1

ENRON: A FINANCIAL REPORTING FAILURE?

Anthony H. Catanach Jr.1
Associate Professor
610-519-4825 [Link]@[Link]
And
Shelley Rhoades-Catanach
Associate Professor
Both at
Villanova University
College of Commerce and Finance
Department of Accountancy
INTRODUCTION
The dramatic collapse of Enron Corporation, following a series of disclosures of accounting improprieties,
has led many to question the soundness of current accounting and financial reporting standards. Within
Enron’s reported financial statements, including related note disclosures, were there signs of Enron’s
accounting and economic issues? Should an astute investor or analyst have been suspicious of Enron’s
reported results? How did management hide debt, inflate profits, and support a stock price that
considerably overstated the firm’s value? Did Enron incorrectly apply existing standards, or do these rules
permit the accounting “gimmickry” that allowed Enron to obscure its true financial position? This paper
attempts to answer these questions by examining the two financial reporting issues that contributed to
Enron's most significant accounting restatements: the consolidation of special purpose entities (SPEs)
and the issuance of stock for notes receivable.
1 The authors gratefully acknowledge the financial support and resources provided by Villanova
University's College of Commerce and Finance. The authors also thank Noah Barsky for comments and
suggestions received on earlier drafts of this paper.
2 First, we examine Enron’s financial performance during the 10 years prior to its declaration of
bankruptcy. This analysis reveals increasing variability of key performance measures from 1997 through
2000, a time during which Enron’s stock price generally outperformed the NASDAQ composite.
Additionally, using metrics developed by Beneish (1997) to measure the likelihood of earnings
management, we find a high probability of earnings manipulation in Enron’s financial statements for
several years preceding its bankruptcy.
2 These results are particularly surprising because they are based on Enron’s reported financial results,
which we now know were erroneous. This investigation suggests that considerable evidence existed that
should have lead analysts, sophisticated investors, and regulators to question Enron’s financial results
and soaring stock price.
Next, we briefly describe the accounting and financial reporting standards applicable to Enron’s
consolidation of SPEs and issuance of stock for notes receivable. We specifically discuss three major
sets of transactions in which Enron created SPEs to hold assets, borrow money, and hedge fluctuations
in the value of its investment activities. In each case, we identify whether Enron’s treatment of these
SPEs complied with or failed to meet the requirements of existing accounting principles. We also discuss
the impact of these transactions on Enron’s true financial position and how its reporting of these
transactions obscured their economic substance. Several of these transactions involved Enron
exchanging its own stock for notes receivable from the SPEs. The financial reporting implications of these
transactions also are discussed. We conclude with a summary of important issues for consideration by
accounting standard setters.2 Beneish, M. 1997. Detecting GAAP violation: Implications for assessing
earnings management among firms with extreme financial performance & Journal of Accounting and
Public Policy 16 (3): 271-309.
3 ENRON'S FINANCIAL PERFORMANCE: WHAT DID THE MARKET SEE?
Reported Financial Performance: 1991-2000
Prior to its collapse in late 2001, Enron was perceived by most analysts and investors as a company that
could do no wrong. The market considered Enron's management talented and aggressive, and its
business model cutting edge and innovative. Investor demand for the Company's stock soared, pushing
its stock price from almost $7 per share in 1990 to over $83 per share a decade later. As Table 1
indicates, much of the stock price increase actually occurred between October 1997 and September
2000. In fact, for all of 2000, Enron's stock even outperformed the NASDAQ composite index which
began to stumble as technology retreated.
INSERT TABLE 1 HERE
What did the market see that caused them to value Enron so highly? The Company's annual financial
statements may have fueled investor passions to own Enron stock. For example, Enron's reported
earnings increased eightfold between 1997 and 2000. As Table 2 illustrates, reported operating
performance in the last four years of the decade were a marked improvement over the preceding six
years. However, Table 2 also highlights an interesting development in Enron's performance measures.
Four financial indicators are commonly used to evaluate corporate performance: income before
extraordinary items (IBE), cash flow from operations (CFO), comprehensive income (CI), and free cash
flow (FCF). According to Table 2, these measures generally moved in tandem between 1991 and 1996
and within a narrow range. But in 1997, these four indicators not only diverged dramatically, but also
appear to have increased in volatility. Could this "uncoupling" have been a signal of the accounting
irregularities which we now know began in 1997? Did the financial statements filed with the Securities and
Exchange Commission (including the admittedly erroneous reports made between 1997 and 2000)
provide 4 any warning of the catastrophe that was about to befall investors? More importantly, how did
well-educated and experienced analysts miss such a signal?
INSERT TABLE 2 HERE
Analysts use a variety of models and techniques to evaluate operational performance in business entities.
Once such tool is the Dupont System of Financial Analysis.3 This simple, but robust framework relies
primarily on three ratios (asset turnover, profit margin, and leverage) to help an analyst see how a firm's
decisions and activities over the course of an accounting period interact to produce an overall return to
the firm's shareholders (i.e., return on equity). Increases in all three of these ratios suggest improved
management of a firm's assets, profit margins, and financing activities, which should contribute to an
overall rise in return on equity. When applied to Enron's reported financial statement data from 1991 to
2000, Dupont System analysis provides additional insight into the company's troubled operations. As
Table 3 indicates, subsequent to the 1997 "uncoupling" noted above, Enron's return on equity plummeted
into single digits from its pre-1997 levels. Although both asset turnover and leverage ratios staged modest
recoveries between 1997 and 2000, the increases were not enough to overcome a precipitous decline in
the profit margin ratio which ultimately drove return on equity down. The declines in profit margin
are particularly noteworthy as they occurred during a period of significant stock price appreciation. Could
profit pressures have created incentives for Enron's managers to engage in the type of behavior which we
now know occurred? Why did so few analysts question the obvious disparity between Enron's operating
performance and its stock price valuation? Were Enron's financial statements and the related accounting
really all that bad if they raised this many questions?
