Enron Scandal Impact on Accounting Accounting has Essays - Economy

Enron Scandal: Impact on Accounting Accounting has been blamed for the losses sustained by Enron, as it allowed the company to hide details of its dealings from its investors, until the company's financial situation was so bad that the firm was forced to go bankrupt almost overnight. Enron's downfall has been characterised as "excessive interest by management in maintaining stock price or earnings trend through the use of unusually aggressive accounting practices." (Healy, 2003) As part of this, Enron used "mark-to-market accounting' for the energy trading business in the mid-1990s and used it on an unprecedented scale for its trading transactions." (Thomas, 2002) Under mark-to-market accounting practices, companies with outstanding derivative contracts or purchases on their balance sheets when accounts are being prepared must adjust them to "fair market value" (Thomas, 2002) As a result, predicted long term gains or losses on these contract are applied to the company's profit s immediately, similar to depreciation, or asset write downs. The main difficulty encountered when doing this for long-term futures contracts in energy markets is that "there are often no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods, as Enron did." (Healy, 2003) Another accounting technique Enron used to hide significant debts was the use of special purpose entities (SPEs), which Enron took to "new heights of complexity and sophistication, capitalizing them with not only a variety of hard assets and liabilities, but also extremely complex derivative financial instruments, its own restricted stock, rights to acquire its stock and related liabilities." (Thomas, 2002) Enron also used these SPEs to hide details of assets which were excessively declining in value, thus avoiding having losses from asset write down and depreciat ion charges on the company books. This practice was applied to "certain overseas energy facilities, the broadband operation or stock in companies that had been spun off to the public." (Thomas, 2002) The accounting treatments around SPEs meant that the losses sustained on these asset write downs would not appear on Enron's accounts. Enron promised share issues to the investors in the SPEs to compensate them for taking these assets on but, as the value of the assets fell even further, Enron found itself unable to meet these commitments from share issues. These creative accounting techniques began to be suspected by investors in October 2001, when Enron several new businesses failed to perform as well as expected. Enron was hoping these new businesses would cover its losses on the SPEs but, in October 2001 the company was forced to announce a major series of write-downs of its own assets, including "after tax charges of $2.87 million for Azurix, the water business acquired in 1 998, $180 million for broadband investments and $544 million for other investments." (Healy, 2003) These write downs amounted to twenty two percent of the capital spent by Enron on developing its business between 1998 and 2000. In addition, Enron sold Portland General Corp., the electric power plant it had acquired in 1997, for $1.9 billion, at a loss of $1.1 billion over the acquisition price. (Healy, 2003) The losses incurred as a result of this caused investors to question whether Enron's strategy was feasible in the long tem, and in markets other than derivatives. In summary, whilst the accounting concepts and strategy underlying the gas derivatives trading was a reasonable attempt to produce value for investors, "extensions of this idea into other markets and international expansion were unsuccessful." (Healy, 2003) However, whilst the mark to market and SPE accounting techniques used by the company helped hide this fact from investors, the stock markets as a whole were guilty of "largely ignored red flags associated with Enron's spectacular reported performance" (Thomas, 2002). This aided and, in the eyes of the management at Enron, vindicated the company's expansion strategy by allowing Enron access to plenty of capital cheaply and easily. As such, accounting cannot be entirely blamed for the losses sustained by investors, as the investors themselves simply assumed that the value Enron appeared to be generating "would be sustained far into the future, despite little economic basis for such a projection."