Advanced Corporate Accounting - Enron Scandal - Essay Example

Advanced corporate accounting – Enron Scandal By: Enron started profitably in 1985 as a merger of Houston Natural Gas and Internorth as the first national natural gas pipeline network. Enron wrongly entered into business combinations to shift the liabilities to its subsidiaries and to avoid payment of taxes. Financial danger gradually sipped in when Enron strategic management goal shifted from the regulated transportation of natural gas to unregulated energy trading markets. The discovery of the true financial condition started in August of 2001 when its Chief Executive Officer, Jeffrey Skilling, resigned followed by an October 16, 2001financial report showing a January to March loss by implementing an earnings deduction of $ 1 billion indicating a poorly run business venture. Restating its 1997 to 2001 financial statements by $586 million triggered the downgrading of Enron stocks to below investment grade or junk bonds status. This triggered a Chapter 11 bankruptcy proceeding in December, 2001 (Sterling, 2002;111). Business combinations should not be entered in order to hide its liabilities and avoid payment of taxes. Collapse of Enron The collapse of Enron started upon the discovery that it presented fraudulent financial statements. The October 16, 2001 restatement of it financial statements from 1997 to 2000 was the spark the uncovered the true depth of Enron’s financial demise (Garsten,2008;11). The downgrading of the Enron stocks to an unworthy investment status was the nail on the coffin of Enron. The financial statements falsely presented the assets bought as credits to investment accounts. The window –dressing of the financial statements falsely fraudulently signaled current and prospect investors to funnel their hard –earned cash into the business (Fox, 2003;1). Unfortunately, the Enron business combination strategy changed from the regulated transportation of natural gas to the unregulated energy trading markets (Tarantino, 2009;97). This was premised on the uncharted lure of buying and selling financial contracts attached to value of the challenging energy assets as compared to the original plan of actual ownership of physical assets. Fraudulent financial statements were issued since 1997 to falsely persuade the current and prospective investors to funnel their hard –earned cash into the Enron stocks. Until 2001, financial and Wall Street stock market analysts praised the success of Enron based on its transformation from a below $10 billion in the early 1990s to $101 billion in 2000, ranking it no. 7 in the Fortune top one companies (Sterling, 2002;112). The discovery of Enron’s fraudulent practices led to its December 2001 filing for bankruptcy. The misdeeds included Fastow’s creation and managing of two of the books partnerships, LJMM1 and LJM2. These were sham Enron transactions. It was unethical for Enron to enter into a fraudulent practice focused on Enron selling an asset to LJM1 or LJM2 with the agreement that Enron will later repurchase the asset. Consequently, this allowed Enron to inflate its profits and to manipulate its balance sheet by removing the related liabilities from the balance sheet. Another fraudulent transaction type included backdating many of the Enron documents to show a more favorable financial statement picture. The LJM partnerships sealed an agreement with Enron officers that they would not lose a single cent from the Enron transactions clearly shows that it was a loan agreement wrongly masked as otherwise. This is a clear indication that the transaction was a loan agreement that was not recorded in the books (Fox, 2003;1). Further, the Enron -Raptor III business combination is an investment to hedge in New Power Stock. This transaction was kept secret from the Enron board of directors. However, this transaction was reviewed by its external auditor, Andersen Auditing. The terms of the Raptor transactions were grossly unfavorable to Enron’s stakeholders. Enron entered into business combination in buying out Raptors. The assets and liabilities of Raptors were recorded at fair market value with the excess attributable to goodwill. However, Arthur Andersen wrongly instructed the Enron to use income in place of goodwill. In 2001, Enron, facing the reality that Raptor did not have enough assets to pay its liabilities, Enron transferred $828 million of forward contracts to the Raptors. Consequently, Enron was paying itself so Raptor could not be report the merchant asset losses. Enron fraudulently shifted risks in its Enron assets to its subsidiaries as hedge (Bierman, 2008;113). In addition, Enron entered into a contract with Condor. Enron used the Bammel, wholly owned Enron subsidiary acquired through business combination, gas storage sale entitled Project Condor. This involved a tax saving plan that used contribution –leaseback to step up its foundation ion some assets. In turn, Condor bought Enron stocks. Enron stocks amounting to $800 million was loaned to Condor. Meanwhile, Enron sold its Bammel facility and its pipeline facilities to AEP Energy Services for $728.7 million. Enron issued its own convertible preferred stocks to an SPE. The proceeds of the sale were used to pay the debt obligations of many Enron affiliate companies. This is one method of moving the Enron debts from the Enron balance sheet. However, if the stocks were not enough to cover the Enron obligations, Enron would issue more stocks to cover the shortfall (Markham, 2006; 96). Enron also used other minority interest financings to cover its ballooning debts. The faulty accounting practice involved the establishment of a majority –owned Enron subsidiary. The subsidiary would buy the poorly –managed and financially unrewarding Enron assets. The purchase was recorded in the balance sheet as minority interest account. There is literal transfer from liability to stockholders’ equity account. The irregularity arose because