Enron: The Largest Accounting Scandal in the History of the United States

In my last blog I talked about fair value accounting and today I am going to talk about how the largest accounting scandal and business fraud in the history of the United States occurred as a result of fair value accounting abuse.

The Enron scandal changed the business and accounting world. Enron was the largest corporate bankruptcy at the time and the fraud committed by the executives cost shareholders and employees millions of dollars. The result of the scandal created an environment filled with laws and regulations to protect the shareholders of public companies. These laws expanded the roles of public accounting and created more jobs in the profession.

History

Enron was founded in 1985 by Ken Lay when Houston Natural Gas and InterNorth merged.  Enron was the wholesaler of electricity and natural gas owning and operating many different plants and gas pipelines worldwide. In 1992, they became the largest seller of natural gas in North America. Along with being a wholesaler of energy, Enron also traded energy and other commodities.

Enron was the seventh largest company on the Fortune 500 and the sixth largest energy company in the world valued at nearly $70 billion. In fifteen years, it went from a $10 billion in assets to 65 billion. It employed approximately 20,000 people and claimed to have revenues of nearly $101 billion dollars. Enron was awarded the most innovative company for six consecutive years by Fortune magazine.

As a result of these great accolades, Enron was considered to be a blue chip stock by many analysts. Its stock price increased by $311 percent from 1990-1998 and another 56% in 1999 and 87% in 2000. During the same years, the S&P increased by only 20% and decreased by 10% in 2000. The company’s stock priced peaked at 90$ with its market capitalization exceeding $60 billion. Enron’s stock drastically outperformed the market.

Mark-to-Market Accounting (Fair Value)

Jeff Skilling was Enron’s CEO and under his guidance, Enron entered the energy trading market.  He developed the idea of using energy as financial instruments like stocks and bonds, which can be traded over an active market.  He predicted huge profits for Enron from this idea. In order for Enron to be successful as energy traders, they needed to be able to use mark to market accounting to account for the trades. Arthur Andersen and the SEC approved the use of mark to market accounting.

It allowed Enron to book future profits on energy contracts and deals. Enron would predict what the future cash flows would be from the contracts and discount them to record profits in the current period. As a result of mark to market accounting, Enron’s profits could be whatever they wanted them to be. Mark to market accounting allowed Enron to record billions in profits from many of their projects. Many times these projects were failures and resulted in huge losses. But in an attempt to keep its stock price high, Enron continued to record profits from these failed projects even though there was never any cash that materialized. These projects include the power plant in Dabhol, India and the bandwidth partnership deal with Blockbuster.

Special Purpose Entities (SPE’s)

Enron was losing cash as a result of these failed projects.  Andrew Fastow was Enron’s CFO and was in charge of covering up these losses and keeping the stock price up. Fastow created multiple special purpose entities (SPE) to hide Enron’s debt. These SPE’s were owned by Andrew Fastow and financed by some of the major banks in the United States such as Merrill Lynch. The SPE’s strictly did business with Enron and Fastow controlled every single transaction, personally profiting $49 million by taking a little bit from every transaction.

The SPE’s would remove Enron’s debt from its balance sheet and be placed on the SPE’s.  This allowed Enron’s balance sheet to appear debt free. The use of SPE’s by Enron was legal and approved by Arthur Andersen. All the information required to be reported was disclosed by Enron. Even though the use of SPE’s was legal, Enron fraudulently used accounting techniques to hide about $30 billion dollars of debt from its balance sheet.

Bankruptcy      

December 2, 2001. Its stock price fell to less than a dollar and over 20,000 employees lost their jobs. It was the largest corporate bankruptcy at the time. Before the bankruptcy, the top executives and other insiders sold off a billion dollars’ worth of Enron stock.  While the average severance pay for the employees was $4,500, top executives were paid bonuses totaling 55 million dollars.  In 2001, employees lost $1.2 billion in retirement funds and retirees lost $2 billion in pension funds, Enron’s top executives cashed in $116 million in stock.

