Forensic Accounting- ACC394

Case Study 1

Wen He - g00078706
Shahzad Sultan - b00078609
Mahnoor Khawaja - g00080843
Question 1: Provide a brief background about Enron.

Answer: Enron Corporation was formed when Houston Natural Gas merged with InterNorth in

1985, In 1986, Kenneth Lay became chairmen of the company and hired Jeffrey Skilling as CEO

and Andrew Fastow as CFO, under their lead, Enron started to adopt a risky but effective growth

strategy, by focusing on three key business areas: water, international energy brokerage and

broad communication. Enron became one of the world’s largest energy traders, Enron used

extremely dangerous and expensive hedging transactions to raise funds. With this strategy and

fundraising, Enron quickly gained a lot of market share in the stock market. However, this

strategy did not last long, because the way Enron raised the funds was too risky and aggressive,

it was heavily in debt. Enron tried to hide all of these liabilities through an “off-balance sheet”

partnership, which is SPE, a special purpose entity. Enron used a special purpose entity to hide

all the liabilities it has, because as long as 3% of the capital came from the outsider, SPE does

not need to combine its financial statements with the parent’s financial statements to form a

consolidated financial statement which will be shown on parent’s financial statements. By using

SPE, Enron can show to the public that they were having a positive image on the financial

statements, and able to attract more investors. The financial statements of Enron were overly

inflated and optimistic as a result. In 2001, the issue of Enron got revealed, the stock price of

Enron dropped sharply. Due to this disclosure, Enron resulted in a dramatic and unexpected

financial collapse, which led to bankruptcy.

This instance became the biggest financial scandal since 1929, its failure was mainly because of

it conducting unethical accounting procedures, improper monitoring, and excessive greed, all of

these reasons resulting Enron taking the wrong path and fell to the bottom at the end.
Question 2: What are the main business segments of Enron and how did they affect the
success or failure of the company?

Answer: The rise of Enron and its roots can be traced back to 1985, with the help of Kenneth

Lay merging Houston Natural Gas and InterNorth and hiring Jeffrey Skilling as their Chief

Executive Officer (CEO) of the firm (Thomas, 2002). Over the years, Enron’s business model

had changed over the years as they grew. They initially started as a firm that did business

through national energy delivery and brokery and before their demise they focused their efforts

on international energy brokerage, broadband communications and water through the plan of

their CFO, Andrew Fastow, they were able to adapt an aggressive growth strategy which

changed their stance from a regulated natural gas company to a major player in the international

energy trading industry (Reinstein & Weirich, 2002, pp.21-22). He helped to construct a

complex financial structure for the new Enron. Moreover, in their annual statements of 2000,

Enron 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 develop

innovative solutions to challenging industrial problems,” (Reinstein & Weirich, 2002, p.21). In

other words, they were the big players in the market of an unregulated derivative-trading

company that generated funds by entering extremely volatile, risky, and expensive hedging

transactions with complicated financial transactions. In so doing, Enron created both a new

product and a new model for the industry – the energy derivative (Moncarz, et.al, 2006). Enron

continued to diversify beyond the energy derivative and wanted to be the leading market player

in “electric power, coal, steel, paper and pulp, water, and broadband fiber optic cable capacity,”

(Healey and Palepu, 2003, p.5). This was all due to the help of deregulation by the state and Lay
took the opportunity to take the "energy supply business from a sleepy monopoly as a regulated

utility, to a free-market commodity that previously did not exist" (Moncarz, et.al, 2006).

However, all of these "endeavors went sour, causing Enron's stock to plummet" (Reinstein &

Weirich, 2002,p.22). Their idea of extending to other markets and international expansion were

unsuccessful, and demise began when they hid billions of dollars of liabilities using special-

purpose entities (SPE) and at the same time cooked the books to make their financial statements

more viable, creating shareholders and creditor value (Thomas, 2002). Therefore, the

stakeholders started to question Enron's accounting methods, and thus the fall of Enron's empire

started to begin and declared bankruptcy by 2001 due to high leverage and hiding it using SPE to

manipulate their business model profits and statements, usually doesn't last long before it is

uncovered (Reinstein & Weirich, 2002, p.22).

Question 3: How did Enron cook the books and how the accounting issues affect the failure

of Enron?

Answer: One of the major and most well-known accounting scandals of all time include the

Enron Scandal 2001. The firm had severely cooked the books so that it could make the company

look better and consequently the share prices could go up. One of the ways the company cooked

the books was by using special purpose entities (SPE) to hide the liabilities worth billions of

dollars and toxic assets from creditors and investors although they were capitalized from Enron’s

stock. Several companies used SPEs because as long as 3% of capital comes from outsiders, the

SPE can be kept separate from its parent company (Reinstein & Weirich, 2002). In total, Enron

used about 500 SPEs and controversial partnerships so that it could form transactions for its off-

balance sheet treatment of assets and liabilities (Reinstein & Weirich, 2002).

