Expert Guidance for Accounting Assignments and DQ Posts
Enron Corporation, based in Houston, Texas, was formed as the result of the July 1985 merger of Houston Natural Gas and InterNorth of Omaha, Nebraska. In its early years, Enron was a natural gas pipeline company whose primary business strategy involved entering into contracts to deliver specified amounts of natural gas to businesses or utilities over a given period of time. In 1989, Enron began trading natural gas commodities. After the deregulation of the electrical power markets in the early 1990s—a change for which senior Enron officials lobbied heavily—Enron swiftly evolved from a conventional business that simply delivered energy, into a “new economy” business heavily involved in the brokerage of speculative energy futures. Enron acted as an intermediary by entering into contracts with buyers and sellers of energy, profiting by arbitraging price differences. Enron began marketing electricity in the U.S. in 1994, and entered the European energy market in 1995.
In 1999, at the height of the Internet boom, Enron furthered its transformation into a “new economy” company by launching Enron Online, a Web-based commodity trading site. Enron also broadened its technological reach by entering the business of buying and selling access to high-speed Internet bandwidth. At its peak, Enron owned a stake in nearly 30,000 miles of gas pipelines, owned or had access to a 15,000-mile fiber optic network, and had a stake in several electricity-generating operations around the world. In 2000, the company reported gross revenues of $101 billion.
Enron continued to expand its business into extremely complex ventures by offering a wide variety of financial hedges and contracts to customers. These financial instruments were designed to protect customers against a variety of risks, including events such as changes in interest rates and variations in weather patterns. The volume of transactions involving these “new economy” type instruments grew rapidly and actually surpassed the volume of Enron’s traditional contracts involving delivery of physical commodities (such as natural gas) to customers. To ensure that Enron managed the risks related to these “new economy” instruments, the company hired a large number of experts in the fields of actuarial science, mathematics, physics, meteorology, and economics.3
Within a year of its launch, Enron Online was handling more than $1 billion in transactions daily. The website was much more than a place for buyers and sellers of various commodities to meet. Internetweek reported that, “It was the market, a place where everyone in the gas and power industries gathered pricing data for virtually every deal they made, regardless of whether they executed them on the site.”4 The site’s success depended on cutting-edge technology and more importantly on the trust the company developed with its customers and partners who expected Enron to follow through on its price and delivery promises.
When the company’s accounting shenanigans were brought to light, customers, investors, and other partners ceased trading through the energy giant when they lost confidence in Enron’s ability to fulfill its obligations and act with integrity in the marketplace.5
ENRON’S COLLAPSE
On August 14, 2001, Kenneth Lay was reinstated as Enron’s CEO after Jeffrey Skilling resigned for “purely personal” reasons after having served for only a six-month period as CEO. Skilling joined Enron in 1990 after leading McKinsey & Company’s energy and chemical consulting practice and became Enron’s president and chief operating officer in 1996. Skilling was appointed CEO in early 2001 to replace Lay, who had served as chairman and CEO since 1986.6
3 “Understanding Enron: Rising Power.” The Washington Post. May 11, 2002. See the following website: http://www.washingtonpost.com/wp-srv/business/enron/front.html4 Preston, Robert. “Enron’s Demise Doesn’t Devalue Model It Created.” Internetweek. December 10, 2001.5 Ibid.6 “The Rise and Fall of Enron: The Financial Players.” The Washington Post. May 11, 2002. See the following website: http://www.washingtonpost.com/wp-srv/business/daily/articles/keyplayers_financial.htmSkilling’s resignation proved to be the beginning of Enron’s collapse. The day after Skilling resigned, Enron’s vice president of corporate development, Sherron Watkins, sent an anonymous letter to Kenneth Lay (see Exhibit 1). In the letter, Ms. Watkins detailed her fears that Enron “might implode in a wave of accounting scandals.” When the letter later became public, Ms. Watkins was celebrated as an honest and loyal employee who tried to save the company through her whistle-blowing efforts.
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Two months later, Enron reported a 2001 third quarter loss of $618 million and a reduction of $1.2 billion in shareholder equity related to partnerships run by chief financial officer (CFO), Andrew Fastow. Fastow had created and managed numerous off-balance-sheet partnerships for Enron, which also benefited him personally. In fact, during his tenure at Enron, Fastow collected approximately $30 million in management fees from various partnerships related to Enron.
