundering, and conspiracy using partnerships that were kept off from the books of Enron. This
marked the last leg of the journey of Enron from a small company to a path-breaking company
instrumental in changing the way old businesses were done and then finally the biggest
bankruptcy of the time in USA epitomising corporate deceit and connivance (Fox, 2003). The
Enron story commences in 1985 and grew in next fifteen years from a large natural gas pipe line
company to an energy trading firm dealing with gas and electricity. In fact Enron had forayed into
non-energy business and entered into deals in metals, paper, financial contracts, commodities, etc.
In fact, the trading business of Enron far outgrew the energy business and Enron revenues grew
from $4.6 billion in 1990 to $101 billion in 2000, making it the seventh largest US Corporation.
Since the growth of Enron was prompted by acquisitions there was significant
accumulation of debt while these investments had long gestation period. At the same time Enron
focused on achieving a minimum US$1 billion of annual profit, 15% annual growth rate, and a
double digit growth (Tebogo, 2011). All these required additional lines of credit which was
difficult to come by in view of existing high debt and associated problem of servicing them.
These compelled Enron to resort to financial and legal shenanigans including recognising
revenue ahead of delivery of energy as well as divesting low return investments to entities within
the same group though legally separate.
5
It was later observed that behind the remarkable growth there were morbid tales of using
partnerships to hide losses and debts. The discovery caused share prices of Enron come down
from a high of US$90 to 36 cents.
The fall of Enron was caused by several factors including the following (Moyer,
McGuigan, & Kretlow, 2005):
1. Poor profit margin from the core energy business which was otherwise growing at a very
fast pace.
2. A number of unprofitable investments were made by Enron including setting up fibreoptic capacity and trading facilities, power plant in India, water business in England, and
electricity distribution in Brazil. Each having significant investment, the cumulative
impact was severe.
3. Enron created a complex series of partnership to keep assets and debt obligations out of
their own balance sheet. The debt obligations required repayment of some off-balance
sheet debt if the corporate credit rating or stock prices went down below a specified level.
When such situation emerged, despite having great leverage potential, Enron failed to
raise capital from the market leading to these debt obligations being dishonoured.
Across the diverse opinions regarding cause of the failure, the gross failure of financial
analysts to foresee the failure from the audited financial statements raised serious questions
on ability of such statements to foresee a fraud.
Financial frauds
SAS 99 (AICPA, 2012) recognises fraud to be a legal concept and limits the auditors
focus on acts that have caused material financial misstatement. The line of distinction between
6
fraud and error remains intent. Fraud is an intentional act while error in unintentional. Fraud has
been classified in the following two groups:
1. Misstatements arising from fraudulent financial reporting: These are deliberate
misstatements or omissions committed with an intention to deceive the users of financial
statement. These are usually committed by compromising accounting records, falsifying
or omitting impact of significant events, and misapplication of accounting principle.
2. Misstatement arising from misappropriation of assets: These are cases of
misappropriation of assets of the entity and hiding the impact thereof in the financial
statements.
SAS 99 identifies three conditions as conducive for a fraud. These are as follows:
1. Incentive: The management and employees have an incentive or are under pressure to
commit fraud
2. Opportunity: There are circumstances including lack of ineffective control that provides
an opportunity to commit fraud.
3. Rationalise: The executives involved in fraud can rationalise their fraudulent act by
ascribing it to compulsion of some kind or other.
One major stakeholder in the process of fraud prevention is the press. Much as the press
can act as a watchdog for financial frauds they themselves face a trade-off between the benefits
of providing a relevant story and potentially alienating business partners (Miller, 2003). It was
observed that the press is more likely to report a financial fraud if the cost of information
collection is low and it involves management misappropriation of fund, insider trading, or
involves material misstatement.
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Fraud and Audit
One of the major reasons behind failure of auditors to identify fraud is the overt attention
to financial measures. It has been observed (Brazen, Jones, & Zimbelman, 2009) that if the
auditors and other stakeholders identify non-financial measures that are correlated with financial
measures, any inconsistency between them can provide valuable insight to possible fraud. Under
SAS 99 (AICPA, 2012) auditors are required to assess the presence and impact of possible frauds
on the audit. In a major departure from conventional audit philosophy of presuming the audit
object to be free from errors and frauds unless there are evidence to the contrary (The Kingston
Cotton Mill Company Limited, 1896), SAS 99 requires the auditors to exercise professional
scepticism when considering the possibility that a material misstatement due to fraud could be
present. SAS 99 clearly states that auditors have responsibility to plan and perform the audit in a
way that can provide reasonable assurance that the financial statements are free from material
statement caused erroneously or fraudulently.
Brainstorming by auditors to generate ideas of possible fraud is a useful way of being
sensitised to fraud risks (Carpenter, 2007). It was also observed that though brainstorming
reduces overall ideas generated, but improves on the quality of the fraud idea. It has also been
observed that auditors who find more fraud ideas employ audit procedures that better targets
possible frauds (Simon, 2008).
Detecting financial distress

