Accounting principles and practices

Accounting of Enron

In recent months the rules regarding special purpose entitles have come under great scrutiny. Special purpose entities allow firms to raise debt while at the same time making it almost impossible for investors to determine the actual amount of debt exposure. ("Special Purpose Entities are Often a Clever Way to Raise Debt Levels") Thus was the case with Enron, which collapsed in 2001 when their fraudulent accounting practice were exposed. The purpose of this discussion is to investigate which accounting practices were violated as it relates to the SEC rules on Special Purpose Entities and full disclosure. We will also discuss the ethical issues that the company made regarding the firms' accounting practices.

Special Purpose Entities and the SEC Rules that Enron Broke

Special Purpose Entities are also called the securitization of debt. They are totally legal and most companies use them for legitimate reasons such as sheltering a new sector of a firm for the rest of the firm in case the new sector of the firm does not succeed. However, in the case of Enron the entities were used to hide the extent of the firms' debt from shareholders. The SPE is used as a trust,

To establish this trust, the company must sell the SPE an asset -- any of the ones listed on its balance sheet will do. In this case, it sells its receivable balance and therefore must remove it from the balance sheet. The SPE pays the company for the receivables with the money it collects from these new investors and the company gets to beef up the cash section of its balance sheet. So the SPE has one big asset on its books. It now can hit the pavement and go find some money for its new project. It is essentially using the receivable as a security to peddle to the market, hence the moniker -- the securitization of assets." ("Special Purpose Entities are Often a Clever Way to Raise Debt Levels")

The SEC rules for SPE's require that the company actually have a special purpose for creating the entity. As stated earlier when a company legitimately creates a SPE it is actually for the purpose of accessing capital or hedging risk. This was what the SEC had in mind when it created the Special Purpose Entity rules. The rules were not created to simply hide a firm's debt from investors. However, according to The Journal of Accountancy, Enron used SPE's to do just that by using the entities to hide troubled assets that were losing value. The Enron Corporation was run using thousands of SPE's. These entities included foreign energy facilities and the broadband operation that the company had created. "Transferring these assets to SPE's meant their losses would be kept off Enron's books." (Thomas)

The most questionable SPE was called LJM Cayman LP and LJM2 Co-Investment LP, which operated from 1999 until 2001. (Thomas) This particular SPE was managed by Andrew Fastow and reportedly paid him a salary in excess of $30 million which was more than he was paid by the Enron Corporation. (Thomas)

According to The Journal of Accountancy Enron used the entity in the following way, the LJM partnerships invested in another group of SPEs, known as the Raptor vehicles, which were designed in part to hedge an Enron investment in a bankrupt broadband company, Rhythm NetConnections. As part of the capitalization of the Raptor entities, Enron issued common stock in exchange for a note receivable of $1.2 billion. Enron increased notes receivable and shareholders' equity to reflect this transaction, which appears to violate generally accepted accounting principles." (Thomas)

Ultimately officials began to questions the convoluted footnotes that accompanied Enron's 2000 financial reports. The company was found out and had to fully explain the way they used SPE's.

Full Disclosure

At the time of the Enron collapse the SEC's rules were that companies had to provide investors with full disclosure of financial dealings. Enron disclosed financial information but did so in ways that were deceitful and convoluted which made them impossible for investors to decipher. This lack of transparency on Enron's part proved to be its undoing. The purpose of the SEC's regulations is to ensure that investors are provided with the financial information that is needed to make an intelligent decision on whether or not to invest or continue investing in the company.

I believe that full disclosure means full disclosure. Investors need to know the true amount of debt that a company possesses to make an educated decision about whether or not to invest in that company. When a company fails to "fully disclose" information they have failed to comply with the regulations set forth by the SEC. The Journal of Accountancy writes,

Methods the company used to disclose (or creatively obscure) its complicated financial dealings were erroneous and, in the view of some, downright deceptive. The company's lack of transparency in reporting its financial affairs, followed by financial restatements disclosing billions of dollars of omitted liabilities and losses, contributed to its demise." (Thomas)

Enron failed to fully disclose information when they did not disclose the true debt exposure of the company, when they formed these erroneous SPE's which served no other purpose than to hide the debt, when they were not honest with investors about the accounting practices that the company used and when top executives received large amounts of money from these nonexistent entities. In fact the CEO of the company borrowed $7.5 million from the company and sold off stock to repay the company.

When Enron made the decision to create SPE's that were erroneous and therefore lacking legality under the SEC rules, their actions were unethical. Enron deceived the people providing capital so that the company could continue to operate. In addition. The top executives of the company made millions in the process. Simply put Enron deceived shareholders so that top executives could make millions of dollars.

In addition to the accountancy fraud Enron's unethical decision also affected millions of people who were not even employed by Enron. The people that were employed by Not only did Enron behave unethically but the entire market failed to inform consumers. This market failure was made by the very institutions that were designed to protect investors. In this case the implications for the accounting firm that was involved proved to be insurmountable. The Andersen Accounting firm was disbanded as a result of its actions in the Enron case. Accountants must be very cognizant of the fact that there decision to be honest or dishonest about a firms' financial dealings may have a profound effect on stakeholders and the accountants themselves. "Accountants and many Wall Street Analysts ratified and legitimized the company's scenarios and statements regarding prospects."(Berenbeim)

In wake of the Enron Debacle the SEC has made the following provisions to the rules of full disclosure for publicly owned corporations