A Question of Ethics
Presented By:
Kim Duong
Aaron Lam
Ben Lehman
Enron: What Happened and What we
Can Learn From It
• Likely the largest case of financial
misrepresentation in recent history
• Provided high income and equity on statements
from 1997-2000, but in 2001 restated as lower
income amounts
▫ 544 million reduction in net income
▫ 1.2 billion reduction in equity
• Filed for bankruptcy on December 2, 2001
Why Is Enron Interesting to
Accountants?
• Arthur Anderson, a long time standing CPA firm
working for Enron, was scrutinized their lack of
integrity when auditing Enron
• Special Purpose Entities (SPE) were used by
Enron as a vehicle to manipulate the earnings
and losses associated with business operations
• Anderson was paid $27 million by Enron for
non-auditing services
▫ How might have this affected the outcome for
Enron?
The Accounting Issues
• The 6 accounting and auditing issues of primary importance are:
▫ The accounting policy of not consolidating SPEs that allowed
Enron to hide losses and debt from investors
▫ The accounting treatment of sales of Enron’s merchant
investments to unconsolidated SPEs that were of arm’s length
transactions
▫ Enron’s income recognition practice of recording as current
income fees for services rendered in future periods and recording
revenue from sales of forward contracts which were disguised
loans
▫ Fair-value accounting resulting in restatements of merchant
investments that were not based on trustworthy numbers
▫ Enron’s accounting for its stock that was issued to and held by
SPEs
▫ The inadequate disclosure of related party transactions and
conflicts of interest, and their costs to stockholders.
Accounting for investments in
subsidiaries and special-purpose
entities
• Enron sponsored hundreds of SPEs that were used
to shelter foreign-derived income from US taxes
• Some very substantial SPEs were sponsored to
conduct business with Enron domestically
▫ At the time, GAAP did not require to consolidate these
SPEs with financial statements if independent third
parties had a controlling and “substantial” equity
interest in the SPE
 Substantial defined as at least 3% of the SPE’s assets.
• Enron usually guaranteed their bank debt, however
the SPE’s principal asset was restricted Enron stock
JEDI and Chewco
• In 1993, Enron joined with the State of California’s pension
system called CalPERS in a joint venture, JEDI, that invested
in energy-related projects
• In 1997, Enron decided to buy out CalPERS so that it could
investest in a larger partnership.
• Enron then sponsored an SPE called Chewco, to take over
CalPERS’s limited partnership interest in JEDI
▫ At the time, Chewco met the 3% of assets criteria
• Michael J Kopper, who was technically not subject to relatedparty regulations was made manager instead of Fastow
• Enron guaranteed almost al of Chewco’s financing but did not
consolidate Chewco or JEDI in its financial statements.
▫ Enron did however report income gains from Chewco and JEDI
through the equity method, eliminating only half the gains,
instead of all of them under full consolidation.
LJM1 and LJM2
• JM1 was established to hedge Enron’s position in Rhythms NetConnections
stock
• Enron was viewed has having control over the SPEs since Fastow was both
general partner of SPEs and senior officer of Enron.
▫ Partnership agreements allowed for his removal as general partner and lead to
sufficient agreement to determine that Enron did not have control of the SPEs
• LJM1 actually wrote the hedge through an SPE it established, called LJM
Swap Sub, and was funded by LJM1 with cash plus 1.6 million restricted
shares
▫ LJM Swap Sub gave Enron a put option valued at $104 million, which was paid
for by a transfer to LJM of $168 million in restricted Enron stock.
▫ LJM1 then gave Enron a $64 million note to make up the difference from the
transfer.
▫ Since LJM Swap had negative equity, it could not meet the 3% rule.
• Overall, Enron would have had to report more actual losses on its financial
statements due to the decline in Rhythms stock, but managed to avoid this
through hedging with LJM Swap Sub in a complex exchange
Raptors (LJM2)
• In 2000, Enron sponsored four SPEs called Raptor I to IV who sponsored other SPEs that
had the effect of keeping losses on its merchant investment portfolio from appearing on its
financial statements.