3. Fraser L, and A. Ormiston. 2001. Understanding Financial Statements. Sixth Edition. Prentice Hall.
Upper Saddle River, NJ.
5
INSERT TABLE 3 HERE “The Potential for Earnings Management”
Many consider Enron a textbook case of earnings management. Mulford and Comiskey (1996) define
earnings management as the active manipulation of accounting results for the purpose of creating an
altered impression of business performance.4 Clearly, Enron was guilty at some level of such behavior,
but were there no signals to alert the market? In 1987, the Treadway Commission provided specific
guidelines for assessing the risk of fraudulent financial reporting.5 The Commission noted three primary
influences on financial reporting: performance pressures, oversight issues, and changing structural
conditions. Enron displayed troubling symptoms in all three categories. For example, Enron was a high
visibility company with significant contractual incentives (e.g. debt and stock options) that put enormous
pressure on management to sustain and improve operating performance. With respect to oversight, the
Company employed complex ownership and financial structures to execute its business strategy which
made it difficult for analysts, auditors, and regulators to effectively monitor its operations. Finally, Enron
was impacted by numerous changes in its business environment that ultimately affected its reporting. The
Company's innovativeness took it into new industries that employed new technologies, required new
financing techniques, and ultimately pushed original accounting rules to their limits. The decline in the
technology sector in the late 1990's also negatively affected the Company's performance, providing
additional incentives for management to engage in earnings manipulation.
4. Mulford, C., and E. Comiskey. 2002. The Financial Numbers Game: Detecting Creative Accounting
Practices. John Wiley & Sons, Inc. New York, NY.
5. Tread way Commission. 1987. Report of the national commission on fraudulent financial reporting.
National Commission on Financial Reporting, In particular, see Appendix F.
6. However, qualitative factors such as those proposed by the Treadway Commission often can be
difficult to apply. Moreover, qualitative arguments are likely to fall on deaf ears particularly in markets as
euphoric as that depicted in Table 1. Consequently, quantitative data must supplement qualitative
arguments when evaluating the potential for earnings management. Historically, analysts have been
content to compare balances and ratios between years to evaluate the quality of reported financial
results. Over the last decade, however, researchers have developed more sophisticated models to
assess the probability of earnings manipulation. One such technique is the Beneish (1997) probate
analysis model.
6 This is a user friendly, low cost approach that yields an earnings manipulation index that can be easily
computed as a linear combination of financial variables and converted to a "probability of manipulation."7
Beneish (1997) used several measures to capture distortions in financial statement data to assess the
probability of detection. These are based on the financial statement analysis literature and are described
in Table 4.
INSERT TABLE 4 HERE
Table 5 compares Enron's index data for the period 1995 through 2000 with that for GAAP violating and
control firms used in Beneish (1997). The gross margin index consistently exceeds that of the GAAP
violators between 1996 and 2000 reflecting declining margins that may have created performance
pressures on management. Between 1995 and 1999, Enron's asset quality index also surpassed that
reported by Beneish's (1997) GAAP violators. In four years, the index was greater than one suggesting a
growing tendency to defer costs. Similarly,
6 Supra note 2.
7 Supra note 2. Beneish uses the probit model to assess the probability that a company manipulated its
earnings. To develop the model, he examined 64 firms who were known to have manipulated their
financial statements through GAAP violations between 1987 and 1993. This sample of firms was then
compared to firms who resembled the violators (large discretionary accruals and increasing sales), but
who had not been identified as having violated GAAP in their financial statements.
7. The depreciation index exceeded one in 1995, 1997, and 2000. The sales growth index also signaled
the potential for manipulation in four of the six years examined. When computed, the probability of
manipulation was quite high in 1996 and 2000 (over 25 percent).8 Therefore, Enron's reported numbers
appear to have provided ample warning to the potential for earnings management. These findings
suggest that Enron's major problem may not have been in the reporting of numbers, but rather in the lack
of oversight that should have been provided by analysts, auditors, institutional investors, and regulators.
Nevertheless, Table 5 clearly indicates that Enron's numbers were suspect. The next two sections shed
light on the extent of the major, non-subjective accounting irregularities that impacted Enron's financial
performance subsequent to 1996.
INSERT TABLE 5 HERE “THE ACCOUNTING AND FINANCIAL REPORTING RULES”
Many of the accounting and financial reporting issues related to Enron deal with the treatment of SPEs.
SPEs may take the legal form of a trust, partnership, or corporation, and are typically established for a
specific purpose or a specific business activity, typically for the benefit of a single company (often referred
to as the SPE’s sponsor). The SPE’s activities are typically limited in scope, often to a single activity such
as leasing, securitization, hedging, research and development, or reinsurance. These activities are often
predetermined by the documents creating the entity or by contracts between the parties involved.
8 The median estimated probability of GAAP violators in the Beneish (supra note 2) model was 9.5
percent and 1.1 percent for control firms. However, selecting the appropriate cutoff point depends on the
analysts’ purpose. For example, Beneish found that using a probability cutoff of 2.94 percent resulted in
the correct classification of 83 percent of GAAP violators in his sample. Conversely, using an 11.72
percent probability cutoff resulted in only 45 percent of GAAP violators being correctly classified.