News of the company’s third quarter losses resulted in a sharp decline in Enron’s stock value. Lay even called U.S. Treasury Secretary, Paul O’Neill, on October 28 to inform him of the company’s financial difficulties. Those events were then followed by a November 8th company announcement of even worse news—Enron had overstated earnings over the previous four years by $586 million and owed up to $3 billion for previously unreported obligations to various partnerships. This news sent the stock price further on its downward slide.
Despite these developments, Lay continued to tell employees that Enron’s stock was undervalued. Ironically, he was also allegedly selling portions of his own stake in the company for millions of dollars. Lay was one of the few Enron employees who managed to sell a significant portion of his stock before the stock price collapsed completely. In August 2001, he sold 93,000 shares for a personal gain of over $2 million.
Sadly, most Enron employees did not have the same chance to liquidate their Enron investments. Most of the company employees’ personal 401(k) accounts included large amounts of Enron stock. When Enron changed 401(k) administrators at the end of October 2001, employee retirement plans were temporarily frozen. Unfortunately, the November 8th announcement of prior period financial statement misstatements occurred during the freeze, paralyzing company employee 401(k) plans. When employees were finally allowed access to their plans, the stock had fallen below $10 per share from earlier highs exceeding $100 per share.
Corporate “white knights” appeared shortly thereafter, spurring hopes of a rescue. Dynegy Inc. and ChevronTexaco Corp. (a major Dynegy shareholder) almost spared Enron from bankruptcy when they announced a tentative agreement to buy the company for $8 billion in cash and stock. Unfortunately, Dynegy and ChevronTexaco later withdrew their offer after Enron’s credit rating was downgraded to “junk” status in late November. Enron tried unsuccessfully to prevent the downgrade, and allegedly asked the Bush administration for help in the process.
After Dynegy formally rescinded its purchase offer, Enron filed for Chapter 11 bankruptcy on December 2, 2001. This announcement pushed the company’s stock price down to $0.40 per share. On January 15, 2002, the New York Stock Exchange suspended trading in Enron’s stock and began the process to formally de-list it.
It is important to understand that a large portion of the earnings restatements may not technically have been attributable to improper accounting treatment. So, what made these enormous restatements necessary? In the end, the decline in Enron’s stock price triggered contractual obligations that were never reported on the balance sheet, in some cases due to “loopholes” in accounting standards, which Enron exploited. An analysis of the nuances of Enron’s partnership accounting provides some insight into the unraveling of this corporate giant.
Unraveling the “Special Purpose Entity” WebThe term “special purpose entity” (SPE) has become synonymous with the Enron collapse because these entities were at the center of Enron’s aggressive business and accounting practices. SPEs are separate legal entities set up to accomplish specific company objectives. For example, SPEs are sometimes created to help a company sell off assets. After identifying which assets to sell to the SPE, under the rules existing in 2001, the selling company would secure an outside investment of at least three percent of the value of the assets to be sold to the SPE.7 The company would then transfer the identified assets to the SPE. The SPE would pay for the contributed assets through a new debt or equity issuance. The selling company could then recognize the sale of the assets to the SPE and thereby remove the assets and any related debts from its balance sheet. The validity of such an arrangement is, of course, contingent on the outside investors bearing the risk of their investment. In other words, the investors are not permitted to finance their interest through a note payable or other type of guarantee that might absolve them from accepting responsibility if the SPE suffers losses or fails.8
7 Since the collapse of Enron, the FASB has changed the requirements for consolidations and now requires a ten percent minimum outside investment among other requirements designed to prevent abuses (See the FASB’s Accounting Standard Codification (ASC) 805 and ASC 810)8 The FEI Research Foundation. 2002. Special Purpose Entities: Understanding the Guidelines. Accessed at http://www.fei.org/download/SPEIssuesAlert.pdfWhile SPEs are fairly common in corporate America, they have been controversial. Some argued at the time that SPEs represented a “gaping loophole in accounting practice.”9 Accounting rules dictate that once a company owns 50% or more of another, the company must consolidate, thus including the related entity in its own financial statements. However, as the following quote from BusinessWeek demonstrates, such was not the case with SPEs in 2001:
The controversial exception that outsiders need invest only three percent of an SPE’s capital for it to be independent and off the balance sheet came about through fumbles by the Securities & Exchange Commission and the Financial Accounting Standards Board. In 1990, accounting firms asked the SEC to endorse the three percent rule that had become a common, though unofficial, practice in the ‘80s. The SEC didn’t like the idea, but it didn’t stomp on it, either. It asked the FASB to set tighter rules to force consolidation of entities that were effectively controlled by companies. FASB drafted two overhauls of the rules but never finished the job, and (as of May 2002) the SEC is still waiting.10
While SPEs can serve legitimate business purposes, it is now apparent that Enron used an intricate network of SPEs, along with complicated speculations and hedges—all couched in dense legal language—to keep an enormous amount of debt off the company’s balance sheet. Enron had literally hundreds of SPEs. Through careful structuring of these SPEs that took into account the complex accounting rules governing their required financial statement treatment, Enron was able to avoid consolidating the SPEs on its balance sheet. Three of the Enron SPEs have been made prominent throughout the congressional hearings and litigation proceedings. These SPEs were widely known as “Chewco,” “LJM2,” and “Whitewing.”
Chewco was established in 1997 by Enron executives in connection with a complex investment in another Enron partnership with interests in natural gas pipelines. Enron’s CFO, Andrew Fastow, was charged with managing the partnership. However, to prevent required disclosure of a potential conflict of interest between Fastow’s roles at Enron and Chewco, Fastow employed Michael Kopper, managing director of Enron Global Finance, to “officially” manage Chewco. In connection with the Chewco partnership, Fastow and Kopper appointed Fastow relatives to the board of directors of the partnership. Then, in a set of complicated transactions, another layer of partnerships was established to disguise Kopper’s invested interest in Chewco. Kopper originally invested $125,000 in Chewco and was later paid $10.5 million when Enron bought Chewco in March 2001.11 Surprisingly, Kopper remained relatively unknown throughout the subsequent investigations. In fact, Ken Lay told investigators that he did not know Kopper. Kopper was able to continue in his management roles through January 2002.12
The LJM2 partnership was formed in October 1999 with the goal of acquiring assets chiefly owned by Enron. Like Chewco, LJM2 was managed by Fastow and Kopper. To assist with the technicalities of this partnership, LJM2 engaged PricewaterhouseCoopers, LLP and the Chicago-based law firm, Kirkland & Ellis. Enron used the LJM2 partnership to deconsolidate its less-productive assets. These actions generated a 30 percent average annual return for the LJM2 limited-partner investors.
The Whitewing partnership, another significant SPE established by Enron, purchased an assortment of power plants, pipelines, and water projects originally purchased by Enron in the mid-1990s that were located in India, Turkey, Spain, and Latin America. The Whitewing partnership was crucial to Enron’s move from being an energy provider to becoming a trader of energy contracts. Whitewing was the vehicle through which Enron sold many of its physical energy production assets.
9 Source: “Who Else is Hiding Debt?” by David Henry, Businessweek. May 11, 2002. Used with the permission of Bloomberg L.P. Copyright © 2014. All rights reserved.10 Ibid.11 The Fall of Enron; Enron Lawyer’s Qualms Detailed in New Memos. The Los Angeles Times. February 7, 2002. Richard Simon, Edmund Sanders, Walter Hamilton.12 Fry, Jennifer. “Low-Profile Partnership Head Stayed on Job until Judge’s Order.” The Washington Post. February 7, 2002.In creating this partnership, Enron quietly guaranteed investors in Whitewing that if Whitewing’s assets (transferred from Enron) were sold at a loss, Enron would compensate the investors with shares of Enron common stock. This obligation—unknown to Enron’s shareholders—totaled $2 billion as of November 2001. Part of the secret guarantee to Whitewing investors surfaced in October 2001, when Enron’s credit rating was downgraded by credit agencies. The credit downgrade triggered a requirement that Enron immediately pay $690 million to Whitewing investors. It was when this obligation surfaced that Enron’s talks with Dynegy failed. Enron was unable to delay the payment and was forced to disclose the problem, stunning investors and fueling the fire that led to the company’s bankruptcy filing only two months later.