Early detection of financial distress has been a challenge to professionals and
academicians alike. Such detection efforts have generally focused on identifying variables that
8
can predict a financial collapse. It may be noted that fraud can be one of the reasons for distress
as much as poor business performance. One of the pioneering works in this area is known as
Altman Z score (Altman, 1968). The model is based on multivariate analysis ascribing weights to
factors that can predict financial solvency of a company. The factors that were considered for this
purpose represented liquidity, past profitability, present profitability, leverage, and sales turnover
of the organisation. The basic model observed the following:
Mean of
Variable
Mean of non-
Computation
F-ratio
Bankrupt Group
bankrupt group
X1
Working capital / Total assets
-6.1%
41.4%
32.60
X2
Retained earnings / Total assets
-62.6%
35.5%
58.86
X3
EBIT / Total assets
-31.8%
15.6%
26.56
40.1%
246.7%
33.26
1.5 times
1.9 times
2.84
Market value of equity / Total

X4
debt
X5
Sales / Total assets
These values resulted in the following model:

Z = 0.012X1 + 0.014X2 + 0.033 X3 + 0.006X4 + 0.999X5
Altman observed that a lower bound of 1.81 for failure and upper bound of 2.99 for nonfailure as optimal. Z-score between 1.81 and 2.99 was considered as zone of ignorance. Altman
had modified his model in 2000 and it stood as follows:
Z = 0.717X1 + 0.847X2 + 3.107 X3 + 0.420X4 + 0.998X5
The functionality and applicability Altman model was significantly enhanced in Emerging
Market Score Model (Altman E. I., 2002). The EM score is computed as under:
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EM Score = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4+ 3.25 where
X1 = Working capital / Total assets
X2 = Retained earnings / Total assets
X3 = Operating income / Total assets
X4 = Book value of equity / Total liability
The EM score is computed and the equivalent rating is obtained by matching the score with US
bond rating equivalence shown below (Caoette, Altman, Narayanan, & Nimmo, 2008):
Z-score Bound
Rating
Zone
Z Score Bound
Rating
>8.15
AAA
5.65
5.85
BBB-
7.60
8.15
AA+
5.25
5.65
BB+
7.30
7.60
AA
4.95
5.25
BB
7.00
7.30
AA-
4.75
4.95
BB-
6.85
7.00
A+
4.50
4.75
B_
6.65
6.85
4.15
4.50
6.40
6.65
A-
3.75
4.15
B-
6.25
6.40
BBB+
3.20
3.75
CCC+
5.85
6.25
BBB
2.50
3.20
CCC
1.75
2.50
CCC-
<1.75
1.75
Grey Zone
8.15
Distress Zone
Safe Zone
Zone
A Z-score type model was developed for small and medium enterprises employing following
five aspects of financial strength (Altman & Sabato, 2005).
1. Leverage: Short-term debt / Book value of equity
2. Liquidity: Cash / Total assets
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3. Profitability: EBITDA / Total assets
4. Coverage: Retained Earnings / Total assets
5. Account: EBITDA / Interest expenses
Another variation of the Z-score is computed as following (Nugent, Pustylnick, & Anderson,
2010). This model suggests that for Z-score of above 3.0 bankruptcies is not likely and for scores
below 1.8 bankruptcies is likely. Score between 1.8 and 3.0 are the grey areas the zone of
uncertainty.
Z = 1.2X1 + 1.4X2 + 3.3 X3 + 0.6X4 + 1.0X5 where
X1 = Working capital / Total assets
X3 = EBIT / Total assets
X4 = Market value of equity / Book Value of debt
X5 = Net Sales / Total assets
Further variation of Z-score, known as P-score uses the following components and weight
(Pustylnick, 2011):
Z = 1.2X1 + 1.4X2 + 3.3 X3 + 0.6X4 + 1X5 where
X1 = Shareholders equity / Total assets
X3 = EBIT / Total assets
X4 = Market value of equity / Book Value of debt
X5 = Revenue / Total assets
Another major tool of forecasting financial failure is C-Score, also known as Chanos
Algorithm (Nugent, Pustylnick, & Anderson, 2010). Chanos score is computed as following:
11
[Working capital (Current Assets) + Retained earnings + Trailing EBIT of 12 months + Trailing
revenue of 12 months] / Average to total asset of 12 month. It has been observed that Chanos
score trend in the same direction as Altman Z or Pustylnick P score.
A probit model for identifying financial characteristics of firms that are likely to
manipulate earnings used eight ratios known as Beneish ratios (James, Stickney, Brown,
Baginski, & Bradshaw, 2010). These are discussed below:
1. Days sales in receivables index (DSRI): This is computed by relating the ratio of
accounts receivables with sales at current year end with the same ratio of last year end.
Often a high fictitious increase in sales is complemented by an increase in accounts
receivable.
2. Gross margin index (GMI): This relates gross margin as a percentage of sales of last
year with the similar percentages of last year. A decline in gross margin will cause a ratio
to be less than 1.
3. Asset quality index (AQI): This computes the share of assets other than current assets,
property, plant and equipment, and security investments in total assets. Remaining assets
are mostly intangible with less certain future benefits. An increase in the index value may
be caused by an increased capitalisation of a rightfully revenue expense.
4. Sales growth index (SGI): This relates the sales of consecutive two years. Though such
growth is not necessarily manipulative but includes such possibility to attract finance.
5. Depreciation index (DEPI): This is expressed as the ratio of depreciation to predepreciation net property, plant, and equipment value of current year with similar ratio of
previous year. A less than 1 ratio may be prompted by a reduced rate of depreciation
effected by lengthening useful life.
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6. Selling and administrative expense index (SAI): This is computed as a ratio of such
expenses with sales value of current year with similar ratio of past year. An index value of
greater than 1 would suggest higher marketing expense in anticipation of future sales. If
the firm fails to increase sales, chances of earning manipulation increases.
7. Leverage index (LVGI): This index is computed by relating ratios of current liabilities
and long term debt to total financing in two consecutive years. An increased debt
enhances the chances of failing debt covenants and consequently resorts to manipulations.
8. Total accruals to total assets (TATA): This ratio is arrived by dividing total accrual by
total asset where total accrual is the difference between income from continuing operation
and cash flow from operations. A high ratio indicates unrealised revenue that has been
recognised in the financial statements.
Beneish has proposed a composite index computation framework, named M-Score with
following values (Beneish, 1999):
Y = - 4.840 + 0.920 DSRI + 0.528 GMI + 0.404 AQI +).892 SGI + 0.115 DEPI 0.172 SAI
0.327 LVGI _ 4.670 TATA
Another set of eleven ratios were proposed by Grove and Cook (2004). The ratios
proposed are as under:
1. Valuation
a. Price to Book Value
b. Price to Earnings
c. Price to Sales
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d. Price to Cash Flow
2. Profitability
a. Profit margin
b. Top line growth (%)
c. Bottom line growth (%)
3. Management Effectiveness
a. Return on Assets (%)
b. Return on Equity (%)
4. Financial Strength
a. Current Ratio
b. Debt equity ratio
Detecting financial fraud