8 Consolidation Rules
ARB 51 provides general rules for combining the financial results of related entities.9 ARB 51 states that
consolidated financial statements are “usually necessary for a fair presentation when one of the
companies in the group directly or indirectly has a controlling financial interest in the other companies.”10
ARB 51 defines a controlling financial interest as “a majority voting interest.”11 Thus, a company and any
entity in which that company has greater than 50% voting control would file consolidated financial
statements reflecting the assets, liabilities, revenues and expenses of each member of the consolidated
group. Application of ARB 51 to SPEs is problematic in many cases, because the parties involved in the
SPE may not control its activities through voting equity interests. For example, the activities of an SPE
formed as a trust are controlled by the trust document under the direction of a trustee. Beneficiaries of the
trust have no voting rights or control over trust activities. In an SPE formed as a partnership, limited
partners are prohibited from participating in partnership management; activities are directed by a general
partner or partners, subject to the terms of the partnership agreement. During the last decade, the
Financial Accounting Standards Board (FASB) has considered the treatment of SPEs used in particular
activities but has not promulgated general guidance on when such entities should be consolidated for
financial reporting purposes. The FASB’s Emerging Issues Task Force (EITF) issued EITF 90-15 to
address the use of SPEs in leasing transactions.12 among other factors; EITF 90-15 indicated that an
SPE lessor should be 9 Committee on Accounting Procedure. 1959. Accounting Research Bulletin No.
51: Consolidated Financial Statements. The American Institute of Certified Public Accountants. New
York, NY (ARB 51). 10 ARB &51 para. 1. 11 ARB 51, para. 2. 12 Emerging Issues Task Force. 1990.
EITF 90-15: Impact of non-substantive lessors, residual value guarantees, and other provisions in leasing
transactions. Financial Accounting Standards Board. Norwalk, CT (EITF 90-15). 9 consolidated with a
lessee when “the owner(s) of record of the SPE has not made an initial substantive residual equity capital
investment that is at risk during the entire term of the lease.”13 In applying this test, the Task Force
indicated that 3 percent was the minimum acceptable investment by owners other than the lessee.
Although EITF 90-15 focused on leasing transactions, the staff of the Securities and Exchange
Commission (SEC) in its comments to the EITF indicated that the conditions set forth in EITF 90-15 might
be useful in evaluating other transactions involving SPEs. Thus, EITF 90-15 provides the underlying
authority by which Enron and many others structured SPEs to avoid consolidation by obtaining 3 percent
outside investment.
Equity Method of Accounting
When an SPE is not consolidated with another entity, investments in the SPE are recorded using the
equity method of accounting under APB 18.14 In addition, transactions between the SPE and its investors
are recorded in the financial statements is if between independent parties. Under APB 18, the equity
method of accounting is appropriate when an investor exercises “significant influence over operating and
financial policies of an investee even though the investor holds 50% or less of the voting stock.”15 Under
the equity method of accounting, the investor records its initial investment in the investee at cost. Then
the carrying amount of the investment is adjusted to recognize the investor’s share of the investee’s
earnings or losses after the date of the investment.16 The investment is shown on the investor’s balance
sheet as a single 13 Id. 14 Accounting Principles Board. 1971. APB Opinion No. 18: The equity method of
accounting for investments in common stock. The American Institute of Certified Public Accountants.
New York, NY (APB 18). 15 APB 18, para. 17.
16 APB 18, para. 6. 10 amount; the investor’s share of earnings and losses from the investment is shown
on its income statement as a single amount.
17 Issuance of Stock for Notes
Many of Enron’s SPEs held Enron stock. In some cases, stock was issued by the corporation to the SPE
in exchange for notes. EITF 85-1 addresses the recording of such stock issuances by the corporation.18
It concludes that recording the note as an asset is generally not appropriate. Instead, the note should be
offset against the stock in the equity section of the balance sheet. The treatment of this transaction in
EITF 85-1 is consistent with the SEC’s Staff Accounting Bulletin 40, applicable to public companies.19
ENRON'S MANIPULATION OF EARNINGS AND EQUITY
As previously shown in Table 2, Enron's performance measures appear to have "uncoupled" beginning in
1997. Clearly, "aggressive" accounting may have played a role in the increased volatility witnessed
among IBE, CFO, CI, and FCF subsequent to 1996.20 This section reviews the Company's failure to
comply with the provisions of EITF 90-15 as it relates to the consolidation of its SPE's which ultimately
distorted financial performance between 1997 and 2000. Enron's practice of recording equity for stock
issuances to its SPEs also is discussed. 17 APB 18, para. 11. 18 Emerging Issues Task Force. 1985.
EITF 85-1: Classifying notes received for capital stock. Financial Accounting Standards Board.
Norwalk, CT (EITF 85-1). 19 Securities and Exchange Commission. 1985. Staff Accounting Bulletin 40:
Receivables from sale of stock. Securities and Exchange Commission. Washington, DC (SAB 40).
20 In fact, the Company's financial reporting recently has been criticized in a number of areas that may
have actually complied with GAAP: revenue recognition on energy trading contracts and securitized asset
sales (e.g. the Braveheart partnership). In such cases, which often involved complex financial structured
transactions, it appears that earnings were recorded incorrectly either because of inadequate accounting
regulation (i.e. vague accounting and reporting guidance) or poor management estimates or a
combination of the two (See discussion by Norris and Eichenwald 2002. Evidence proving fraud may turn
out to be elusive. The New York Times January 30, 2002.) Therefore, this paper focuses only on those
transactions where the accounting rules were clear and where the role of management judgment or
interpretation was small.
