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Aspects of the Enron Scandal

Introduction

Enron entered into long-term contracts with gas suppliers. The company was to buy oil reserves at a fixed price, then sell to potential customers. It was to benefit from the difference since it had capability to control the supply in the market and not worry about the movement of the prices. This is because Enron had already locked its cost at a fixed value (Page 63).

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Guaranteeing Price to Be Paid

Enron entered into a contract with its customers, Kaiser, guaranteeing them that they would never pay more than $2.50 for every thousand cubic feet. Additionally, if the prices were to increase, Enron was to supply the oil at the stated price. Enron would also benefit when the oil price decreased below $2.50. Therefore, Enron was paid for assuming the price risk for Kaiser. This was an aggressive but illegal way of managing its business. This is because Enron assured its customers of supply of oil in future from the company reserves once Enron secured the contracts. Enron would also manipulate the market prices upwards, benefiting from the difference. Such decisions like assuming the risk were not very necessary for the firm since this was not its primary business. Consequently, it was assuming very huge risk. Locking prices was an aggressive way of making money (Page 66).

Establishing Gas Banks

Enron provided finance to other oil companies to acquire fixed-price gas. They intended to increase their revenues (Page 67).

Profit Shifting

Enron used non-existing companies such as Southwest Oil to transact with it to make enormous profits through the profit-shifting scheme. They also used ghost accounts, such as the ‘Y’ Account.

Examples Loopholes exploited by Enron

Revenue recognition

The company accountants adopted a method of recognising revenues on accrual basis. This is a process where the company decided to recognize revenues from twenty-year contracts in the first year. This led to reporting high revenues for the company (Page 83-90). The executives wanted to report high earnings to meet Wall Street projections, which the company was unable to meet by following the traditional accounting procedures.

Fire sale of off book investments

Enron would enter into deals to sale part of its investments and record the proceeds from those sales as part of the operating revenues of the company. E.g. the sale of Braveheart for more than $100 million, recorded as revenue (Page 541). Enron was also entering into swaps to report huge earnings. For example, the capacity swaps by global crossings and Qwest. These were sham transactions made to boost the revenues of Enron (Page 979-981).

Expenses

Unreported expenses: Enron used to avoid reporting all the relevant expenses to overstate their profits and their auditors overlook such details. For example, expenses in transactions with WorldCom telecommunications.

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Omission of financial expenses: Enron used to report its earning without charging the financial expenses incurred during the financial year. This led to reporting of huge profits than it was the case. (pg. 896-897)

Rhythms and EDS

I think Enron’s situation with Rhythms was similar to that of EDS. This is because Enron was afraid of incurring losses because of the prediction of uncertain future of Rhythms since they were to hold the stock for six months and feared that its price would fall. Therefore, Enron was to purchase put options to hedge against the losses. It faced the same future problem of the foreseen losses. This made the executives to purchase options to hedge against the anticipated future loss.

Quality of Earnings and Cash Flow

A company has high quality earnings if the cash is from aspects of the company business. This includes decrease in production costs or increase in sales rather than external forces. For Enron, most of its earnings and cash flow were attributable to external forces such as sale of stocks in the financial markets. Therefore, I think that Enron’s earnings and cash flows are of low quality.

Merger and Acquisition of Electro and AGOSBA

Enron paid three billion for the total merger and acquisition. The valuation of the target firm was based on the exchange of shares. This saw Enron shares rise significantly from about seven dollars to nine dollars when the news reached the market. Consequently, Enron became one of the most valuable companies in a matter of hours.

The bidding of the companies by Enron based on the valuation of shares, therefore, was for the benefit of Enron. It took advantage of their high share price to make sure they got a better deal compared to its competitors. The competitors used the revenues of the firm and its future prospects, which made them, quote fewer prices, thus, making them less competitive. A better way for valuation would have been to use the annual revenues of the firm to bid the target price (Santa Clara University).

Merger and Acquisition (Economics of Hedging)

Enron’s investment in Rhythms rose from $28 million to $400 million, since Enron was supposed to hold the stock six months before selling they had to hedge. They had to set up a hedge at a high price, which would enable Enron to halt everything at the best possible point for the company (Santa Clara University).

Another perfect hedge was to move up the value of the exact amount that the investment moved down. Therefore, the best hedge for the stock was to short the same stock, which would mean selling the stock, which Enron was not willing to do. The most viable option for Enron was to set up different short positions betting that prices would fall in stocks of companies similar to Rhythms. This was to protect Enron from a price collapse from the technology industry but from problems limited to Rhythms (White et al, 69).