In the summer of 2001, Enron’s stock price began to decline.  On August 14, 2001, Skilling announced his resignation as CEO of Enron. But before he left, he sold off $66 million worth of stock. Unable to sustain its stock price, Enron declared bankruptcy on December 2, 2001. Its stock price fell to less than a dollar and over 20,000 employees lost their jobs. It was the largest corporate bankruptcy at the time.

The Enron scandal was one of the largest corporate frauds committed in the history of the United States. Many of the top executives including Skilling, Fastow, and Ken Lay were convicted of criminal charges for their roles in the fraud. Jeff Skilling was indicted in 2004 on 35 counts of fraud, insider trading and other crimes. On October 23, 2006, he was sentenced to 24 years and four months in prison and fined $45 million. Andrew Fastow who made more than $45 million through his LJM partnership took a plea bargain with prosecutors and agreed to testify against the other executives in order to get a reduced sentence.  He pled guilty to conspiracy to commit wire fraud, forfeited $23 million in assets, and was sentenced to ten years in prison. Ken Lay was convicted of six counts of securities and wire fraud and was looking to face up to 45 years in prison. He died of a heart attack prior to sentencing.

For their involvement in Enron, Arthur Andersen was charged with obstructing justice. They were forced to give up their CPA license and were no longer able to practice in public accounting.  Although this charge was later overturned, it was too late for Arthur Anderson. Their reputation was tarnished. They went from being one of the largest, oldest, and respected accounting firms in the world to a firm no one wanted to do business with. With their reputation ruined, the firm was ultimately destroyed losing all of its clients.

Results of Scandal

The Enron scandal resulted in major changes to the world of business and accounting. In an effort to prevent future corporate scandals, the United States government created the Sarbanes-Oxley Act of 2002 to protect investors and shareholders from corporate greed. Along with more government regulations, the New York Stock Exchange issued a new Governance Proposal. In order to be listed on the exchange, the proposal required companies to have a majority of independent directors, all audit committee members should be financially literate, and at least one member of the audit committee is required to have accounting or related financial management expertise. In addition, the board should hold additional sessions without management and the compensation committee, nominating committee, and audit committee shall consist of independent directors.

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Fair Value Accounting: Beneficial or Problematic?

 

What is Fair Value?

According to the FASB Accounting Standards codification 820, fair value is defined as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Quite simply, fair value is what someone is willing to pay for an asset or transfer a liability in a transaction.

Benefits of Fair Value

Some benefits of Fair Value accounting is that it provides investors and creditors with better information. It allows financial statement users such as investors to more accurately measure a company’s worth because they know exactly the value of a company’s assets and liabilities.  Fair value provides the most relevant measure of a company’s assets and liabilities and is a better measurement than the current methods such as historical cost. Could theoretically enhance comparability between companies because there will no longer be management judgment and estimation on the value of certain items such as depreciation on equipment.

Top ten issues with Fair Value: 

Issue 10: Depreciation expense would be eliminated because it would theoretically the fair value of the asset would decrease as the asset is used up. Investors and creditors may have a difficult time distinguishing between depreciation and this could potentially translate into a loss of information.

Issue 9: There would be Enormous book/tax differences because it can complicate book/tax differences dramatically. There could be an incentive to use fair value for books and another method for tax.

Issue 8: What would be the definition for Fair Value? Would it be what someone is willing to pay for something or a discounted cash flow model? Who would be in charge of making the fair value valuation? Would it be the firms themselves or independent appraisers.

Issue 7: Which market would be used to determine the fair value of the item? Would it be a local market, global market, or an average of the two?

Issue 6: Net income would be largely impacted by market conditions because market fluctuations in the price of items could influence net income more than operations.

Issue 5: Fair value would create greater volatility in earnings so it could be difficult to discern between fair value changes and operations. Giant swings in net income could make investing very difficult to predict.

Issue 4: Fair value measurement can cause erroneous “gains” from asset acquisitions and exchanges.