• These SPEs sold Enron put options on several of its investments that allowed Enron to
avoid showing losses when they declined in value, because these losses were offset by the
put-option obligations of the SPEs.
▫
▫
If the investments decline in value, Enron had provided almost all the funds for the SPEs to
pay Enron back.
This lead to Enron’s shareholders absorbing all the losses and to Enron being able to avoid
showing these losses on their financial statements.
• Raptor I created Talon, who was contractually obligated to pay LJM2 a fee for a six-month
put-option on Enron stock paid by Enron to Talon, and Enron was required to purchase
LJM2’s interest in Talon.
• As the market prices of the merchant investments and Enron fell, Enron gave Talon a
“costless collar” that obligated Enron to pay Talon for losses on Enron stock so that Talon
would be able to meet its obligations on the derivatives owed to Enron
• If Enron’s stock price fell, that loss could not be covered
▫
If it increased sufficiently to cover Talon’s obligation, the loss on its merchant investments
would be hidden, but the shareholders would have to pay through stock issued at less than its
market price.
Timberwolf and Bobcat
• Enron sponsored 2 additional SPEs, Timberwolf which was
sponsored by Raptor II and Bobcat sponsored by Raptor IV, using a
similar procedure as Talon’s
▫ Raptor III created another SPE, Porcupine, was structured to write a
put-option on the stock of The New Power Company (TNPC)
• Enron had sold warrants on some of its holdings in TNPC to another
SPE that it formed with an outside investor called Hawaii 125-0
• Enron recorded revenue of $350 million to account for the increase
in TNPC shares
• However TNPC’s share price fell quickly after, diminishing
Porcupine’s ability to fulfill its put obligation on TNPC shares.
• To reduce this amount, Enron executed a 45-day cross-guarantee
agreement that merged the credit capacity of all four Raptors
Subsequent actions and accounting
changes as Enron’s stock prices
declined
• Enron had entered into derivative contracts with the Raptors
with a value of $1.5 billion on which it had a gain of $500
million.
▫ However the Raptors’ principal asset from which it could pay this
amount consisted of Enron stock or obligations, or TNPC stock.
• To avoid reporting this $500 million loss when Enron’s share
price fell
▫ Enron executed a cross-collateralization among the Raptors,
invested additional Enron stock contracts, and engaged in a
series of complex hedges that led to them only having to report a
$36.6 million loss.
• Enron’s not consolidating its SPEs lead to a increase in
reported earnings from the third quarter of 2000 to 2001, and
led to considerable costs to shareholders.
Sales of merchant investments to
unconsolidated SPEs as if these were
arm’s length transactions
• Enron entered into forward contracts with an investment bank to
purchase Enron’s stock at a fixed price,
▫ As market price increased in value, GAAP stated that Enron cannot be
recorded as income because the gain was due to an increase in the value
of its own stock
• Enron then used the gain on these contracts to fund its investment
in several of its SPEs
▫ Including those in Brazil that supported Enron’s recorded mark-tomarket gain due to alterations in Enron’s accounting treatment of related
gas supply contract
• Enron sold to LJM1 13% of its 65% ownership of another Brazilian
company, EPE
▫ As a result of the decrease in its ownership interest, Enron no longer
controlled EPE and was not required to consolidate EPE in its balance
sheet
▫ This allowed Enron to record an additional gain of $65 million by
marking to market a portion of a gas supply contract with EPE
Recording as current income fees for
services rendered in future periods
• Several of the SPEs paid Enron fees for guarantees on loans made
by the SPEs
• Enron recorded $10 million of fee income from Chewco, even
though it was outstanding for the next 12 months,
▫ Breaching the matching principal of recognizing the income over the
period of the guarantees.
• Enron reported false revenues when they sold forward gas
commodity contracts to Mahonia Ltd, and simultaneously
purchased an offsetting forward gas commodity contract from
another company
▫ Both companies being connected to Chase Bank.