In addition to designing of tools focused on identifying financial distress, efforts have also
been made to identify financial frauds. It has been admitted earlier that financial fraud can lead to
financial distress much as poor business performance can. A fraud prediction model was
constructed using factors relating to pressure and opportunity the primary enablers of fraud
(Skousen & Wright, 2006). This model is constructed as following:
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FRAUD i = + 1NICFOTAi + 2SGROWi + 3AGROWi + 4SALARi + 5SALTAi +
6FREECi + 7LEVERAGEi + 8OWNERSHIPi + 95%OWNi + 10ROAi + 11FOROPSi +
12BOUTPi + 13AUDCOMMi + 14AUDCSIZEi + 15INDi + 16AUDMEETi + 17CEOi +
18AUDCHANGi + 19AUDREPORTi + 20TATAi + i
The following table explains the risk factors used along with their classification under
SAS 99 (AICPA, 2012) and basis of computing values of each of these risk factors.
SAS 99 Factors
Category
Legend
NICFOTA
SGROW
Financial
stability
Pressure factors
External
Pressure
AGROW
(Operating income Cash flow from

operations) / Total assets
Change in sales Industry average
change in sales
Average % change in total assets for
two years before the year of fraud
SALAR
Sales / Accounts Receivable
SALTA
Sales / Total assets
FREEC
LEVERAGE
OWNERSHIP
Personal
Financial Need
Definition
Net cash flow from operating activities

cash dividend capital expenditure
Total debt / Total assets
The cumulative percentage of
ownership in the firm held by insiders
Percentage of shares held by
5% OWN
management who hold greater than 5%

of the outstanding shares
Financial
Targets
ROA
Return on assets
15
SAS 99 Factors
Category
Nature of
Industry
Legend
Definition
FOROPS
Foreign sales / Total sales
BOUTP
Percentage of board members who are

outside members
A dummy variable where 1 = mention
AUDCOMM
of oversight by an internal audit

committee and 0 = no such mention
Ineffective
Opportunity
Monitoring
AUDSIZE
IND
AUDMEET
The size of audit committee scaled by

board size
Percentage of audit committee members
who are independent of the company
The number of audit committee meeting
held
Binary value with where value is 1 if
CEO
chairperson holds managerial position

and otherwise 0
A dummy variable for change in
AUDCHANG
auditor: 1 = change in auditor in 2 years

prior to fraud occurrence and 0 = no
change
Rationalisation
Rationalisation
A dummy variable for an audit: 1 =

AUDREPORT
unqualified opinion and 0 = unqualified

opinion with additional language
TATA
Total accruals / total assets
16
In an interesting study of assessing performance of a company based on usage of negative
words in the text of financial reports, it was observed textual analysis contributes to improved
predictive ability along with traditional financial variables (Loughram & McDonald, 2011). It
was also observed that most of words that have negative implication is common parlance are not
considered negative is financial usage.
Study of financial performance of Enron
A review of the financial performance of Enron between 1996 and 2000 brings out that
the focus was mostly on growth of balance sheet rather than on profitability or stability. The
following section describes various aspects of the analysis.
Poor profitability
The profitability of Enron in the years of study shows a very low percentage when
expressed against total revenue. In fact, other income has often been contributing more than the
operating income as is evident from the table below
Operating Income
Other Income
Gross Income
Net Income
2000
2%
0%
2%
1%
As on 31st December
1999
1998
1997
2%
4%
0%
3%
1%
3%
5%
5%
3%
2%
2%
0%
1996
5%
4%
9%
4%
A closer evaluation of the components of revenue and cost expressed as a percentage of