Issue 3: It can lead to fraudulent valuations. Fair value is highly subjective measurement so firms could engage in appraisal “shopping” and go with the appraisal which results in the highest measurement. This could lead to an independent issue as well.

Issue 2: It is difficult to value certain assets such as rare items which are used in niche industries or trademarks and other intangible assets. For example: how much is the Nike logo worth?

Issue 1: Lastly, it could cause financial statement preparation costs and audit costs to increase significantly because auditors would have to test the fair value valuation methods and appraisers must be hired by the firm and the auditors to determine the fair value of the items.

In conclusion, the fair value valuation method provides very little additional beneficial information but creates a number of issues which prove to be very problematic.

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Education Tax Credits

 

Why is it important to know about Education Tax Credits?

Education has always been seen as the key to a successful career but the rising cost of post-secondary education has deterred many people from pursuing a college degree.  However the federal government has several tax laws to help mitigate the cost of education and reduce a person’s tax liability. The cost of college is a major expense for college students. It is important for students like me to understand that these expenses can be mitigated by reducing their taxes.

American Opportunity Credit

The tax credits which I am going to talk about are the American opportunity credit, and lifetime learning credit. The American Opportunity Credit was created by President Obama when he signed the American Recovery and Reinvestment Act.  The credit increased the income limit of the Hope credit and allowed more items to be considered qualified education expenses. It also allowed students to claim the credit for four post-secondary education years rather than two.

The amount of the American Opportunity Credit a taxpayer can claim is the sum of 100% of the first $2,000 of qualified education expenses paid and 25% of the next $2,000. The maximum amount of the credit that can be claimed is $2,500. If a taxpayer paid at least $4,000 for qualified education expenses, they can claim the maximum amount per student.

The amount of the credit is gradually phased out if a taxpayer’s modified adjusted gross income is between $80,000 and $90,000 or $160,000 and $180,000 if filing a joint return. If the taxpayer’s income is $90,000 or more or $180,000 or more if filing jointly, they cannot claim the American Opportunity credit. These income limits are larger than the Hope Credit and the Lifetime Learning Credit.

A taxpayer cannot claim the American Opportunity Credit if their filing status is married filing separately or listed as a dependent on another person’s tax return. They also cannot claim the credit if their MAGI is greater than $90,000 ($180,000 if filing jointly) or if they or their spouse were nonresident aliens for any part of the tax year and they did not elect to be treated as a resident alien for tax purposes. Forty percent of the credit may be refundable and the rest is nonrefundable and it is available only if the student had not completed the first four years of post-secondary education before 2012.

Lifetime Learning Credit

If a student does not qualify for the American Opportunity Credit, they may be able to claim the Lifetime Learning Credit.  The Lifetime learning Credit is a nonrefundable credit so it can reduce one’s tax liability to zero and if there is an excess, it will not be refunded. It is available for an unlimited number of years for education expenses related to post-secondary education and for courses to acquire or improve job skills. The student does not need to be pursuing a program leading to a degree or other educational credential to claim the credit. Unlike the American Opportunity Credit, a felony drug conviction does not make the student ineligible for the Lifetime Learning Credit. The Lifetime Learning Credit is especially helpful for graduate students, students who are taking only one course, or students who are not pursuing a degree.

The amount of the Lifetime Learning Credit a taxpayer can claim is 20% of the first $10,000 of qualified education expenses. The maximum amount of the credit for 2012 is $2,000 but the amount can be reduced based on your MAGI. The amount of the credit is gradually reduced if your MAGI is between $52,000 and $62,000 or $104,000 and $124,000 if filing a joint return. It is completely reduced and you cannot claim the credit if your MAGI is higher than $62,000 or $124,000 if filing a joint return.

A person cannot claim the Lifetime Learning Credit if their filing status is married filing jointly or they are listed as a dependent on another person’s tax return. They cannot claim the credit if they or their spouse were nonresident aliens. Lastly, they cannot claim the Lifetime Learning Credit if they claimed the American Opportunity Credit or deducted their education expenses. If a taxpayer is eligible to claim the lifetime learning credit and also eligible to claim the American opportunity credit in the same year, they can choose which credit to claim, but they cannot claim both.  A person cannot deduct education expenses and claim any of the credits on the same expenses as well.