In addition to these partnerships, Enron created financial instruments called “Raptors,” which were backed by Enron stock and were designed to reduce the risks associated with Enron’s own investment portfolio. In essence, the Raptors covered potential losses on Enron investments as long as Enron’s stock market price continued to do well. Enron also masked debt using complex financial derivative transactions. Taking advantage of accounting rules to account for large loans from Wall Street firms as financial hedges, Enron hid $3.9 billion in debt from 1992 through 2001. At least $2.5 billion of those transactions arose in the three years prior to the Chapter 11 bankruptcy filing. These loans were in addition to the $8 to $10 billion in long and short-term debt that Enron disclosed in its financial reports in the three years leading up to its bankruptcy. Because the loans were accounted for as a hedging activity, Enron was able to explain away what looked like an increase in borrowings, (which would raise red flags for creditors), as hedges for commodity trades, rather than as new debt financing.13
The Complicity of Accounting Standards.Limitations in generally accepted accounting principles (GAAP) are at least partly to blame for Enron executives’ ability to hide debt, keeping it off the company’s financial statements. These technical accounting standards lay out specific “bright-line” rules that read much like the tax or criminal law codes. Some observers of the profession argue that by attempting to outline every accounting situation in detail, standard-setters are trying to create a specific decision model for every imaginable situation. However, very specific rules create an opportunity for clever lawyers, investment bankers, and accountants to create entities and transactions that circumvent the intent of the rules while still conforming to the “letter of the law.”
In his congressional testimony, Robert K. Herdman, SEC Chief Accountant at the time, discussed the difference between rule and principle-based accounting standards:
Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting. Examples of rule-based accounting guidance include the accounting for derivatives, employee stock options, and leasing. And, of course, questions keep coming. Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard.14
In some cases it is clear that Enron neither abode by the spirit nor the letter of these accounting rules (for example, by securing outside SPE investors against possible losses). It also appears that the company’s lack of disclosure regarding Fastow’s involvement in the SPEs fell short of accounting rule compliance.
13 Altman Daniel. “Enron Had More Than One Way to Disguise Rapid Rise in Debt,” The New York Times, February 17, 200214 Herdman, Robert K. “Prepared Witness Testimony: Herdman, Robert K., US House of Representatives. See the following website: http://energycommerce.house.gov/107/hearings/02142002Hearing490/Herdman802.htmThese “loopholes” allowed Enron executives to keep many of the company’s liabilities off the financial statements being audited by Andersen, LLP, as highlighted by the BusinessWeek article summarized in Exhibit 2. Given the alleged abuse of the accounting rules, many asked, “Where was Andersen, the accounting firm that was to serve as Enron’s public ‘watchdog,’ while Enron allegedly betrayed and misled its shareholders?”
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THE ROLE OF ANDERSEN
It is clear that investors and the public believed that Enron executives were not the only parties responsible for the company’s collapse. Many fingers also pointed to Enron’s auditor, Andersen, LLP, which issued “clean” audit opinions on Enron’s financial statements from 1997 to 2000 but later agreed that a massive earnings restatement was warranted. Andersen’s involvement with Enron ultimately destroyed the accounting firm—something the global business community would have thought next to impossible prior to 2001. Ironically, Andersen ceased to exist for the same essential reasons Enron failed–the company lost the trust of its clients and other business partners.
Andersen in the BeginningAndersen was originally founded as Andersen, Delaney & Co. in 1913 by Arthur Andersen, an accounting professor at Northwestern University in Chicago. By taking tough stands against clients’ aggressive accounting treatments, Andersen quickly gained a national reputation as a reliable keeper of the public’s trust:
In 1915, Andersen took the position that the balance sheet of a steamship-company client had to reflect the costs associated with the sinking of a freighter, even though the sinking occurred after the company’s fiscal year had ended but before Andersen had signed off on its financial statements. This marked the first time an auditor had demanded such a degree of disclosure to ensure accurate reporting.15
15 Brown, K., et al., “Andersen Indictment in Shredding Case Puts Its Future in Doubt as Clients Bolt,” The Wall Street Journal, March 15, 2000.Although Andersen’s storied reputation began with its founder, the accounting firm continued the tradition for years. An oft-repeated phrase at Andersen was, “there’s the Andersen way and the wrong way.” Another was “do the right thing.” Andersen was the only one of the major accounting firms to back reforms in the accounting for pensions in the 1980s, a move opposed by many corporations, including some of its own clients.16 Ironically, prior to the Enron debacle, Andersen had also previously taken an unpopular public stand to toughen the very accounting standards that Enron exploited in using SPEs to keep debt off its balance sheets.