Enron’s business combination with Condor guaranteed that other companies would not lose a single cent from Enron. In effect, this was actually a Condor loan that was hidden from the public scrutiny. To complete the picture of fraud, Enron fraudulently recorded the fund investments as operating profits (Markham, 2006;97). In terms of business combination, Enron was able to avoid paying income taxes for 4 or 5 years until the illegal acts were discovered by investing using and estimated 900 subsidiaries in tax –haven countries and other techniques. An estimated 80% of its foreign business combinations were dormant accounts. Dormant accounts are not engaged in any legitimate or profitable businesses and were irrelevant for tax purposes. For example, Enron created business combinations in countries that impose no taxes. For example, Enron formed 441 companies in the Cayman Islands because they company does not impose corporate taxes (the majority was dormant companies to save on taxes). Specifically, Enron’s business combinations was illegally focused on acquiring through business combination 692 subsidiaries in the Turks and Caicos Islands, 43 companies in Mauritius, and 8 companies in Bermuda. It was wrong for Enron to consummate a business combination policy to set up companies around the world expecting a few of the dormant companies to profitably cover the losses of all its dormant companies. For example, the domestic Enron entity owns Cayman Parent Company (under U.S. territorial & tax jurisdiction). Specifically, Cayman subsidiary would own 99% and Cayman Parent would own 1 % of Cayman Islands Ltd Life Company – a partner for U.S. Tax purposes to save on U.S. taxes. Enron is using technicalities to prolong tax payments. As a business combination partner, Enron’s US income tax is postponed until the earnings are transferred to the U.S specifically avoidance of subpart F income on the distribution of earnings from foreign project entity(Joint Committee on Taxation, 2003;375) Watkins’ “incredibly nervous” report of Enron’s accounting scandals Sherron Watkins was referring to some Enron partnerships entered into by is chief financial officer, Andrew Fastow which were classified as scandals. Sherron Watson emphasized that several Enron employees had voiced their sentiments over Enron’s accounting methods to Senior Enron officer including Mr. Skilling, personally. Sherron Watson insisted that the chairman of the board of directors should scrutinize the improper accounting practices which could bring down the company. Consequently, the company filed for bankruptcy after the officers admittedly overstated its profits at $600 million (Natta, 2002;1). Questionable and /or Fraudulent Enron Accounting Practices There are questionable and/ or fraudulent accounting practices Enron was engaged in. First, the top executives hid billions of dollars in liabilities. The mounting debts accumulated by the Enron subsidiary companies were not included in the financial statements of the parent company because of the business combination accounting principle stating that this is allowed if the parent company did not own more than half of the subsidiary company. Second, the officers fraudulently presented unprofitable business combinations as profitable ones (a violation of U.S. GAAP prevailing in those accounting periods). The officers’ investments in internet and communications businesses and foreign subsidiaries turned out to be unprofitable ventures. In response, the Enron officers assigned the business losses and near worthless investments to unconsolidated partnerships and special purpose entities to fraudulently increase its profits. In addition, the Enron officers falsely presented bank liabilities as energy derivatives to hide its true debt (another violation U.S. GAAP of those accounting periods). Other irregularities include the Raptor and Condor subsidiary business combination accounts were loans which were fraudulently recorded as investments. Also, bank loans were recorded as derivative investments to hide the company’s true liabilities (Purpura, 2002;259). In response, Kenneth Lay, age 64, was convicted by a U.S. court of fraud, conspiracy, and lying to banks. The judge also convicted other Enron officers. Andrew Fastow, former chief financial officer, cooperated with the prosecutors and had a reduced prison sentence of only 6 years. Andrew Fastow was instrumental in pinpointing to Jeffrey Skilling, former chief executive officer, resulting to Skilling’s 24 year prison conviction. In response, the Sarbanes –Oxley Act of 2002 was crafted to prevent a repeat of the Enron accounting fraud, WorldCom, and other accounting scandals (Purpura, 2002;260). Comment wise, managing the ethics perspective and eliminating the high risk of falsifying financial statements, and managing human behavior of risk, the introduction of corporate social responsibility and unwavering ethics lessons as a subject in the academic environment will erase all reasons for making the mistake of falsifying financial statements. Teaching the importance of business ethics should be prioritized as part of the college curriculum to avoid another Enron scandal. For, the business goal of generating profits must not violate any tax laws, labor laws, and other laws of the land. The profit orientation must not outshine the company’s corporate social responsibility to present fairly presented financial statements. Effects of Such Practices on the Reported Results of Enron There were several effects of such practices on the reported results of Enron. First, not presenting the liabilities in the balance showed a better picture of the company financially. This is known in accounting parlance as window –dressing. Next, the investors are enthusiastic to invest more in the company because of the fraudulent profitable status of the company. Third, investors would strongly recommend extending credit to the company after observing that the company