Enron's Collapse: Accounting Fraud, SPEs, and Corporate Failure

Enron's Rise to Corporate Prominence

Enron was a Texas-based, low-profile gas pipeline company that progressed from delivering energy to brokering energy futures. Exploiting deregulation, it pioneered an innovative mark-to-market pricing strategy and began selling electricity in 1995, simultaneously entering the European energy market. Enron broke new ground by buying, selling, and hedging electricity against market risk in much the same way as shares and bonds are traded.

In 1999, Enron entered the high-tech Internet bandwidth market, buying and selling access to high-speed broadband. Enron Online was its next cyberspace venture — a web-based commodity trading platform — and the company reinvented itself as an e-commerce enterprise. Testimony to its perceived success came from many quarters; 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 a first-name basis with President Bush.

Within 15 years, Enron had morphed into the seventh largest publicly 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 major billion-dollar project underway in India.

Enron was a twentieth-century wonder (Eliza S. Moncarz, 2006). Yet as the century came to a close, the slide had already begun. Its innovations in structuring extremely complex financial arrangements that defied comprehension by ordinary investors, and the vaulting ambition of its high-flying, high-spending executives, led to its undoing. A time came when Enron crossed legal boundaries and began presenting patent falsehoods as innovation. In doing so, it sealed its own fate.

Questionable Accounting Practices and Financial Statement Manipulation

The phrase creative accounting — or creative, aggressive accounting — has become synonymous with the deliberate manipulation of financial data (David R. Herwitz, 2006) and the violation of accounting rules with ulterior motive, which is at the very heart of questionable accounting practices. The objective is to inflate profit and asset value while understating debt and amounts owed.

Transparency and the law demand that final accounts and the 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 base their decisions on their perception of the company's wellbeing. This perception influences their current stockholdings as well as those of prospective new investors.

Typical accounting gimmicks employed to dress up accounts include off-balance-sheet financing, accelerated revenue recognition, and the use of greatly exaggerated non-recurring items.

Debt financing not reflected on the balance sheet is known as off-balance-sheet financing. By removing the item from the balance sheet, debt is artificially reduced, which improves the company's credit rating with investors and financial institutions such as banks.

Removing an item from the balance sheet, however, is not as simple as it sounds. The accounts of public limited companies are certified by professional accountants who stake their reputation and careers each time they sign a declaration of a company's financial veracity. 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 does more than attract attention. That is why, when the decision is taken to purge debt from the company balance sheet, considerable ingenuity and daring are required.

Enron used Special Purpose Entities (SPEs) to accomplish this. Though created by Enron, the SPEs were legally not Enron's property but rather belonged to an outside trustee. This was necessary because Enron could not be the beneficial owner if the SPE was to remain off Enron's balance sheet. As the name suggests, an SPE is designed with a specific objective in mind. Its management structure is kept flexible so that it does not need to be cited as a subsidiary of the creating company — which would require consolidation and thus disclosure.

In addition to hiding debt, accelerated revenue recognition was another reason Enron devoted such time, effort, and money to setting up SPEs.

In 1997, Enron entered into an agreement with its limited partner JEDI, under which JEDI was to pay Enron an annual management fee for services rendered. Accounting rules generally require that such management fees be recognized as income only when the services have actually been rendered. In this case, however, the agreement was drafted so that Enron was able to recognize as income the discounted net present value of 80% of the annual management fees in advance of actual receipt. As a result, as of March 31, 1998, Enron recorded a $28 million asset representing the discounted net present value of management fees payable over the period 1998–2003, of which $25 million were immediately recognized as income.

From 1993 to 2000, pursuant to another agreement, Enron also recognized as revenue any appreciation in the value of Enron stock held by the limited partner JEDI — something that would not have been permissible under normal accounting rules. The exact amount recognized over this period has not been fully determined, but the accounting firm Arthur Andersen — which audited Enron's accounts and was responsible for much of the creative accounting that made accelerated income recognition possible — reported that in the first quarter of 2000 alone, Enron recorded a $126 million increase in the value of its stock held by JEDI as its own income.

In yet another example of accelerated revenue recognition, Chewco, another limited partner, received an unsecured subordinated loan from Barclays in December 1997, with Enron providing the guarantee. 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. The basis on which this fee calculation was made is unclear and appears to have been determined arbitrarily. In the one year the loan remained outstanding, Enron received $17.4 million under the fee agreement. These payments were characterized for accounting purposes as "structuring fees," and the $10 million upfront payment received in December 1997 was recognized immediately as income. This was inconsistent with accounting rules, which required that guarantee fee income be recognized over the guarantee period. The entire arrangement was clearly designed solely to facilitate accelerated income recognition in a manner not permissible under the law.