Andersen’s Loss of ReputationWhile Andersen previously had been considered the cream of the crop of accounting firms, just prior to the Enron disaster Andersen’s reputation suffered from a number of high profile SEC investigations launched against the firm. The firm was investigated for its role in the financial statement audits of Waste Management, Global Crossing, Sunbeam, Qwest Communications, Baptist Foundation of Arizona, and WorldCom. In May 2001, Andersen paid $110 million to settle securities fraud charges stemming from its work at Sunbeam. In June 2001, Andersen entered a no-fault, no-admission-of-guilt plea bargain with the SEC to settle charges of Andersen’s audit work on Waste Management, Inc. for $7 million. Andersen later settled with investors of the Baptist Foundation of Arizona for $217 million without admitting fault or guilt (the firm subsequently reneged on the agreement because the firm was in liquidation). Due to this string of negative events and associated publicity, Andersen found its once-applauded reputation for impeccable integrity questioned by a market where integrity, independence, and reputation are the primary attributes affecting demand for a firm’s services.
Andersen at EnronBy 2001, Enron had become one of Andersen’s largest clients. Despite the firm’s recognition that Enron was a high-risk client, Andersen apparently had difficulty sticking to its guns at Enron. The accounting firm had identified $51 million of misstatements in Enron’s financial statements but decided not to require corrections when Enron balked at making the adjustments Andersen proposed. Those adjustments would have decreased Enron’s income by about half, from $105 million to $54 million--clearly a material amount-but Andersen gave Enron’s financial statements a clean opinion nonetheless.17
Andersen’s chief executive, Joseph F. Berardino, testified before the U.S. Congress that, after proposing the $51 million of adjustments to Enron’s 1997 results, the accounting firm decided that those adjustments were not material.18 Congressional hearings and the business press allege that Andersen was unable to stand up to Enron because of the conflicts of interest that existed due to large fees and the mix of services Andersen provided to Enron.
In 2000, Enron reported that it paid Andersen $52 million—$25 million for the financial statement audit work and $27 million for consulting services. Andersen not only performed the external financial statement audit, but also carried out Enron’s internal audit function, a relatively common practice in the accounting profession before the Sarbanes-Oxley Act of 2002. Ironically, Enron’s 2000 annual report disclosed that one of the major projects Andersen performed in 2000 was to examine and report on management’s assertion about the effectiveness of Enron’s system of internal controls.
Comments by investment billionaire, Warren E. Buffett, summarize the perceived conflict that often arises when auditors receive significant fees from clients: “Though auditors should regard the investing public as their client, they tend to kowtow instead to the managers who choose them and dole out their pay.” Buffett continued by quoting an old saying: “Whose bread I eat, his song I sing.”19
16 Ibid17 Hilzenrath, David S., “Early Warnings of Trouble at Enron.” The Washington Post. December 30, 2001 See the following website: http://www.washingtonpost.com/wp-dyn/articles/A40094-2001Dec29.html18 Ibid19 Hilzenrath, David S., “Early Warnings of Trouble at Enron.” The Washington Post. December 30, 2001. See the following website: http://www.washingtonpost.com/wp-dyn/articles/A40094-2001Dec29.htmlIt also appears that Andersen knew about Enron’s problems nearly a year before the downfall. According to a February 6, 2001 internal firm e-mail, Andersen considered dropping Enron as a client due to the risky nature of its business practices and its “aggressive” structuring of transactions and related entities. The e-mail, which was written by an Andersen partner to David Duncan, partner in charge of the Enron audit, detailed the discussion at an Andersen meeting about the future of the Enron engagement.