total revenue reveals that earning from the main operating segments were even negative. This is
excluding other operating expenses and depreciation.
Share of revenue
Natural Gas and Other products
2000
As on 31st December
1999
1998
1997
1996
50%
49%
84%
42%
65%
17
34%
38%
45%
25%
7%
Electricity
84%
87%
87%
90%
91%
Total Share of Revenue
94%
87%
84%
85%
79%
Cost of gas, electricity, and other products
It is to be noted that in the years 1999 and 2000, Enron actually lost money in the main
line of activity. It was earning from metals (1999: 0%, 2000: 9%) and other sources (1999: 13%,
2000: 7%), both in 1999 and 2000 as a percentage to total revenue that prevented Enron from
having an operating loss.
Mark to market
A study of the accounting policies of Enron reveals use of mark to market accounting for
the price risk management activities which includes exposure in forwards, swaps, options, and
other derivatives. These are reflected in fair value in the Balance Sheet and the impact of
valuation difference, unrealised gains, and losses were recognised under other revenues. The
cash flow impact of the same was considered as cash flows from operating activities in the
consolidated statement of cash flow.
The importance of assets from price risk management activities can be understood from
the following table expressing this asset as a percentage of total assets.
Assets from price risk management activities

Included in current assets
Included in Investments and Other Assets
Total Share in Total Assets
Liabilities from price risk management activities
Included in current liabilities
Included in Deferred credits and Other liabilities
Total share in Total Liabilities
2000
1999
1998
1997
18%
14%
32%
7%
9%
16%
6%
7%
13%
6%
5%
11%
16%
14%
30%
6%
9%
15%
9%
5%
14%
6%
4%
10%
18
It is noteworthy that increasing part of the total assets and liabilities of Enron comprised
of volatile assets and liabilities. This also shows that Enron has been increasingly moving away
from a traditional energy company to an energy trading company.
Reporting agency earnings at contract value

Enron has increasingly focused on the wholesale energy services where they entered
market early and acted as a market maker. This was supported aggressively by Enron Online
which was launched in 1999 and handled 548000 transactions with a gross notional value of USD
336 billion in the year 2000 (Enron, 2000).
The trading activity of Enron was reported in the notional value. Using merchant model
of accounting Enron reported all the transactions at the value of the trade instead of at the amount
earned as brokerage and trading fees. Under the merchant model, the object of the trade was
taken over by Enron, including the risk of selling and collecting the accounts receivables. Though
not illegal to adopt, usage of this method allowed Enron to report their revenues and cost of
goods sold at least fifty times over what would have been reported under traditional accounting
where only the revenue earned would have been recognised as is evident from the following table
(Rapoport & Dharan, 2004).
Particulars
Reported operating revenues (Million USD)
Less: Reported cost of goods sold (Million USD)
Gross Profit (Million USD)
Per cent revenue growth reported by Enron
Per cent real revenue growth
2000
1999
1998
100,789
40,112
31,260
94,517
34,761
26,381
6,272
5,351
4,879
151.3%
28.3%
17.2%
9.7%
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This is one reason why Enron had such poor profit ratios, a weakness which was
successfully obscured by a great growth story. Reporting under alternative method of accounting
would have relegated rank of Enron from number 7 to number 287 in the Fortune 500 list.
Special purpose entity

The increased impact of energy trading and its potential to adversely affect Enron, prompted
Enron to use off-balance sheet financing vehicles to finance many such transactions. These
special purpose entities were also used to offset investment losses incurred by Enron by posing
these as third party entities hedging the loss. The fact remained that Enron had substantial stake
in these entities. A special purpose vehicle can be treated as a separate entity if following two
conditions are met (Barreveld, 2002):
1. There must be a 3% owner of that entity independent of the reporting company
2. The independent owner must have control over the SPE
If these conditions are fulfilled the reporting entity can book profits and losses with such
organisation and are also not required to consolidate the balance sheet and income statement.
Enron used these rules to hide huge losses and liabilities, often by misrepresenting the extent of
control over such special purpose vehicles.
Business Model and Stability
20
The income statement of Enron over five years (1996-2000) was studied to arrive at the
average structure of the income statement as percentage of total revenue. The coefficient of
variation as computed to find out how stable was the structure around the average across these
five years. The results of the study are provided in the following table.
Coefficient
Income Statement
Revenues
Natural Gas and other products
Electricity
Transportation
Metals
Other
Total Revenue
Cost and Expenses
Cost of gas, electricity and other products
Operating expenses
Oil and gas exploration expenses
Depreciation, depletion and amortization
Taxes, other than income taxes
Contract restructuring charge
Impairment of long-lived asset
Total Costs and Expenses
Operating Income
Other Income and Deductions
Equity in earnings of unconsolidated affiliates
Gains on sales of assets and investments/ non merchant assets
Gains on issuance of stock by RNPC, Inc.
Interest Income
Other income, net
Income Before Interest, Minority Interests and Income Taxes
Interest and related charges, net
Dividends on company-obligated preferred securities of
subsidiaries
Minority interests
Income Tax expense (benefit)
Net Income before cumulative effect of accounting changes
Cumulative effect of accounting changes
Net Income
Average of variation
58%
30%
2%
2%
8%
100%
29%
48%
107%
224%
47%
0%
86%
7%
0%
2%
1%
1%
0%
97%
3%
6%
37%
97%
42%
45%
224%
224%
2%
76%
1%
1%
0%
0%
0%
5%
2%
79%
87%
224%
148%
84%
56%
30%
0%
0%
1%
2%
0%
2%
44%
46%
160%
71%
-224%
73%
21
Preferred stock dividends
Earnings on common stock
0%
2%
42%
76%
It may be observed that though the total costs and expenses remained fairly stable around
97% of the total revenue, share of each individual constituent varied radically with exception of
cost of gas, electricity, and other products. It is interesting to observe that Enron did not report
any expenses on Oil and Gas Exploration in 1999 and 2000, a testimony to the fact that the
company was moving away from a manufacturer to a trader.
Balance Sheet Analysis