11 Non-consolidations of SPEs Joint Energy Development Investments LP (JEDI) and the Chewco
SPE
Between 1993 and 1996, Enron and the California Public Employees' Retirement System (Calpers) were
50 percent joint-venture partners in the JEDI limited partnership.21 Enron (the general partner) and
Calpers (the limited partner) each initially contributed $250 million to JEDI to fund a variety of investment
transactions.22 Because Enron did not have a controlling interest (greater than 50 percent) in the limited
partnership during this three year period, JEDI's assets and liabilities were not required to be included in
the Company's balance sheet.23 Additionally, Enron recognized income (or loss) for JEDI only to the
extent of its ownership percentage (50 percent) as required by APB No. 18. In 1997, Calpers sought to
liquidate its investment in JEDI in order to pursue another investment opportunity. To accommodate
Calpers' wishes, Enron created a new investment partnership to purchase Calpers' investment 50 percent
limited partner investment. This new partnership, Chewco Investments LP (Chewco), was funded with
$383.5 million from the following sources: a $240 million unsecured subordinated loan to Chewco from
Barclays Bank PLC (guaranteed by Enron), a $132 million advance from JEDI to Chewco under a
revolving credit agreement, and $11.5 million in equity from Chewco's general and limited partners (Big
River LLC and Little River LLC).24 Chewco then purchased Calpers' interest with these funds.25 JEDI
continued to be reported as an unconsolidated entity at the end of 1997.26 This treatment was based on
the assertion that Chewco owned 50 percent of JEDI, thus precluding 21 Powers, W. C. Jr., R. Troubh,
and H. S. Winokur, Jr. 2002. Report of investigation by the special investigative committee of the board of
directors of Enron Corp. (Powers Report), p. 43. 22 Id. 23 Id. 24 Powers Report, p. 49 25 Powers Report,
p. 44 26 Enron Corporation Form 10-K, for year ended December 31, 1997, note 8. 12 Enron from having
a "controlling interest" which would trigger consolidation of JEDI. Accordingly, Enron continued to record
50 percent of JEDI's income and losses in its income statement.27 However, several Enron related loan
guarantees associated with the initial funding of Chewco made this treatment inappropriate. When
Chewco was initially formed as an SPE, Enron carefully crafted its capitalization such that it would not
have to be consolidated into Enron's financial statements either. Enron made sure that Chewco's
investors (Big River LLC and Little River LLC) appeared to meet the 3 percent "at risk" provisions of EITF
90-15. However, the investors' entire $11.5 million investment was funded by Barclays Bank PLC, which
required that $6.6 million of the loan be secured by a reserve provided by JEDI.28 Since Enron owned 50
percent of JEDI, Enron effectively guaranteed $3.3 million of the Chewco investors’ contribution. This
meant that the investors in reality had less than 3 percent of their monies "at risk" thus failing EITF 90-
15's test. Moreover, since Enron guaranteed most of Chewco's debt and also shared in substantially all of
Chewco's risks and rewards, EITF 90-15 required that Chewco be consolidated into Enron's financial
statements. Requiring Chewco's consolidation results in Enron (the consolidated entity) now owning (and
controlling) 100 percent of JEDI. Therefore, JEDI should have been consolidated with Enron as well.29
The effects on Enron's balance sheets and income statements were dramatic. As indicated in Table 6, net
income and stockholders' equity were overstated by a total of $405 million between 1997 and 2000 by the
failure of Enron to properly consolidate both JEDI and 27 It should be noted that JEDI also owned Enron
stock and recognized gains on its appreciation (Powers Report, p. 59). By using the equity method of
accounting, Enron was able to report revenues related to the price appreciation of its own stock.
28 Powers Report, p. 50-1. 29 Powers Report, p. 52. 13 Chewco in its financial statements.30 Failure to
correctly apply EITF 90-15 also resulted in an understatement of liabilities on Enron's balance sheet by
amounts ranging from $561 million to $711 million during the same period.31
INSERT TABLE 6 HERE The Rhythms Hedging SPE
In March 1998, Enron purchased a $10 million investment in Rhythms Net Connections, Inc. (Rhythms), a
privately-held internet service provider for businesses using digital subscriber line technology.32 In April
1999, Rhythms went public and within a month, Enron's investment in Rhythms had soared to $300
million.33 However, Enron was prohibited from selling its shares before year end.34 Since the Rhythms
investment was carried at market value in Enron's balance sheet, changes in the price of Rhythms stock
were reported in Enron's income statement.35 The Company wanted to "lock in" its gains on the Rhythms
stock and protect itself from any price depreciation, but hedging a position as large and as illiquid as
theirs commercially was considered too costly.36 Therefore, in June 1999, Enron decided to hedge
against the potential price volatility of its Rhythms investment using an SPE named LJM Swap Sub LP
(Swab Sub).37 This was the first of many SPEs that the Company allegedly created for hedging
purposes. Enron contributed 3.4 million shares of its own stock to Swap Sub's limited partner who
in turn used 1.6 million shares of Enron's stock (and $3.75 million in cash) to provide the 3 percent
outside equity "at risk" required by EITF 90-15 to prevent consolidation.38 Swap Sub 30 Powers Report,
p. 42. 31 Id. 32 Powers Report, p. 77.