▫ Enron collected immediately the discounted present value of the sales
contract as sales revenue, but did not record the matching expense of
this transaction
• Surety companies are now refusing to pay the bonds because they
were sure Enron had no intent to deliver the commodity and
because Enron and Chase were conspiring to disguise loans
Fair value restatements of merchant
investments that were not based on
trustworthy numbers
• GAAP Fair value accounting should be based on market prices derived
from arm’s length transactions involving the same or similar assets,
• FASB 133 allows the values of derivatives to be determined by marking
to model, which can result in substantially varying estimates
• Estimating procedures allow managers who want to manipulate net
income the opportunity to make “reasonable” assumptions
• Enron employees claimed that Enron’s policy was to reward those who
met their revenue targets and dismissed or effectively demoted those
who didn’t
▫ As it was difficult to maintain the target set by Enron, employees
could mark assets to “market” and record the presumed gains they
needed.
• In 1999 and 2000, Enron reported that its merchant investments and
energy assets are recorded at fair value
▫ But there was no breakdown provided on the extent to which each of
these methods was employed
Broadband and blockbuster inc
partnership, braveheart
• In 2000, Jeffrey Skilling told stock market analysts
that Enron was about to create a market for trading
space on the high-speed fiber optic networks that
form the backbone for internet traffic
▫ Revenue was generated by a sale of excess unused
(dark) fiber-optic connections to LJM2, the SPE
owned by Andy Fastow since LJM2’s principal asset
was Enron stock
• Another broadband venture was Project Braveheart
▫ Enron assigned the partnership a value of $124 million
based on its projections of the revenue and earnings
potential although the venture was incorporated in the
same year
Energy contracts
• Enron was required to mark-to-market the value
of its contracts to supply energy
▫ When its energy services unit signed a powersupply contract with a company, it would project
electricity and natural gas prices for the full term
of the deal
▫ Then based on these projections they would
recognize profit immediately
Enron’s merchant investments
• Enron’s merchant investments portfolio was
apparently organized as an investment fund
▫ Under GAAP they must revalue such assets at fair
value
▫ Since reliable market prices were not available,
Enron had the opportunity of assigning values
that permitted it to record earned revenue
Accounting for Enron stock issued to
and held by SPEs
• JEDI, owned 12 million shares of Enron stock,
and recorded at market and recognized income
from the amount of increased market value
▫ Though GAAP does not permit a corporation to
record as income increases in the value of its own
stock.
▫ Enron accounted for its investment in JEDI with
the equity method, and recorded the appreciation
in market value on its own financial statements
Disclosure of conflicts of interest and
its costs to stockholders
• SEC Regulation requires disclosure of transactions
exceeding $60,000 in which an executive officer of a
corporation has a material interest
▫ Disclosure is also required for material related-party
transactions. Enron’s transactions with the SPEs LJM1 and
LJM2 however do not appear to have been made at arm’s
length.
• Andrew Fastow and employees who reported to him
were on both sides of the transactions and benefited
personally from Enron’s dealings
• An example of this would be in 1999 when Enron sold
several investments to LJM1 and LJM2, SPEs of which
Fastow was general partner, at what appears to be
inflated profits
What Happened Because of Enron?
• Financial Literacy of all individuals working
within the auditing committee became required,
with one individual being a financial expert
being required
▫ However, Enron’s committee seemed to have
exceeded this requirement already
▫ Given this fact, why do you think the dishonest
behaviour still occurred?
What Happened Because of Enron?
• SPE creation and maintenance became a much
more important topic to accountants
▫ Enron’s negligence in disclosing their investments
and connection with SPEs is the reason for this
▫ Vinson and Elkins were Enron’s outside attorneys
at the time and were held liable for the errors
What Did Enron Do?
• Vinson and Elkins were criticized for their
negligence on assessing the SPEs
▫ Although the Enron vice president Sherron
Watkins took action to address the issues, they
were still considered:
 Not worthy of “further widespread investigation by
independent council or auditors”
 But also “a serious risk of adverse publicity and
litigation”
What Did Enron Do?
• Class Question: Which of theories can be applied
to explain the actions and response of the parties
involved in the SPE matter? How can they be
applied?