Even though the cost of education may be expensive, it still pays to earn a college degree over your lifetime.

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Conceptual Framework for Financial Reporting

What is the Conceptual Framework?

The Conceptual Framework for financial reporting was one of the biggest achievements for FASB.  The achievement of Conceptual Framework for financial reporting can be explained by the necessity to find a solution to the failures of standard setting by the AICPA. The AICPA was under criticism because of its refusal of a single uniform system of accounting which had led to many options that reduced the quality of financial reporting. A lack of consistent objectives and principles made it difficult to impose accounting solutions which could be accepted by everyone. A Conceptual Framework was therefore crucial to justify standards and make them acceptable.

Is the Conceptual Framework Useful?

The purpose of the U.S. Conceptual Framework is to be used as a guide in the development of consistent accounting standards, leading to a more coherent set of accounting principles to aid practice. Literature shows that Conceptual Framework has not fulfilled its purpose. Many researchers have pointed out the incompleteness, the inconsistency, and the circular reasoning of the Framework. Standards prior to the Framework have not been revised and as such were not consistent and the Framework has not provided sufficient grounding to achieve the consistency and comparability objective.

Conceptual Framework not an Authority

Conceptual Framework has to be treated as “the literature” not as an authority to be referred to, but as a useful source of ideas and to attempt to see alternative ways of framing the issues. It provides interpretations for GAAP, rule-based principles. The Conceptual Framework is a conception or model of what is out there – a tentative theory of phenomenon. The purpose of the conceptual Framework is not only to be descriptive, but also critical. If the Conceptual Framework becomes GAAP, it will be based on rules, instead of principles.

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Economic Consequence and Accounting Standards

What is Economic Consequence?

Economic consequence is the impact accounting reports and accounting standards have on the decision making behavior of business, creditors, investors, and other users of financial reports. When considering accounting questions, accounting standard setters should take into consideration the potential harmful effect the standard could have on companies and related parties. Accounting setters should not pass standards which result in unhealthy economic and social consequences.

Why is it an Issue?

Economic consequences is an issue for accounting standard setting bodies because accounting standard setting bodies should be seen as independent decision makers. They should be neutral in the decision making process and create standards which accurately reflect items on the financials.  The FASB’s main focus should be to provide useful, accurate, and relevant information to the users of financial statements. So when third parties begin to influence certain decisions, the standards become biased and are not accurately presented. For example when the housing bubble crashed in 2008, the FASB was influenced by the banks to not switching to mark-to-market accounting for the loans on their balance sheets. By not valuing the loans at their current fair values, the balance sheets of banks were inflated and did not fairly present their true financial position.

Should it be an issue when setting accounting standards?

Economic consequence should not be considered an issue when it comes to setting standards.  The FASB should consider what third parties have to say on proposed standards but they should not be influenced by them. The FASB is not changing the substance of the item. Its economic substance does not change. The only thing that changes is how the users of financial statements perceive the item.  Therefore, the FASB should consider the potential costs vs. the benefits of the proposed standard and set the standard if it enhances accounting measurement. When the FASB sets a standard, they are not changing the economic nature of the item. 

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Who should be in charge of creating accounting standards?

Financial Accounting Standards Board

Currently the Financial Accounting Standards Board (FASB) has the authority to establish accounting standards in the United States. They are an independent, non-profit entity and therefore bring an unbiased stance when it comes to setting accounting standards.  Financial statement users can have more faith in the accounting standards by knowing they were created by an independent body comprised of accounting professionals who set standards objectively to enhance accounting measurement to fairly represent accounting items.