33 Id. 34 Id. 35 Id. 36 Powers Report, p. 78. 37 Powers Report, p. 79. 38 Powers Report, p. 80. 14
Then gave Enron a put option on 5.4 million shares of Rhythms stock.39 If the Rhythms stock declined in
value, the put option would increase in value, thus protecting Enron from price volatility of the Rhythms
stock. Given the structure of the Swap Sub SPE (i.e. Enron stock was its principal asset), Enron was
using its own stock to hedge its Rhythms investment. Enron hoped that price appreciation in its own stock
would generate sufficient funds to allow Swap Sub to make good on Enron's put option should the price of
Rhythms stock decline. For what remain unknown reasons, at its formation in June 1999, Swap Sub's
liability (the $104 million Enron put option) greatly exceeded its assets ($3.75 million in cash and $80
million in Enron stock).40 Therefore, Swap Sub had no equity and failed EITF 90-15's three percent "at
risk" equity test. Consolidation of Swap Sub should have occurred but did not.41 As indicated in Table 6,
failure to consolidate Swap Sub (the correct application of EITF 90-15 in the Rhythms hedge transaction)
overstated net income (and stockholders' equity) by a total of $103 million in 1999 and 2000.42 These
income declines essentially reflect "unhedged" price decreases in the value of Rhythms stock during
these two years.
The Raptors Hedging SPEs
In April of 2000, Enron extended the hedging methodology used for its Rhythms investment to its
merchant investment portfolio. As in the case of the Rhythms securities, the merchant investments
(primarily high-technology and energy stocks) had increased in value dramatically and price changes
were reflected quarterly in the Company's financial statements. Again, commercial hedging vehicles were
not considered practical by Enron management. Therefore, over the next several months, Enron created
four new, much larger SPE's (Talon, 39 Powers Report, p. 81. 40 Powers Report, p. 83. 41 Apparently,
Arthur Andersen erroneously approved Swap Sub for non-consolidation (Powers Report, p. 83-4). 42
Powers Report, p. 84. 15 Timberwolf, Porcupine, and Bobcat, hereafter referred to as the Raptors) to
handle its hedging transactions.43 The general structure of each transaction is as outlined in Table 7.
INSERT TABLE 7 HERE
For all the Raptors, the 3 percent outside "at risk" investment needed to avoid consolidation was provided
by LJM2 Co-Investment LP (LJM2), a partnership run by Andrew Fastow, Enron's Chief Financial
Officer.44 LJM2 transferred $30 million to each Raptor SPE as its initial investment.45 For each SPE
(except Porcupine, also known as Raptor III), Enron contributed its own stock and a promissory note via a
100 percent Enron-owned subsidiary.46 Each of these three Raptors (Talon, Timberwolf, and Bobcat)
delivered a put option to Enron.47 As in the Rhythm's transaction, Enron attempted to hedge value
declines in its merchant portfolio with its own stock's appreciation. In Porcupine's case, Enron contributed
TNPC stock (a residential and commercial power delivery company created by Enron) rather than Enron
stock, to hedge its investment in TNPC stock.48 Clearly, the put option Enron received from Porcupine
was not a "true" economic hedge, since price movements of the put option (secured by TNPC stock)
would parallel that of the hedged asset (also TNPC stock).49 Shortly after each of the four Raptors was
formed, each transferred approximately $40 million back to LJM2.50 Enron contended that these
transfers (made within just weeks of each SPE's initial formation) were simply a return on LJM2's initial
$30 million "at risk" investment. However, statements by Mr. Fastow to his limited partners in LJM2 in
April of 2001 suggest that 43 Powers Report, p. 97. 44 Powers Report, p. 72. 45 Powers Report, pp. 100,
116 and 117.46 Powers Report, pp. 100 and 111. 47 Powers Report, pp. 103 and 113.
48 Powers Report, p. 114. 49 Unlike the other Raptor transactions, Porcupine was not presented to the
Board or to any of its Committees (Powers Report, p. 116). 50 Powers Report, pp. 104, 113 and 117. 16
these transfers may have been both a "return of and return on capital."51 In fact, he indicated to these
investors that LJM2's investment was "not at risk" anymore.52 If this was true, then all of the Raptor SPEs
failed EITF 90-15's three percent "at risk" rule and should have been consolidated into Enron's financial
statements. The effects of consolidating the Raptors on Enron's balance sheets and income statements
were huge. As indicated in Table 6, net income and stockholders' equity were overstated by a total of
$1.077 billion in 2000 and 2001 by Enron's failure to properly consolidate the Raptors in its financial
statements.53
Stock for Note Exchange Transactions
The accounting treatment accorded the "stock for note exchanges" that took place when three of the
Raptor SPE's (Talon, Timberwolf, and Bobcat) were formed also violated generally accepted accounting
principles (GAAP). These exchanges occurred between 100 percent owned Enron subsidiaries and the
three Raptor SPEs, resulting in the same outcome as if Enron itself had executed the transaction. Enron
accounted for the "sale" of its own shares to the three SPEs in 2000 and the first quarter of 2001 by
increasing its notes receivable and shareholders equity.54 This treatment was inconsistent with the
guidance provided in the accounting literature, both EITF 85-1 and SAB 40, which requires that notes
received in payment for stock be reported as a deduction from shareholders equity. According to Table 6,
this GAAP violation alone overstated 51 Powers Report, p. 130. 52 See additional discussion in Kranhold,
K., R. Wartzman, and J. R. Wilke. 2002. Following the trail: As Enron inquiry intensifies, midlevel players
face spotlight - They could help prosecutors build a criminal case against top executives. The Wall Street
Journal. April 30, 2002. A1. 53 Powers Report, p. 133. 54 Enron's 2001 second quarter 10Q filing reports
the increase in notes receivable in "Investments in and advances to unconsolidated equity affiliates."
Enron's no par, common stock reflects a similar increase. Also see discussion in Powers Report, p. 125.
17 assets and shareholders equity by $1 billion, $172 million in 2000 and $828 million in the first half of
2001.55
Cumulative Impact of Financial Statement Errors
In all of the transactions described in the preceding section, Enron’s financial reporting treatment failed to
comply with existing accounting standards. Table 8 summarizes all of Enron's major GAAP violations.