The fact of shift of emphasis is also evident from the structure of the balance sheet. Under
the head of report of Property, plant, and equipment, major components were totally replaced
and restated between 1997 - 1998 and 1999 2000 as is shown in the table below:
Property, Plant, and Equipment, at cost (USD Million)

Exploration and production, successful efforts method
Transportation and distribution
Wholesale energy operations and services
Retail energy services
Corporate and other
Natural gas transmission
Electric generation and distribution
Fibre optic network and equipment
Construction in progress
Other
Less: Accumulated depreciation, depletion, and amortization
Property, and Equipment, Net
2000
6916
4766
839
682
2256
15459
3716
11743
1999
1998
4814
5481
4858
141
498
1997
4291
5279
3879
44
249
6948
3552
379
1120
1913
13912 15792
3231 5135
10681 10657
13742
4572
9170
22
An analysis of common size statement of Balance Sheet of Enron from 1997 to 2000 brings out
interesting observations. The complete common size statement is produced in Table I in the
annexure.
Balance Sheet
ASSETS
Total current assets
Total investment and other assets
Total Assets
LIABILITIES AND SHAREHOLDERS EQUITY
Total current liabilities
Long term debt
Total deferred credits and other liabilities
Commitments and contingencies
Minority Interests
Company obligated preferred securities of subsidiaries
Total shareholder's Equity
Total Liabilities and Shareholder's Equity
2000
1999
1998
1997
46% 22%
36% 46%
18% 32%
100% 100%
20%
43%
36%
100%
18%
41%
41%
100%
43% 20%
13% 21%
21% 19%
4%
7%
1%
3%
0%
0%
18% 29%
100% 100%
21%
25%
19%
0%
7%
3%
24%
100%
17%
28%
21%
0%
5%
4%
25%
100%
The overall change of the structure of the balance sheet is noteworthy. The shareholders
equity decreased consistently as a percentage of totals of the balance sheet but the decrease was
covered by enhanced current liability. Thus the dependence on short term source for funding is
evident which will lead to a serious structural issue in terms of increased duration gap (Kolb &
Overdahl, 2007). The mismatch of maturity profile of assets and liabilities are indicators of
serious asset liability management problem for the Enron which can lead to eventual bankruptcy.
This observation is also reflected in the cash flow statements. The share of net income in
net cash provided by operating income has been going down and is being replaced by proceeds
from sales of assets and investments, an ominous sign that Enron was divesting of its assets. This
was also complemented by movement in working capital component in the year 2000. It later
23
became public knowledge that the divestments were mostly to associate companies and were
more of book entries than being actually realised revenue. This inflow was being used in
investing activities including repayment of long and short term debts. At the same time Enron
was inducting new long term debts which was merely changing the debt composition rather that
debt equity ratio. Thus effectively proceeds from release of working capital and sale of merchant
assets were being used to repayment of debts. The cashflow statement of Enron is provided in
Table II of the annexure.
Pustylnick Modified Altman

The following table shows computation of the Pustylnick modified Altman score of Enron
for five years.
Computation Factors
Weight
2000
1999
1998
1997
1996
Shareholders Equity /Total Asset
1.2
0.210
0.344
0.288
0.288
0.277
Retained earnings / Total assets
1.4
0.001
0.001
0.001
0.003
0.002
EBIT / Total Assets
03.3
0.001
0.002
0.002
0.001
0.003
Market value of equity / Total debt
0.6
0.048
0.027
0.016
0.013
0.022
0.999
1.537
1.200
1.064
0.865
0.823
1.797
1.574
1.371
1.170
1.127
Revenue / Total assets