I believe accounting standards should be created by an independent body such as the FASB, the government should play some role in the process. The government should not create standards but should enforce the standards to some degree.  With the accounting world being as large and complex as it is today, the FASB cannot enforce the standards it sets. The accounting profession can police itself but I think that would be difficult to do so. An independent body like the FASB does not have the power to penalize organizations for not following the standards. Without this power, it would give companies freedom to pick and choose the standards they want to follow.  Without potential penalties from the government, there would be no deterrent for companies to manipulate financial statements like Enron did in the early 2000’s.  The scandal of Enron prompted the government to get involved in the standard setting process and create the Sarbanes-Oxley Act. The Sarbanes-Oxley act deters companies from acting fraudulently because of the risks involved with getting caught.

However in today’s technological advanced world where information is made available instantaneously, the accounting profession could police itself. In order for companies to be listed on the major markets of the United States, they need to have financial statements in accordance with GAAP. This need for capital by companies can be enough incentive for them to abide by the standards set forth by the FASB.

Is the Government too Involved?

I do think the government is too involved when it comes to setting accounting standards.  The government is not in the business of setting accounting standards and should leave it up to the professionals who work for the FASB.  They should only act as the police, and enforce and penalize companies who do not abide by the standards.  They should not influence the FASB to take certain positions when it is not in the best interest of faithful accounting measurement.  By acting as the ultimate authority and influencing the FASB it is hindering the FASB’s independence.  With the loss of independence, the public could lose faith in the FASB’s ability to set standards.

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Bonds and Corporations

Creation of Bonds and the Bond Market

The birth of the bond market was the second biggest revolution in finance behind the rise of banks. Bonds were created during the Renaissance in Italy to finance the continuous wars between the city-states.  Instead of increasing taxes, citizens were obliged to take loans and receive interest payments in return. Government bonds were liquid assets and citizens became the biggest investors. Citizens were able to buy and sell the bonds the held as they saw fit and the bond market was created.

The Bond market played a major role in shaping world history. Bonds dictated the outcome of the Battle of Waterloo, the civil war, and were the instruments which created the Rothschild dynasty. They set interest rates for the market as a whole, and continue to benefit the government to finance its needs.  They are the link between government and finance and play an important role in today’s financial markets.

World’s First Corporation

The United East India Company (VOC) was chartered in 1602.  It was the world’s first corporation. It allowed individuals to pool their resources while not having to risk their entire life fortune. They can only lose what they invested in the company. This pooling of resources allowed the VOC to raise 6.45 million guilders making it the largest company of its era. The VOC issued shares and anyone was allowed to buy them. These shares were owned by individuals. If shareholders wanted their cash back they had no alternative but to sell their shares to another investor. This buying and selling of VOC shares led to the creation of the world’s first stock market.

The creation of the VOC was an important event because it created a way for people to pool their resources and allowed companies and business’s to raise more capital than ever before. By having more capital companies were able to expand and take on greater projects which required more resources than one individual could contribute.  It also made investing in ventures less risky because they people longer had to risk losing their life savings on business ventures. They were only able to lose the capital they put into the company. Lastly, it paved the way for the modern corporations and the stock market.

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Accounting: More than just “math”

What is accounting?

 When I tell people I am an accounting major, many people instantly assume I am good at math and good with money. Many people associate accounting with math and do not truly understand what accounting is. According to Merriam-Webster’s dictionary, accounting is defined as “the system of recording and summarizing business and financial transactions and analyzing, verifying, and reporting the results.” Accounting is more than just math and keeping track of money. Accounting is not just record keeping. It is the understanding of business’s and how they function and operate. It is an understanding of how companies make money.

 Why is it important?

Money makes the world go round! Companies use accounting to reduce costs and increase profits. They use accounting to raise capital by pooling the resources of individual investors. Individual and institutional investors use the financial statements companies report to make good investment decisions. This exchange of capital based on financial statements is how financial markets are created and operate. Financial markets are the bases of the world economy and their performance affects the economies of many countries around the world.

In today’s complex financial world, it is important for people to be financially literate. Being financially literate allows people to better manage their finances. It allows them to live a comfortable life where they do not need to stress about money. The more people who are financially literate would result in a more stable economy and a better standard of living for society as a whole.

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