The impact of these failures on Enron’s financial statements is summarized in Table 6. Over the four
years from 1997 through 2000, Enron overstated reported net income in total by $1.577 billion. It
overstated reported stockholder’s equity in total by $2.585 billion. Although Enron declared bankruptcy
prior to year-end 2001, reports indicate that its quarterly reports for 2001 overstated net income and
shareholder’s equity by $545 million and $828 million, respectively.56
INSERT TABLE 8 HERE
These overstatements impacted measures of Enron’s financial health in important respects. Note from
Table 6 that restatement of Enron’s net income decreased its earnings per share (EPS) by amounts
ranging from 19% of reported EPS in 1998 to 64% of reported EPS in 2000. In addition, these
restatements increased Enron’s debt-to-equity ratios in all four years, with a high of 5.33 in 2000. Finally,
the restatements decreased Enron’s return-on-assets (ROA) in every year, with a reduction of nearly two-
thirds in 2000.57
IMPLICATIONS AND CONCLUSIONS
While the implications of Enron’s accounting errors for its financial position are clear, conclusions
regarding the adequacy of existing accounting standards are less apparent. In each 55 Powers Report, p.
126. Also see discussion in Weil, J. 2001. Enron's accounting violated accepted financial practices. The
Wall Street Journal . November 9, 2002. Heard on the Street. 56 Powers Report, pp. 15 and 126.
18 of the cases discussed above, Enron violated existing financial reporting standards and SEC reporting
regulations. Following the collapse of Enron, many argued that inadequate accounting principals were at
fault.58 Yet, Enron’s financial statements did not conform to existing accounting standards, suggesting
that the standards themselves were not at fault. While the recent focus on financial reporting
requirements may bring about needed changes and improvements in the quality of financial information
provided to investors, current standards should not be blamed for Enron’s failure. Had existing standards
been correctly applied, particularly with respect to consolidation of the SPEs, Enron’s financial statements
would have more accurately reflected the underlying economic substance of its activities. Alternatively,
had Enron legitimately secured a 3% outside equity investment that was at risk for the entire term of the
SPE, existing accounting standards would not have required consolidation? However, one must ask
whether the 3% outside equity investors would have permitted Enron to engage in the transactions that
occurred in these SPEs. In total, the required 3% equity investment in Chewco and the Raptors totaled
$131.5 million.59 It is unlikely that independent outside investors would have been willing to risk these
dollars in investments that were purely speculative, did not represent true economic hedges, and were
created only to remove assets and debt from Enron’s balance sheet while inflating Enron’s reported net
income. Enron’s financial reporting failures attempted to create an erroneous image of financial health.
Yet, this paper’s analysis shows that Enron’s incorrect financial statements signaled 57 EPS, ROA, and
debt-to-equity ratios recalculated by the authors using Enron’s publicly available financial reports. 58 See
for example, Weil, J. What Enron's Financial Reports Did -- and Didn't -- Reveal --- Auditor Could Face
Scrutiny on Clarity Of Financial Reports The Wall Street Journal November 5, 2001, C1. 59 Because of
valuation issues and SwapSub’s negative equity at formation, it is unclear what investment would have
been required to meet the 3% equity rule in the Rhythms transaction (Power Report, p. 84). 19
serious problems with Enron’s financial condition. Why were these signals largely ignored? The collapse
of Enron has implications for the functioning of business and capital markets far beyond financial
reporting standards and accountants’ responsibilities. In particular, it raises questions regarding the
oversight responsibilities of Enron’s board of directors, the financial advisers that assisted the company in
structuring its SPEs, the banks and other lenders that provided ‘off balance sheet’ financing, and the
brokers, analysts, and other investment advisers that ignored the warning signs of trouble apparent in
Enron’s financial reports. All of these parties actively assisted Enron’s management in its efforts to distort
fair presentation of the company’s financial condition. Recent Congressional investigations indicate that
Citigroup Inc., J.P. Morgan Chase & Co., and federal regulators all share blame in facilitating Enron’s
financial manipulations.60 Thus, non-accounting solutions are required as well. What policy, legal and
regulatory changes are needed to ensure adequate oversight in monitoring the activities and reports of
aggressive, cutting edge businesses like Enron? Is the severity or enforcement of existing penalties
sufficient? Or are additional professional sanctions, regulatory, civil and criminal penalties needed to
motivate all involved parties to act responsibly in the interest of all market participants? The failure of
Enron, initially attributed to accounting and reporting inadequacies, continues to raise broader issues of
corporate governance and regulation that will likely be the subject of much debate in years to come.60
See Simpson, G.R. and J. Sapsford, Banks’ Enron Deals Draw Scrutiny, The Wall Street Journal
December 9, 2002, A11, and Fialka, J., Jurisdiction Issues May Have Put Off Action On Enron, The Wall
Street Journal , November 12, 2002, A2. 20
Table 1 Enron Stock Price Performance vs. NASDAQ Composite Index
October 1997 - January 2001
Source: [Link]
Note: This table compares stock price performance of Enron Corp. with the NASDAQ composite index for
the period October 1997 through January 2002. It shows the Enron generally outperformed the NASDAQ
composite from late 1997 through the end of 1999. However, Enron significantly outperformed the
NASDAQ composite during 2000. 21
Table 2 : Enron Operating Performance
1991-2000
Source: Research Insight supplemented with data from 10K annual filings. IBE - Income before
extraordinary items and discontinued operations. CFO - Cash flow from operations. CI - Comprehensive
income defined as the change in owners' equity plus dividends net of capital contributions. FCF - Free
cash flow is measured by cash flow from operations (CFO) minus net capital expenditures plus net
interest payments. Note: The four performance measures shown in Table 2 are commonly used by
analysts to evaluate a company's operations. The graph shows that all four performance indicators
closely tracked with each other between 1991 and 1996. In 1997, however, the four measures uncoupled,
with comprehensive income and free cash flow actually diverging. This "uncoupling" provided an "early
warning" of the "earnings games" that Enron had begun to play in 1997. The increased variation among
the four performance measures continued through 2000.