Z Score
The computed P-score clearly established Enron a probable candidate for bankruptcy the
score being less than 1.8 in all cases. It was evident that the problem of Enron could have been
identified at an earlier stage.
24
Chanos Discriminant Function
The value of Chanos discriminant function can be computed as below:
Computation Factors
2000
1999
1998
1997
1996
2.090
1,560
1.397
1.168
1.271
[ Working capital (Current Assets) + Retained

earnings + Trailing EBIT of 12 months + Trailing
revenue of 12 months ] / Average to total asset of
12 month
The Chanos discriminant score maintains a close correlation with Pustylnick P-score
signifying its efficiency in foreseeing failure of Enron.
Beneish Ratios
Following table shows select Beneish ratios for Enron for the five years of study.
Ratios
2000
1999
1998
1997
1996
Days sale in receivables index
1.38
0.96
0.15
0.63
1.45
Gross margin index
1.03
2.21
0.02
70.18
1.30
Asset quality index
0.77
1.06
1.06
1.31
Sales growth index
2.51
1.28
1.54
1.53
1.45
Total accruals to total assets index
0.05
0.14
0.19
0.19
0.28
The mean value of these ratios for manipulators and non-manipulators are given below
(Golden, Shalak, & Clayton, 2006):
Ratios
Non-manipulators
Manipulator
25
s
Days sale in receivables index
1.031
1.465
Gross margin index
1.014
1.193
Asset quality index
1.039
1.254
Sales growth index
1.134
1.607
Total accruals to total assets index
0.018
0.031
The ratios computed above bring forth the following salient revelations:
1. Since 1998 the days sale in receivable index shows an increasing trend culminating in a
value exceeding 1 in the year 2000. This signifies that the component of accounts
receivable in total sales was increasing. These are usual when either the entity
aggressively uses credit to boost sales or have non-moving debtors. Possibility of
artificially enhancing sales cannot also be ruled out.
2. The gross margin ratio was at extreme ends in the years 1997 and 1998 compared to the
previous year suggesting possible manipulation.
3. The asset quality index was away from the benchmark for non-manipulators indicating
increased capitalisation. This is also supported by the fact that Enron observed successful
extraction method to capitalise the oil exploration costs and capitalised the cost of
development of software for internal use.
4. The sales growth index has been breaching the non-manipulators mark even in the earlier
years. We have discussed elsewhere how focused was Enron to show high growth rate and
their selective adoption of accounting policies helped them in achieving a high growth
rate in sales.
26
5. Similar situation is observed from the values of accruals to asset base index implying
accelerated accruals using the credit policy.
Summarily the Beneish ratios unequivocally pointed out towards the possible manipulation in
the financial statements of Enron.
Grove and Cook Ratios:
The Grove and Cook ratios for performance appraisal are computed below (Tebogo,
2011):
Category
Ratio
2000
1999
1998
1997
1996
Price to Book Value
1.04
0.97
0.67
0.59
0.75
75
38
28
141
21
0.68
0.80
0.62
0.68
0.91
50
112
176
81
47
Profit margin
0.97
0.89
0.70
0.10
0.58
Top line growth (%)
151
28
54
53
45
Bottom line growth (%)
10
27
570
82
13
Management
Return on Assets (%)
1.5
2.7
2.4
0.4
Effectiveness
Return on Equity (%)
10
1.9
16
Current Ratio
1.07
1.07
0.97
1.06
1.07
Debt equity ratio
0.75
0.75
1.04
1.11
0.90
Valuation
Price to Earnings
Price to Sales
Price to Cash Flow
Profitability
Financial Strength
Analysis of these ratios brings out the following highlights:

1. Despite the great growth rate, the market valuation of Enron has been extremely poor. In
fact except in 2000, the market did not even recognise the book value of the company.
This may also indicate that the market was not convinced on the financial reports of
27
Enron. This is also reflected in the low price earning and price to sales ratios. The high
price to cash flow was contributed greatly by aggressive recognition of revenue by Enron
despite low realisation.
2. The profitability ratios were very low though the growth rate was extremely high. In fact
the year on year growth rate of Net income was 570% in 1998 whereas the revenue
growth was 54%. Similarly in the year 2000, revenue growth was 151% as against a net
income growth of 10%. These non-conforming signs were strong indicators that
something was not right in the reported values or management strategy of Enron.
3. The overt focus on growth is clearly reflected in the poor return on assets and return on
equity ratios. This also reflects the aggressive policy of capitalisation of expenses as
assets which leads to a greater asset base. Similarly the current ratio shows a consistently
aggressive stand indicating lack of liquid assets to pay off the creditors. The current
liabilities was 43% of total assets in the year 2000 and 16% of the same was liabilities for
price risk management activities. Current assets were 46% of total assets wherein 18%
were assets for price risk management activities. The debt equity ratio was more
contributed by the fact that Enron used special purpose vehicle to book these liabilities.
It is obvious that use of Grove and Cook ratios would have also alerted the analysts about the
rampant accounting and strategic manipulations that Enron was resorting to.
Study of incomplete disclosures of Enron
Large number of disclosures in the Enron annual report for the year 2000 was incomplete,
if not misleading. Some of the instances are stated below (Bierman, 2008):
1. Derivatives: The notes do not reveal the types of derivatives it had with the associate
company JEDI and associated obligations of Enron.
28
2. The fair value of plan assets (USD 858 Million) and benefits obligation (USD 745
Million) under employee benefits plan seemed well matched. The disclosure did not
reveal that assets included ESOP of Enron valued at USD 166 million which actually
brings down the asset value to USD 742 million.
3. The extent of related party transaction was not disclosed.
The problem in these cases was not legality but intent. Analysts focused mostly in what was
disclosed and not on what was not. This is where SAS 99 comes in useful by suggesting
consideration of possible fraud while preparing the audit plan.
Conclusions
It must be noted that best use of ratio analysis requires understanding of the associated
limitations. Some of the major limitations are described below (Guerard, Guerard, & Schwartz,
2007):
1. Ratios differ from an industry to another
2. Misleading financial disclosures will generate misleading ratios.
3. The impact of seasonal factors should be understood
It must also be noted that whenever we relate an item in the balance sheet with another in the
income statement, we are comparing a period data with a time data. This usage is prone to
misleading interpretations. For example if the inventory level goes up in the last day of the
29
accounting year, all ratios involving inventory will change though, in reality, the impact of the
high value was very limited.
The analytical framework for assessing potential fraud may also focus on adequacy of capital
in face of various risks faced by the entity. A company with adequate capital is less likely to be
terminally affected by a fraud or adverse impact from normal business risk exposure. Usage of
due diligence process including quantitative analysis can contribute significantly to assess
performance credibility (Clauss, Roncalli, & Weisang, 2009). Much as it is necessary to prevent
fraud, it is equally important to survive the impact of fraud. Provision of adequate amount of
capital is a strong step in that direction.
30
Reference
The Kingston Cotton Mill Company Limited, 2 (CA 1896).
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http://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU00316.pdf
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CPAs:
http://www.aicpa.org/InterestAreas/ForensicAndValuation/Resources/FraudPreventionDet
ectionResponse/Pages/Summary%20of%20SAS%20No.aspx
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Bierman, H. (2008). Accounting/finance lessons of Enron: a case study. Singapore: World
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Golden, T. W., Shalak, S. L., & Clayton, M. M. (2006). A guide to forensic accounting
investigation. New Jersey: John Wiley and Sons.
Grove, H., & Cook, T. (2004). Lessons for Auditors: Quantitative and Qualitative Red Flags.
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Guerard, J., Guerard, J., & Schwartz, E. (2007). Quantitative Corporate Finance. Springer: New
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Loughram, T., & McDonald, B. (2011). When is a Liability not a Liability? Textual Analysis,
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Ohio: Cengage Learning.
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TIME FOR A REFERENDUM? Retrieved from http://ssrn.com/abstract=1579785
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Risks. Las Vegas: Department of Accounting, University of Nevada.
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Financia Statement Fraud. Retrieved from http://ssrn.com/abstract=938736
Tebogo, B. (2011). Does the Enron Case Study Provide Valuable Lessons in the Early Detection
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Tebogo, B. (2011). Does the Enron Case Study Provide Valuable Lessons in the Early Detection
of Corporate Fraud & Failure? Institute of Development Management, Botswana.
33
Table I: Common Size Statement Balance Sheet

Balance Sheet
ASSETS
Current Assets
Cash and cash equivalents
Trade receivables (net of doubtful)
Other receivables
Inventories
Deposits
Other
Total current assets
Investments and Other Assets
Investments in and advances to unconsolidated affiliates
Goodwill
Other
Total investment and other assets
Property, Plant, and Equipment, at cost
Exploration and production, successful efforts method
Transportation and distribution
Wholesale energy operations and services
Retail energy services
Corporate and other
Natural gas transmission
Electric generation and distribution
Fibre optic network and equipment
Construction in progress
Other
Less: Accumulated depreciation, depletion, and amortization
Total Assets
LIABILITIES AND SHAREHOLDERS EQUITY
Current Liabilities
Accounts payable
2000
1999
1998
1997
2%
16%
3%
18%
1%
4%
2%
46%
1%
9%
2%
7%
2%
0%
2%
22%
0%
7%
3%
6%
2%
0%
2%
20%
1%
6%
2%
6%
1%
0%
3%
18%
8%
14%
6%
8%
36%
15%
9%
8%
14%
46%
15%
7%
7%
15%
43%
12%
5%
8%
16%
41%
0%
0%
0%
0%
0%
0%
0%
0%
0%
0%
11% 21%
7% 11%
1%
1%
1%
3%
3%
6%
24% 42%
6% 10%
18% 32%
100% 100%
16%
19%
17%
0%
2%
0%
0%
0%
0%
0%
54%
17%
36%
100%
19%
23%
17%
0%
1%
0%
0%
0%
0%
0%
61%
20%
41%
100%
8%
9%
8%
6%
15%
16%
6%
6%
34
Short term debt
Customer's deposit
Other
Total current liabilities
Long term debt
Deferred credits and other liabilities
Deferred income taxes
Other
Total deferred credits and other liabilities
Commitments and contingencies
Minority Interests
Company obligated preferred securities of subsidiaries
Shareholders Equity
Preferred stock
Convertible junior preferred issue
Common stock
Retained earnings
Accumulated other comprehensive income
Treasury stock
Restricted stock and other
Other
Total shareholder's Equity
Total Liabilities and Shareholder's Equity
3%
7%
3%
43%
3%
0%
5%
20%
0%
0%
4%
21%
0%
0%
4%
17%
13%
21%
25%
28%
3%
14%
4%
21%
4%
6%
9%
5%
19%
7%
8%
5%
7%
19%
0%
9%
4%
8%
21%
0%
1%
0%
3%
0%
7%
3%
5%
4%
0%
0%
2%
3%
13% 20%
5%
8%
-2%
-2%
0%
0%
0%
0%
0%
0%
18% 29%
100% 100%
0%
0%
17%
8%
-1%
-1%
0%
0%
24%
100%
1%
0%
19%
8%
-1%
-1%
0%
-1%
25%
100%
35
Table II: Statement of Cash Flow