Response of the SEC
• The SEC has the power to discipline CPAs who
do not demonstrate a proper care for auditing
activities through disallowance of auditing
capabilities
▫ This can be exercised in the case of either
dishonest accounting, or in the case of negligent
acts on behalf of the accountant
▫ Despite this, the SEC rarely attempts to suspend
independent auditors – what kind of economic
consequences may occur to do this?
Lessons From Enron
• GAAP is often interpreted and followed by the
letter, but in doing so, companies can bypass the
basic objectives of the system
▫ GAAP should remain constantly changing to
match an ever-changing world
 How might an ever changing GAAP be relevant to
the fundamental dilemma of Financial Accounting
Theory?
Article: The Ethical Dilemma at
Northlake
• Article by Grant Russel
• Associate professor or management accounting
at the University of Waterloo
• Director-at-large for The Society of Management
Accountants of Canada
• Based on fictitious people and circumstances
• Amalgamated Forest Products Inc.
• Four members of the company involved (see
organizational chart)
Frank’s Achievements With Company
• Worked Amalgamated Forest Products for over
ten years after completing high school
• Worked as yard helper, then accounting clerk
• University studies arranged by company
• Complete Certified Management Accountant
(CMA) designation following graduation
Frank’s Achievements With Company
(cont’d)
• Awarded CMA Gold Medal
• Appointed new position in corporate reporting
• Promoted as manager of corporate reporting
after a year
Story
• Jean, Jim, and Tina plans environmental mill
project to make large profits
• Frank finds Tina’s report on the mill project
• Notices altered company information that are
unethical and against Corporate Social
Responsibility (CSR)
• Frank feels responsible for the problems caused if
project initiates and confronts Jean, Jim, and Tina
• As company president, Jean Letourneau, is
scheduled to testify truthfulness of information
before legislative sub-committee
Problems
•
•
•
•
Numbers in report have no foundation in fact
Estimates of costs highly inflated
Operating costs raised 30% instead of 8-10%
Report does not take into account damages
toward Wanawashee River
• Damages to river subject to huge lawsuit
Ethical Issues
• “We have to use different figures for different purposes”
• Trade off between reliability and relevance in presenting
financial statements
• “When we report to our shareholders, we give tem
numbers that are substantially altered from the internal
documents.”
• Does not think the pollution problem is the company’s
problem
• “This pollution problem is a ‘Northern problem’ that we
can resolve here, not in some fancy legislature in the
south.”
• Believes that a few extra years of pollution won’t hurt
Temptations & Threats
• Make Frank feel special
• “You’re an important part of our team – we’ve
invested a lot in you.”
• Promote as Vice President, Controller
• Indirectly threatens Frank
• “ We’d hate to let you go because of this small
issue.”
Temptations & Threats (cont’d)
• Indirectly tells Frank it doesn’t concern him
• “Besides, Jim tells me this isn’t even your
responsibility.”
• If Frank interferes, company will not survive and
workers will blame him for unemployment
Class Thoughts
WHAT DO YOU GUYS THINK?
How should Frank react to this situation?
1. Do nothing: it’s not his problem – the problem is Tina’s
2. Do nothing: the personal consequences to Frank are greater
than the ethical problem
3. Do nothing: the personal consequences to Frank are greater
than the ethical problem
4. Do nothing: he has already informed his supervisors,
nothing else is appropriate
5. Do nothing: his cocal management understands the situation
better than the legislative committee
6. Write an anonymous note to the local/national press
7. Resign: write a signed note to the local/national press
Class Thoughts (cont’d)
Frank’s decision should be made:
1. By himself
2. With legal counsel
3. With his family
4. With confidential friends
5. With assistance from the Society of
Management Accountants
Class Thoughts (cont’d)
If Frank approaches the Society of Management
Accountants for assistance, the Society should:
1. Do nothing: this is the member’s personal
responsibility
2. Provide confidential advice to Frank
3. Provide support to Frank in the event he needs
to seek new employment (e.g. letter of
reference)