-1000.00
0.00
1000.00
2000.00
3000.00
4000.00
5000.00
6000.00
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
IBE CFO CI FCF
22
Table 3
Dupont Analysis of Enron Performance
1991-2000
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
Return on Equity 11.25% 11.16% 12.03% 15.22% 15.93% 15.26% 1.57% 9.73% 8.64% 7.81%
Asset Turnover 0.53 0.59 0.69 0.75 0.69 0.82 0.87 1.07 1.20 1.54
Profit Margin Ratio 3.90% 4.49% 3.96% 4.88% 5.49% 4.27% 0.43% 2.19% 2.06% 0.89%
Leverage Ratio 5.40 4.19 4.39 4.15 4.18 4.33 4.17 4.16 3.49 5.71
Source: Research Insight supplemented with data from 10K annual filings.
Return on Equity - Net earnings or income divided by total stockholders' equity. Measures the rate of
return stockholders (owners)
earn on their investment. High returns on equity (relative to industry norms) generally are favored by
stockholders.
Asset Turnover Ratio - Net sales or revenues divided by total assets. Measures a company's efficiency in
managing its assets. High
asset turnover ratios (relative to industry norms) generally are considered favorable.
Profit Margin Ratio - Operating profit divided by net sales or revenues. Measures the profit generated by a
company from its primary
operations. High profit margin ratios (relative to industry norms) generally are considered favorable.
Leverage Ratio - Total assets divided by total stockholders' equity. Measures the extent to which a
company relies on external
financing (debt). High leverage ratios (relative to industry norms) generally are considered unfavorable
and signify excessive reliance
on debt.
Note: The Dupont System uses the four performance measures shown in Table 3 to analyze company
performance. The table
suggests that Enron's operating performance was significantly poorer than reflected by its stock price in
Table 1. In fact, as Enron's
share price soared between 1997 and 2000, its return on equity and profit margins performed badly when
compared to pre-1996
operating levels. The disparity between Enron's stock price and its operating performance should have
raised a "warning" in the
investment community. Although post-1997 asset turnover and leverage ratio trends appear to improve,
their increases are not enough
to overcome the precipitous decline experienced in the profit margin ratio.
23
Table 4
Beneish (1997) Model Variable Definitions
Days Sales in Receivables Index1: Measures if changes in receivables are consistent with
changes in sales. Increases suggest that either (1) more and more sales are made on credit rather
than cash, or (2) a company is experiencing collection problems.
Gross Margin Index1: Measures whether gross margins (sales less cost of goods sold) have
declined suggesting negative future firm prospects. Increases in this index signal declining
margins.
Asset Quality Index1: Measures changes in quality of a company's assets (e.g. tangible vs.
intangible assets). Increases in this index (i.e. a decline in asset quality) suggest a growing
tendency to capitalize intangibles or expenses, thus deferring costs.
Depreciation Index1: Measures the change in the rate of depreciation. Increases in this index
suggest company efforts to slow depreciation to increase earnings.
SG&A Index1: Measures sales, general, and administrative expenses (SG&A) relative to sales.
Increases suggest loss of managerial cost control or unusual sales efforts. However, significant
declines may also signal manipulation if sales are materially distorted.
Total Accruals to Total Sales: Measures the extent to which earnings are cash based. High
increases in non-cash working capital may reflect possible ma nipulation.
Sales Growth Index: Index measures the growth in sales between periods. The index may
reflect earnings manipulation because research suggests that high-growth firm stock prices are
may be sensitive to news that may give the impression that growth is slowing.
Abnormal Return: Companies that under perform their peer group (e.g. declining stock prices)
have incentives to violate GAAP. This measure quantifies the performance difference (size
adjusted return) of Enron with its peer group of companies.
Leverage Index: Measures the company's total debt relative to assets at the beginning of the
fiscal year. High values may identify companies whose managers have incentives to manipulate
earnings to avoid debt covenant violations.
Probability of Manipulation: Using coefficients from the Beneish (1997) probit analyis, an
earnings manipulation index is computed. The index is then converted into a probability of
manipulation using a standard normal distribution table. The median estimated probability of
manipulation of GAAP violation from the model was .095 and .011 for control firms.
1 This measure has an expected value of 1.0 reflecting the assumption that relationships between
certain financial statement items remains constant over time.