Statement of Cash Flow
2000
Cash flow from operating activities
Reconciliation of net income to net cash provided by operating activities
Net income
979
Cumulative effect of accounting changes
Depreciation, depletion and amortisation
855
Oil and gas exploration expenses
Impairment of long lived assets
326
Deferred income tax
207
Gains on sales of non-merchant assets
-146
Changes in components of working capital
1769
Net assets from price risk management activities
-763
Merchant assets and investments
Realized gains on sales
-104
Proceeds from sales
1838
Additions and unrealized gains
-1295
Other operating activities
1113
Net cash provided by operating activities
4779
Cash flows from investing assets
Capital expenditures
Equity investments
Proceeds from sales of non-merchant assets
Acquisition of subsidiary stock
Business acquisitions, net of cash acquired
Other investing activities
Net cash used in Investing activities
Cash flows from financing activities
Issuance of long term debt
Repayment of long term debt
Net increase (decrease) in short term borrowings
Net issuance (redemption) of company obligated preferred
securities of subsidiaries
Issuance of common stock
Issuance of subsidiary equity
Dividends paid
1999
1998
1997
19
893
131
870
703
105
827
121
600
102
441
21
-541
-1000
-395
87
-82
-233
350
-174
-195
-65
201
2
-2
1
-756
2217
-827
174
1228
-628
1434
-721
-218
1640
-136
339
-308
-258
211
-1
-1
8
-2381
-933
494
-485
-777
-182
-4264
-2363
-722
294
-1392
-700
473
-8
-6
4
-311
-405
-3507
-1905
-1659
239
-180
-104
-356
-3965
-82
-445
-2146
-10
3994
-2337
-1595
1776
-1837
1565
1903
-870
-158
1817
-607
464
3
-2
2
372
852
568
-467
8
867
828
-414
2
1
-96
307
500
-523
555
-354
-2
36
Net (acquisition) deposition of treasury stock
Other financing activities
Net cash provided by financing activities
Increase (Decrease) in Cash and Cash Equivalents
Cash and cash equivalents, beginning of year
Cash and cash equivalents, end of year
Changes in components of working capital
Receivables
Inventories
Payables
Other
Total
327
-6
571
139
-140
2456
13
89
2266
-422
24
1849
1086
288
1374
177
111
288
-59
170
111
-86
256
170
1
1
2
-8203
1336
7167
1469
1769
-662
-133
-246
41
-1000
-1055
-372
433
761
-233
351
63
-366
-113
-65
-6
8

Identification of Financial Fraud in Enron

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Identification of Financial Fraud in Enron

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INVESTMENT, TAXATION AND FRAUD EXAMINATION: ASSIGNMENT 3

5523S1531: Investment, Taxation, and Fraud Examination

Assignment 3: Identification of financial fraud in Enron Corp.

Submitted To: Dr. John H. Nugent

This paper is submitted in partial fulfilment of the requirements of course on Investment,

March 25, 2012

Background Rise and fall of Enron

Detecting financial distress

Working capital / Total assets

Retained earnings / Total assets

EBIT / Total assets

Market value of equity / Total

Sales / Total assets

These values resulted in the following model:

Detecting financial fraud

(Operating income Cash flow from

Sales / Accounts Receivable

Sales / Total assets

Net cash flow from operating activities

management who hold greater than 5%

Foreign sales / Total sales

Percentage of board members who are

of oversight by an internal audit

The size of audit committee scaled by

chairperson holds managerial position

auditor: 1 = change in auditor in 2 years

A dummy variable for an audit: 1 =

unqualified opinion and 0 = unqualified

Total accruals / total assets

A closer evaluation of the components of revenue and cost expressed as a percentage of

Assets from price risk management activities

Reporting agency earnings at contract value

Special purpose entity

Business Model and Stability

Balance Sheet Analysis

Property, Plant, and Equipment, at cost (USD Million)

Pustylnick Modified Altman

Shareholders Equity /Total Asset

Retained earnings / Total assets

EBIT / Total Assets

Market value of equity / Total debt

Revenue / Total assets

[ Working capital (Current Assets) + Retained

Days sale in receivables index

Gross margin index

Asset quality index

Sales growth index

Total accruals to total assets index

Gross margin index

Asset quality index

Sales growth index

Total accruals to total assets index

Price to Book Value

Top line growth (%)

Bottom line growth (%)

Return on Assets (%)

Return on Equity (%)

Debt equity ratio

Analysis of these ratios brings out the following highlights:

Table I: Common Size Statement Balance Sheet

Table II: Statement of Cash Flow

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