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Year-End Scramble for Fictitious Profits

1997

By the end of the year, Enron had made more than half a billion dollars in profit which made Enron executives very happy. They had incurred a cost of $450 million taxes after due to the contract made with J-Block. This was to reduce their actual profits. Another cost incurred was through the shutdown of MTBE, due to the government’s change of rules on additive fuels. This cost Enron $74 million after taxes. The company remained with $ 105 million but this was before adjusting to $51 million from Bonneville Power, which Andersen had recommended not to be included in the profits, therefore, the profits would be just $49 million.

After adjustment of all the errors, omissions, and bad decisions Enron’s profit for 1997 would be $8 million and total revenue of $ 20 billion.

1999

Enron borrowed half a billion dollars from Citibank and used the money to purchase treasury bonds then called this as merchant investment. They would sell the bonds immediately and record the proceeds as cash from operations. After the trading frenzy, the company had made 40% of $ 1.2 billion, which they reported as operating cash flow though almost all of it had to belong to Citibank with interest.

By the end of the year, the company had hit its target within few weeks making almost $500 million in cash flow and around $125 million in profits. Almost half of that, Wall Street had hoped Enron would generate in the fourth quarter of 1999. The earnings are not correct since they are from trading stocks. I would value the company according to its earnings from energy business (White et al, 69).

Behavioural Issues

The culture adopted by Enron encouraged development of environment perfect for fraud. The management allowed the employees to use any means they think would enable the firm to make money. The end justified the means used and the management supported the actions taken by employees, e.g., when Skilling recommended the use of long term contracts to lock in cost and manipulate the market to make profit from the difference, Mr Kinder, a senior executive, supported his idea (Page 73). The board adopted the idea despite knowing it was a fraudulent way of making money. The senior executives were under pressure from the board to meet set targets. Enron allowed the creation of Special Purpose Entities, which were avenues for fraud. The company board allowed the Special Purpose Entities owned by senior management and failed to disclose the owners in the financial statements (Page 227).

The encouragement and incentives given to employees by Enron management allowed the highly educated of Enron to become notorious financial criminals. Investment banks such as Citibank allowed Enron to use special accounts to borrow money and trade the treasury bonds making huge profits (from Page 404). Enron reported these as cash flow from operations. The senior management put pressure on employees to conceal any information, which would ruin Enron’s business even if it were the correct move (Page 449). For example, when they realised that southwest oil was a sham company, they had to drop the argument through private investigation (Page 914).If I find myself in such environment, I would report the malpractice’s to necessary authorities or resign if no action is taken against the company (White et al, 69).

Reforms GAAP Made After Enron Scandal

After the scandal, several changes made included creation of a more restrictive structure known as Variable Interest Entity (VIE). This was to strengthen the rules of ownership in the Special Purpose Entities (SPEs). It required that the amount of investment by an outsider in the special purpose entity be increased from at least 3% to at least 3%. The investment from the outsider must be treated as on off-balance sheet item. It was made to avoid fraudulent activities committed by Enron through exploitation of the 3% rule. Therefore, all the special purpose vehicles qualify to be variable interest entities but the reverse is not true (White et al, 50).

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The second major change in GAAP required that all special purpose entity’s transactions recorded on the balance sheet. This means that all the investments made in the special purpose vehicle on the face of the balance sheet as opposed to the reporting in the additional notes to the financial statements. This is to avoid hiding the owners and the actual amounts and owners of the special purpose vehicles as Enron did. The investments must be consolidated with other investments in the group rather than a one-line Equity method. This is to ensure full disclosure of the special purpose vehicle (Santa Clara University).

The external auditors of the firm should not work as the consultants of their client. This is to prevent the auditors from auditing their own work and avoids conflict of interest, as was with the case with Arthur Andersen and Enron whereby Andersen provided both consulting services and audit. GAAP required that there should be separation of certain and uncertain projections and auditors are required to attest on the former only.

Valuation of Enron Earnings

I would use three approaches to determine Enron Earnings. First is Asset Approach. In this method, I would determine the value of assets and liabilities acquired using the earnings of Enron. The difference between the value of assets and liabilities is the value of earnings. Secondly, I would use Market approach, whereby, I would determine how much an investor is willing to pay to acquire Enron as a company assuming that he has all the relevant facts. That price is the value of Enron earnings. Using Income Approach, I would determine the expected cash flows and value them using either capitalization method or discounting methods to get the value of Enron earnings.

Enron’s Culture and Fraud Triangle

There are three factors necessary for fraud to occur. That is Pressure, Opportunity and Rationalization. Enron’s employees were always under pressure to meet targets from the board and senior management. They (employees) would always reconcile their behaviour with accepted standards. This would rationalize the financials. Enron had weak internal control procedures, which created an opportunity for fraud. Therefore, the culture of Enron fitted the fraud triangle of Pressure, Opportunity and Rationalization.

Works Cited

Santa Clara University. Lessons from the Enron Scandal. 2012. Web.

White, Gerald et al. The Analysis and Use of Financial Statements, New York: John Wiley & Sons, 1998. Print.

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