24
Table 5
Earnings Manipulation Indicators
from Beneish (1997)
Ratiosa 1995 1996 1997 1998 1999 2000
GAAP
Violatorsb
Control
Firmsc
Days Sales in Receivables Index 1.644* 0.989 0.625 0.872 0.955 1.376* 1.269 1.199
Gross Margin Index 1.027 1.263* 1.447* 2.015* 1.169* 2.143* 1.042 1.004
Asset Quality Index 0.992* 1.136* 1.308* 1.062* 1.064* 0.771 .937 .807
Depreciation Index 1.039* 0.946 1.017* 0.852 0.956 1.109* .981 1.021
SG&A Index 1.059* 0.806 0.648 1.084* 1.008* 0.416* .997 .981
Total Accruals to Total Assets 0.010 -0.039 -0.005 -0.040 0.027 0.001 .204 .441
Sales Growth Index 1.022 1.446* 1.525* 1.541* 1.283 2.512* 1.431 1.379
Abnormal Return 0.232 -1.337* 0.102 0.742 -0.534* -1.271* -.325 0.011
Leverage Index 0.426 0.415 0.437 0.455 0.458 0.416 .564 .500
Probability of Manipulation 0.018 0.257** 0.035 0.024 0.087 0.392**
a See Table 3 for index definitions.
b These are median measure values for the GAAP violators in Beneish (1997). They include 64 firms that
during the period 1987-1993
were know to have manipulated their financial statements through violations of generally accepted
accounting principles (GAAP).
c Median measures for a sample of firms in Beneish (1997) that resemble the GAAP violators but that
were not identified as having
violated GAAP in their financial statements.
* Ratio indicates possible earnings manipulation when compared to Beneish (1997) GAAP Violator
median ratios or historical trend
for the company.
** Probability of manipulation exceeds the median found for Beneish (1997) GAAP Violators (.095)
suggesting possible earnings
manipulation in the year indicated.
Note: The first five ratios (days sales in receivables, gross margin, asset quality, depreciation, and SG&A)
all have an expected value
of 1.0 reflecting the assumption that relationships between certain financial statement items should
remain constant over time. All of
the indexes (excludes total accruals to total assets and abnormal return) are constructed with the
expectation of being positively related
to the probability of manipulation.
25
Table 6
Summary of Enron's Accounting and Reporting Adjustments
(000's)
Transaction Assets Liabilities
Stockholders'
Equity
Net
Income
Return
on Assets
Debt to
Equity EPS1
EPS
Change
1997 Reported Balances 22,552,000 16,934,000 5,618,000 105,000 0.47% 3.01 0.19
Chewco and Jedi 683,000 711,000 (28,000) (28,000)
1997 Corrected Balances 23,235,000 17,645,000 5,590,000 77,000 0.33% 3.16 0.14 -26.67%
1998 Reported Balances 29,350,000 22,302,000 7,048,000 703,000 2.40% 3.16 1.10
Prior period corrections (28,000) (28,000)
Chewco and Jedi 428,000 561,000 (133,000) (133,000)
1998 Corrected Balances 29,750,000 22,863,000 6,887,000 570,000 1.92% 3.32 0.89 -18.92%
1999 Reported Balances 33,381,000 23,811,000 9,570,000 893,000 2.68% 2.49 1.27
Prior period corrections (161,000) (161,000)
Chewco and Jedi 532,000 685,000 (153,000) (153,000)
Rhythms (95,000) (95,000) (95,000)
1999 Corrected Balances 33,657,000 24,496,000 9,161,000 645,000 1.92% 2.67 0.91 -27.77%
2000 Reported Balances 65,503,000 54,033,000 11,470,000 979,000 1.49% 4.71 1.33
Prior period corrections (409,000) (409,000)
Chewco and Jedi 537,000 628,000 (91,000) (91,000)
Rhythms (8,000) (8,000) (8,000)
Raptors:
Consolidation Effects (532,000) (532,000) (532,000)
Stock for Note Effects (172,000) (172,000)
2000 Corrected Balances 64,919,000 54,661,000 10,258,000 348,000 0.54% 5.33 0.47 -64.45%
Note: 2001 adjustments for Raptors' consolidation reduced net income and stockholders equity by
$545,000,000. 2001 adjustments
for Raptors' stock/note exchanges reduced assets and stockholders equity by $828,000,000.
1 EPS signifies earnings per share. Numbers differ from reported EPS as net income has not be reduced
for preferred stock dividends
not available to common shareholders.
26
Table 7
Common Structure of SPE Transaction
Enron
Corp.
Enron
Subsidiary
100%
Owned
Subsidiary
Note
Special
Purpose
Entity
Enron
Put Stock
Option
Outside
3%
Investor
27
Table 8
Summary of Major Enron GAAP Violations
Consolidation Rules
EITF 90-15 required consolidated reporting of SPEs when “the owner(s) of record of the
SPE has not made an initial substantive residual equity capital investment that is at risk." In
applying this test, the EITF indicated that 3 percent was the minimum acceptable investment by
outside owners.
Enron failed the 3 percent "at risk" threshold in five separate cases:
Chewco and JEDI Over half of Chewco's 3 percent partners' investment was secured by
JEDI, which was 50 percent owned by Enron. This meant that the
outside investors did not have the entire 3 percent "at risk." Enron did
not consolidate either Chewco or JEDI.
Rhythms At the date of formation, the SPE's liabilities exceeded its assets.
Therefore, the entity had no equity. Therefore, it was impossible for
the investors to have any investment "at risk." Nevertheless, Enron
reported the Rhythms SPE as an unconsolidated entity.
Talon (Raptor I)
Timberwolf (Raptor II)
Porcupine (Raptor III)
Bobcat (Raptor IV)
In each of these transactions, investors received a return on and of
their capital within weeks of the SPE's formation. This meant that
outside investors did not have any of their 3 percent "at risk," once the
entity began its hedging activities. However, Enron continued to
report these SPEs as unconsolidated entities.
Issuance of Stock for Notes Receivable
EITF 85-1 and SAB 40 require that notes received in payment for stock be reported as a
deduction from shareholders equity.
Talon (Raptor I)
Timberwolf (Raptor II)
Bobcat (Raptor IV)
In each of these transactions, Enron used a wholly owned subsidiary to
exchange Enron stock for an SPE's note receivable. Enron accounted
for these transactions by increasing both notes receivable and
shareholders equity.