fraudulently indicated a prior year profitable status. Explanation of basic principles of accounting to the man on the street. Definitely, explaining the accounting treatment to a man in the street would influence a person’s decision -making activities. For example, it is easy to explain that the business combinations will increase the company’s market segment with the acquisition (parent –subsidiary accounting) of another profitable company. However, it would be unethical to enter into a business combination to avoid taxes or violate U.S. GAAP and IFRS principles in the recording of business combinations. Likewise, it is correct to inform the man on the street that the bottom line is the first item to look for in determining whether to enter into a business combination is to determine if the acquisition will increase profits, increase client base, acquire another company’s technology, or enter into a new market. Specifically, telling the same man on the street that a profit bottom line indicates that investing in the company listed in the stock exchange will be a good decision because he will be able to earn dividends will convince the listener to invest in the stock discussed. Likewise, it is correct for a person to inform the man on the street that a net loss bottom line is an indication the company is not a good business combination prerogative. Inadequate footnotes – Watkins’ comments. Further, the Watson’s message was correct in stating that footnotes to the financial statements do not satisfactorily explain the business transactions. The financial statements hid the true loan status of the company from the footnotes. There would be no sense in presenting the true loan value in the footnotes if the Enron officers hid the loan value from the liabilities portion of the Enron balance sheet. In layman’s term, it is like secretly stealing money (presentation in the balance sheet) and stating that one stole the money (footnote). The preferable presentation would be to present the loans in the liabilities portion of the balance sheet. Enron - Arthur Andersen Conspiracy, Watkins’ Warning In terms of Watkin’s memo refers to Arthur Anderson & Co (AA) at several places, Sherry Watson indicated that there was a conspiracy between he external auditors, representing Arthur Andersen, and the fraudulent Enron officers. The external auditor’s main job is to present an audit opinion indicating that the financial statements are fairly presented. However, another speculation emphasizes that the external auditors assigned to audit the balance sheet, income statement, and statement of cash flows connived with the Enron officers because they did not perform standard auditing procedures like testing the internal control as a reliance measure for extending or minimizing the length and depth of the audit engagement. There is a better reason here which states that conspiracy is the real cause of the Enron debacle. David Duncan’s friend and former Arthur Andersen auditor, Richard Causey, had joined Enron as Chief Accounting Officer on the same year that David Duncan became the engagement officer of Arthur Andersen assigned to audit the books of Enron. In one of David Duncan’s audit procedure, he interviewed PSG member Ben Neuhausen and Carl Bass about the complexity and compliance of Enron accounting procedures to ethical and GAAP standards (Squires, 2003;126). Enron should implement its corporate social responsibility to focus on presenting a fair financial statement that benefits the most number of financial statement users (Mullerat, 2005;3). Further, Carl Bass warned David Duncan that, in his professional judgment, some of the Enron deal financial transactions were obviously wrong. However, Carl Bass’ warnings were ignored and misinterpreted by David Duncan. In response, Enron officials requested David Duncan to remove Carl Bass from the external audit team. David Duncan’s compliance with the Enron request is against auditing standards. Many Arthur Andersen partners opined that David Duncan’s ignoring the Carl Bass comment, as a PSG member, was a violation of Arthur Andersen external auditing policy (Squires, 2003;126). BRIEFLY, the Enron scandal entered into business combinations to fraudulently present a better picture of Enron’s financial statements. Hiding the real liabilities and avoiding taxes are fraudulent reasons for entering into a business combination. Recording bank loans as derivative investment runs against the grain of generally accepted accounting principles during those Enron years. The Condor, Raptor, and other business combinations shift the Enron loan agreements to its acquired subsidiaries. Upon discovery of the true financial position of the company, the Enron stock was downgraded to an unworthy stock investment option forcing the company to file for Chapter 11 bankruptcy. Definitely, business combinations should not be entered in order to hide its liabilities and avoid payment of taxes. REFERENCES Bierman, H. Accounting /Finance Lessons of Enron. New York: World Scientfic, 2008. Congress, US. Report of Investigation of Enron Corporation and RElated Enities Regarding Federal Tax and Compensation Issues. New York: Diane Press, 2003. Fox, L. Enron: The Rise and Fall. New York: J. Wiley & Sons, 2003. Garsten, C. Ethical Dilemnas in Management. New York: Taylor & Francis Press, 2008. Markham, J. A Financial History of Modern U.S. Corporate Scandals. New York: M Sharpe, 2006 . Natta, D. "Enron's Chairman Received Warning About Accounting." New York times, January 15, 2002: 1. Mullerat, R., “Corporate Social Responsibility: The Corporate Governance of the 21st Century, New York: Kluwer Law International Press, 2005: 11. Purpura, P. Security and Loss Prevention: An Introduction. New York: Butterworth -Heinemann, 2007. Squires, S. Inside Arthur Andersen: Shifting Values,Unexpected Consequences. New York: FT Press, 2003. Sterling, T. The Enron Scandal. New York: Nova Press, 2002. Read More