Despite excessive buildup of debts, the SPEs aided the company financially as Enron was

able to borrow funds through them. Since Enron was already drowning in debts, raising money

through acquiring additional debt was unattractive because it would cause the earnings per share

to dilute, so back in 1990, Enron borrowed funds directly from its outside lenders, mostly by

supplying its own credentials and stock guarantees. The money borrowed was then used to

balance Enron’s overvalued contracts (Li, 2010). The SPEs then empowered Enron to convert

loans and debt-obligated assets into income. The debts and assets purchased through SPEs were

actually not reported in the accounts of Enron which led the shareholders astray making it seem

that the debt was not increasing, and that revenue was increasing instead (Li, 2010).
Moreover, as the company required the need to increase its SPEs for the purpose of moving its

debts and losses from the balance sheet, they started to use its own stocks as collateral. Hence,

the company would be able to report an increase in its stock as income, which would further

allow them to increase its income through the equity accounting method (Reinstein & Weirich,

2002).

Another course of action Enron took to cook the books was incorporating ‘market to

market accounting’. Under this accounting system, whenever a company has outstanding assets

or liabilities, the value is adjusted to the value determined by the market. So accordingly, any

fluctuations between the values would be recorded as unrealized gains and losses in the income

statement (Thomas, 2002). This method let Enron write its unrealized future gains into its

current income statements, which in fact gave the misconception of higher current profits – the

aim of the company was the make its financial statement attractive by overstating incomes,

reducing expenses, and thus higher profits, but in fact the company was highly indebted.

Primarily, the hiking number of SPEs and the use of market-to-market accounting method

contributed towards the downfall of the company and a sharp decline in its stock prices. Figure 1

shows how the stock price started off with $71.12 to $90.00 in 2000 to a sudden decrease to

$0.61 in the years 2001. Similarly, revenues of the year 2000 was $100.8 billion dollars but

significantly reduced to $-0.6 billion dollars which is exceptionally drastic (Li, 2010).
 Figure 1: Stock prices, assets, and revenues before and after bankruptcy

Furthermore, Enron had several accounting issues that affected its failure. One of them is

establishing SPEs as discussed before. These SPEs allowed Enron to shift its liabilities off the

book; however, Enron was at the same drastically drowning in debt - it was the deceptive

financial statements that were showing otherwise. Another accounting issue was making a series

of restatement, corrections and new disclosures which caused pessimism towards Enron’s

management and financial reporting and a subsequent run on the book. An example of this is

when on 8 November the company restated its financial statement to 1997 to show the omitted

SPEs. As a cause of this restatement, the company lost $591 million in four years followed by

additional liabilities worth $628 million by the end of 2000 (Thomas, 2002).

Moreover, rather than benefiting the stockholders and creditors, the company was hiding

the necessary write off to benefit the insiders i.e., management executives. Enron’s executives

held large personal interests in partnerships and made massive personal gains from such

transactions so with the help of SPEs and market-to-market accounting, they cooked the books

making the financial statements seem highly profitable so that the shares could sell at a high
price. As much as the top management individuals were working on personal enrichment, their

deceptive actions were exposed to the public. This personal interest led to Enron’s failure. The

company’s lack of disclosure of its related party transactions with the SPEs also affected its

failure. On Oct 22 SEC started looking into the related party transaction between Enron and its

partnerships. Enron, however, on November 8 restated its financial statements back to 1997

which resulted in $591 million in losses over 4 years and $628 million in liabilities (Thomas,

2002).
Question 4: What lessons had the USA government learned from Enron Failure and what

actions did the USA government take as a result of the Enron failure?

Answer: Due to this significant scandal, United States realized that they need to reforms their

accounting and corporate governance regulations, and they need to focus on ethical cultural of

the corporations in the United States, the importance of external auditor, and its ethical conduct

also need to pay attention to.

The former SEC Chair Harvey Pitt gives out following suggestions:

● Development and implementation of a system of current disclosure, which would

provide material information in real time

● Disclosure of significant current trend and evaluative data, in addition to historical data

● The issuance of financial statements that can be easily interpreted and understood

● The establishment of a strong corporate governance system, with an audit committee

that has expertise to review the financial reporting system and the audit function.

The USA government started the Sarbanes-Oxley (SOX) Act of 2002, which will change the

processes for creating and adopting auditing, accounting, independence, ethic and quality

standards for CPAs, these standards also applied to non-registrants. The four principal areas

mentioned and altered in the Sarbanes-Oxley (SOX) Act of 2002 were corporate responsibility,

increased criminal punishment, accounting regulation, and new protections.

 References

Healy, P. M., & Palepu, K. G. (2003). The Fall of Enron. The Journal of Economic Perspectives,

17(2), 3–26. http://www.jstor.org/stable/3216854

Li, Y., 2010. The Case Analysis of the Scandal of Enron. International Journal of Business and

Management, 5(10). Retrieved from

https://www.ccsenet.org/journal/index.php/ijbm/article/view/7627

Moncarz, Elisa S., & Moncarz, Raúl, & Cabello, Alejandra, & Moncarz, Benjamin (2006). The

Rise and Collapse of Enron: Financial Innovation, Errors and Lessons. Contaduría y

Administración, (218),17-37. ISSN: 0186-1042. Retrieved from

https://www.redalyc.org/articulo.oa?id=39521802

Reinstein, A., & Weirich, T. R. (2002). Accounting issues at Enron: Certified Public

Accountant. The CPA Journal, 72(12), 20-25.

http://aus.idm.oclc.org/login?url=https://www.proquest.com/scholarly-journals/

accounting-issues-at-enron/docview/212308790/se-2?accountid=16946

Thomas, C., 2002. The Rise and Fall of Enron. Journal of Accountancy. Retrieved from

https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.htm