Enron was a Texas based, low profile, gas pipeline Company that progressed from delivering energy to brokering energy futures. Exploiting de-regulation, it pioneered an innovative mark- to- market pricing strategy and started selling electricity in 1995, entering the European energy market in 1995. Enron broke new ground by buying, selling and hedging electricity against market risk just like shares and bonds.
In 1999 Enron entered the hi-tech, Internet bandwidth market buying and selling access to high speed broadband. Enron Online was the next cyberspace venture, a web-based commodity trading site. Enron now became an e-commerce company. Testimony to its success came from many quarters and Fortune magazine named Enron "America's Most Innovative Company" for six consecutive years from 1996 to 2001. Enron cultivated key figures in government and was especially close to the Republican Party. Enron's CEO, Ken Lay was on first name basis with President Bush.
Within 15 years the company Enron had morphed into the 7th largest publically owned corporation in America boasting revenues in excess of $100 billion and employing 20,000 workers, worldwide. The company owned or had a controlling interest in 30,000 miles of gas pipeline, 15,000 miles of fiber optic network and electricity generating operations around the world, including a giant, billion dollar plus project underway in India.
Enron was a 20th century wonder. (Eliza S. Moncarz, 2006) Yet as the century came to a close, the back slide had already started in Enron (Fig-1_ Appendix). It's innovations in structuring extremely complex financial arrangements that defied comprehension by the ordinary man in the street, and the vaulting ambition of its high flying, high spending, globe- trotting executives led to its undoing. A time came when Enron broke the law and started peddling patent falsehood as innovation. It then sealed its own fate.
Overview of the Questionable Accounting Practices and the Financial Statement Highlights.
The phrase, creative accounting or creative, aggressive accounting has become synonymous with the deliberate manipulation of financial data (DAVID R. HERWITZ, 2006) and violation of accounting rules with ulterior motive that is at the very heart of questionable accounting practices. The objective is to inflate profit and asset value, and understate debt and amounts owing, perforce.
Transparency, and the law, demands that the final accounts and Balance Sheet, properly drawn up, should correctly reflect all income, expenses, assets and liabilities germane to a business venture. This is especially important in the case of a Public Company in which shareholders with a financial stake in the company base their decision on their perception of its well being or otherwise. This will influence their current stock holding in the Company and that of prospective new investors from the market.
Typical accounting gimmicks employed to window dress accounts include off balance sheet financing, accelerated revenue recognition and the use of non-recurring items that are usually greatly exaggerated.
Debt financing that is not reflected on the Balance Sheet itself is known as off Balance Sheet financing. By removing the item from the Balance Sheet, debt stands reduced, artificially of course and that improves the Company's credit rating with investors and financial institutions like Banks.
However, removing an item from the Balance Sheet may not be as simple as it sounds. Accounts of Public Limited Companies are certified by professional accountants who stake their reputation and careers every time they affix their signature on a declaration of the veracity of a Company's accounts and Balance Sheet. When financial reporting requirements mandate that all debt contracted on transactions incidental to a Company's business ventures be shown in the financial statements, any lapse will do more than simply attract attention. That is why when the shocking decision to get rid of debt on the Company Balance Sheet, perforce, is taken, much ingenuity and daring goes into efforts to achieve this objective.
Enron used Special Purpose Entities or Vehicles (SPE / SPV) to do so.
Though created by Enron, legally, the SPE's were not Enron's property but that of an outsider trustee. That is because Enron could not be the beneficial owner if the SPE was to remain off Enron's Balance Sheet.
As the name suggests, a SPE is designed with a special objective in mind. Its management is kept flexible so that there is no need to cite the SPE as a subsidiary of the Company that created it since consolidation cannot then be avoided.
Besides camouflaging or hiding debt, accelerated revenue recognition was another reason why Enron put so much time, effort and money in setting up the SPE's.
In 1997 Enron entered into an agreement with its Limited Partner, JEDI and as per the agreement, JEDI was to pay Enron an annual management fee for services rendered. Accounting rules generally require that that such management fees be recognized as income only when the services have been rendered. In this case however, the agreement was drafted in such a way that Enron was able to recognize as income the discounted net present value of 80% of the annual management fees in advance (required payment) of the actual receipt of payment. As a result as of March 31, 1998, Enron recorded a $28 million asset which represented the discounted net present value of management fees payable over the period 1998-2003. $25 million were immediately recognized as income.
From 1993-2000, Enron pursuant to another agreement also recognized as revenue any appreciation in the value of Enron stock held by the Limited partner JEDI. Under normal accounting rules this would not have been possible. The exact amount so recognized over this period has not been determined but the accounting firm, Arthur Anderson, that audited Enron accounts and was responsible for a great deal of the 'creative accounting' that made the accelerated recognition of income possible, reported that in the first quarter of 2000 Enron recorded a $126 million increase in the value of its stock held by JEDI as its income.
In yet another example of accelerated revenue recognition by Enron, Chewco, another limited partner, received an unsecured subordinated loan from Barclays in Dec 1997 and Enron provided the guarantee on the loan. Pursuant to an agreement between Enron and Chewco, Chewco agreed to pay Enron a guarantee fee of $10 million plus 315 basis points annually on the average loan balance due. The objective basis on which the fee calculation was made is not evident and it appears to have been determined arbitrarily. In the one year that the loan remained outstanding, Enron received $17.4 million under the fee agreement. These fee payments were characterized by Enron for accounting purposes as "structuring fees" and $10 million upfront payment received in Dec 1997 was recognized as income. This was not consistent with accounting rules as they required that guarantee fee income be recognized over the guarantee period. The entire arrangement between Enron and Chewco regarding the guarantee fee payment's recognition was clearly designed solely to facilitate accelerated recognition in a manner not permissible in law.
The Rhythms Hedge
RhythmsNetConnections was a privately held Internet Service Provider in which Enron invested $10 million in March 1998 by purchasing 5.4 million of its shares at $1.85 per share. By May 1999 the value of this investment had gone up to $300 million and the increase was recognized as income as the investment was accounted for by Enron as part of its merchant portfolio. In order to capture the increase and hedge the investment against any future market volatility that may decrease the value of the stock, Enron sought to hedge the Rhythms investment by creating a limited partnership SPE capitalized mainly by appreciated Enron Stock from forward contracts. The appreciated value would be transferred to the Limited Partnership SPE LJM1 in exchange for a note receivable that would permit LJM1 to enter into a swap with Enron to hedge Enron's Rhythm investment. This Rhythms hedge impacted on Enron's income statement affecting gains and losses thereon but it was not a true economic hedge. An SPE (LJM1) could not have been used legitimately as a counterparty to hedge against price risk when the primary source of any payment that the SPE might make is the entity's own stock. In essence what this amounted to was Enron hedging risk with itself which is an absurdity not a bona fide hedge against risk.
The Rhythms Hedge was repeated in another transaction, this one between Enron and the limited partnership, LJM2. It involved the creation of four SPE's that were called "the Raptors." These were essentially structured finance vehicles (William C. Powers, 2002)designed to avoid showing losses on Enron's financial statements from any fall in the value of its merchant portfolio. This was achieved by entering into derivative transactions with the Raptors that functioned as accounting hedges. Thus if there was a decline in the value of the merchant investment the value of the Hedge would appreciate by an equivalent amount. As a result, in Enron's quarterly income statement the decline in value of the merchant investment would be offset by the increase in income…