Enron's Off-Balance-Sheet Transactions and Accounting Scandals, Study notes of Financial Statement Analysis

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Enron Accounting 1 12-1 Enron What happened ? 12-2 Enron And Growth During the late 1990s, Enron grew rapidly and moved into areas it believed fit its basic business plan: buy or develop an asset, such as a pipeline or power plant, and then expand it by building a wholesale or retail business around the asset. - This growth involved large initial capital investments - not expected to generate earnings or cash flow in the short term. - placed immediate pressure on Enron's balance sheet Enron already had a substantial debt load. - place pressure on Enron's credit ratings. - Maintaining Enron's credit ratings at investment grade was vital to the conduct of its energy trading business. 12-3 Enron – Off-balance sheet transactions Solution - find outside investors willing to enter into arrangements. - joint investments typically were structured as separate entities - in many cases a guaranty or other form of credit support was required from Enron. Enron's treatment of the entities for financial statement purposes was subject to accounting rules that determine whether the entity should be - consolidated in its entirety (including all of its assets and liabilities) - or should instead be treated as an investment by Enron. 12-4 Enron and SPE Enron preferred the latter treatment "off-balance- sheet” -because it would enable Enron to present itself more attractively as measured by the ratios favored by Wall Street analysts and rating agencies. Enron used Special Purpose Entities in many businesses - synthetic lease transactions: sale to an SPE of an asset and lease back (Enron's headquarters in Houston); - sales to SPEs of "financial assets" (a debt or equity interest owned by Enron); - sales to merchant "hedging" SPEs of Enron stock and contracts to receive Enron stock; 12-5 SPE Hundreds of respected U.S. companies have trillions of dollars in debt in off-balance-sheet subsidiaries, partnerships, and assorted obligations, including leases, pension plans, and take-or-pay contracts with suppliers. Potentially bankrupting contracts are mentioned vaguely in footnotes to company accounts The goal - skirt the rules of consolidation the bedrock of the American financial reporting system and the source of much its credibility. Set in 1959, aim to make public companies give a full and fair picture of their business--including all the assets and liabilities of any subsidiaries. 12-6 SPE and consolidations Accountants, lawyers, and bankers have learned to drive a coach and horses through them. Special-purpose entities (SPEs). the parent can bankroll up to 97% of the initial investment in an SPE (debt) without having to consolidate it into its own accounts. Normally, once a company owns >50% of another, it must consolidate it under the 1959 rules. But parent companies own 0% of SPE equity. The controversial exception: outsiders need invest only 3% of an SPE's capital Enron Accounting 2 12-7 SPE standards Fumbles by the Securities & Exchange Commission and the Financial Accounting Standards Board. In 1990, accounting firms asked the SEC to endorse the 3% 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. FASB drafted two overhauls of the rules but never finished the job, and the SEC is still waiting. 12-8 Enron Acounting literature provides only limited guidance concerning when an SPE should be consolidated - the context of synthetic lease transactions SEC staff concerns that there was no standard practice FASB Emerging Issues Task Force released several statements If there is no independent equity, or if the independent equity fails to meet the criteria, then the presumption is that the transferor of assets to the SPE or its sponsor should consolidate the SPE.. 12-9 SPE This presumption in favor of consolidation can be overcome only if two conditions are met: First, an independent owner(s) of the SPE must make a substantive capital investment in the SPE, and that investment must have substantive risks and rewards of ownership during the entire term of the transaction. The SEC - 3% of total capital is the minimum acceptable investment Second, the independent owner must exercise control over the SPE to avoid consolidation. 12-10 Enron SPE Chart . 12-11 Enron Charts . 12-12 Chewco The first related-party transactions: Chewco Investments L.P., a limited partnership managed by Kopper. Led to inaccurate financial statements from 1997 through 2001, 1993 -1996, Enron and CalPERS - partners in $500 million joint venture JEDI Because Enron and CalPERS, had joint control. So Enron did not consolidate JEDI Enron would record its contractual share of gains and losses from JEDI on its income statement but would not show JEDI's debt on its balance sheet. Enron Accounting 5 12-25 Raptor 1 Raptor vehicles. Extraordinarily complex structures. funded principally with Enron's own stock intended to "hedge" against declines in the value of a large group of Enron's merchant investments. Andersen approved the transactions, in fact the "hedging" transactions did not involve substantive transfers of economic risk. Enron never escaped the risk of loss, because it had provided the bulk of the capital with which the SPEs would pay Enron. 12-26 Raptor 2 Enron used this strategy to avoid recognizing losses In 1999, Enron recognized after-tax income of $95 million from the Rhythms transaction, which offset losses on the Rhythms investment. In the last two quarters of 2000, Enron recognized revenues of $500 million on derivative transactions with the Raptor, which offset losses in Enron's merchant investments. "Earnings" from the Raptors accounted for more than 80% of that total. 12-27 Raptor 3 Hedging Enron's investments with the value of Enron's capital stock Two of the Raptor SPEs lacked sufficient credit capacity to pay Enron on the "hedges." In late March 2001, Enron would be required to take a pre-tax charge against earnings of more than $500 million Rather than take that loss, Enron "restructured" the Raptor vehicles by, among other things, transferring more than $800 million of contracts to receive its own stock to them just before quarter-end. 12-28 Raptor 4 These efforts could not avoid the inevitable results of hedges that were supported only by Enron stock in a declining market. Ultimately, the SPEs were terminated in September 2001. - announcement on October 16, 2001, of a $544 million aftertax charge against earnings - was the result of Enron's "hedging" its investments Enron was required to reduce shareholders' equity by $1.2 billion - result of accounting errors made in 2000 and early 2001, 12-29 Watkins memo 12-30 Enron Issues Consolidation Issues In 2001, Enron and Andersen concluded that Chewco lacked sufficient outside equity at risk to qualify for non-consolidation. This retroactive consolidation decreased Enron's reported net income by $95 million (of $893 million total) in 1999 and by $8 million (of $979 million total) in 2000. Self-Dealing Issues These related-party transactions facilitated - accounting and financial reporting abuses by Enron - extraordinarily lucrative for Fastow and others. Enron Accounting 6 12-31 Enron Fraud A partnership called "Southampton Place," provided spectacular returns. In exchange for a $25,000 investment, Fastow received (through a family foundation) $4.5 million in approximately two months. Two other employees, who each invested $5,800, each received $1 million in the same time period. 12-32 Public Disclosures Very Little 10-K Note: Note 16 RELATED PARTY TRANSACTIONS In 2000 and 1999, Enron entered into transactions with limited partnerships (the Related Party) whose general partner's managing member is a senior officer of Enron. The limited partners of the Related Party are unrelated to Enron. Management believes that the terms of the transactions with the Related Party were reasonable compared to those which could have been negotiated with unrelated third parties. 12-33 Is Enron Overpriced? Monday, March 5, 2001 By Bethany McLean In Hollywood parlance, the "It Girl" is someone who commands the spotlight at any given moment--you know, like Jennifer Lopez or Kate Hudson. But for all the attention that's lavished on Enron, the company remains largely impenetrable to outsiders, as even some of its admirers are quick to admit. 12-34 Enron Note 16 “Enron guarantees the performance of certain of its unconsolidated equity affiliates in connection with letters of credit issued on behalf of those entities. At December 31, 2000, a total of $264 million of such guarantees were outstanding, including $103 million on behalf of EOTT Energy Partners, L.P. (EOTT). In addition, Enron is a guarantor on certain liabilities of unconsolidated equity affiliates and other companies totaling approximately $1,863 million at December 31, 2000, including $538 million related to EOTT trade obligations. 12-35 Enron . .