International Accounting Standard
There are times when an event changes our perspectives to the way business is conducted. Some of these events are positive and contribute to the advancement of mankind and some are negative that change the entire course of existence and the way day-to-day business activities are done. There have been many such occurrences in the field of business that have had a dramatic effect in the way we conduct business today. The Wall Street crash in the 1929, the Asian financial crisis in the late 1990s, the recent World Trade Center disaster and of course the corporate failures witnessed recently are some of the events that will shape business boardroom decisions.
The Enron collapse has affected capital markets around the world and the accounting boards and regulators are finding better systems to prevent another corporate collapse. The Enron disaster has had a massive effect on the investor confidence, billions of dollars of market value were erased, savings of millions were wiped out, thousands of jobs lost and a number of internal scandal like shredding vital documents, lobbying with the White House political figures to name a few were fully exposed by the media.
With so much happening in the Enron headquarters and in Wall Street, a simple question comes to every interested individual. What went wrong in Enron? How did Enron lose so much money? What happened to corporate governance? Why didn’t the regulators expose such happenings within Enron? Such questions have dumbfounded investors and experts in recent months and it will perhaps take a long time before the entire scandal is unraveled.
Enron: The Genesis
In 1985 Houston Natural Gas merged with Omaha, Neb.-based InterNorth to create the company that would eventually be named Enron Corp. The deal integrated several pipeline systems to create the first nationwide natural gas pipeline system and in 1986 Kenneth Lay, who had been chief executive officer of Houston Natural Gas, was named chairman and chief executive officer. The company chose the name Enron after rejecting Interon and Kenneth Lay had been anxious to expand the business.
Jeff Skilling, an ambitious thinker from the world famous consultancy firm McKinsey, offered a way to do it. Skilling believed that Enron could profit from trading futures in gas contracts between suppliers and consumers – effectively betting against future movements in the price of gas-generated energy. Buyers and sellers used futures markets to get what they hope will be a better deal on commodity prices than they would do on the open market. 1 Enron from being an energy producer turned to a sharp dealer in complex derivates – that is billions of dollars were transacted in forward contracts, options and swaps. The core of Enron’s business appears to have been dealing in derivative contracts based on the prices of oil, gas, electricity and other variables. Enron sold long term contracts to sell energy at fixed prices. These contracts allowed the buyers to avoid or hedge the risks that increased (or dropped) in energy prices posed to Enron’s businesses.
Since the markets in which Enron traded were largely unregulated, with no reporting requirements, little information was available about the profitability of Enron’s derivatives. In the deregulated energy world, it appeared to make sense to many suppliers and industry consumers who took up the offer. During these times a new Enron was emerging. Industry Analysis: A major factor that contributed to Enron’s success was that it operated in an unregulated market. The energy power regulation in the U.S was in a mess and the regulation was split between the State and Federal government. For instance California would experience extreme power shortage and Enron would manipulate prices to obtain work for itself.
In the 1980s, energy corporations lobbied Washington to deregulate the business. Companies including Enron said the extra competition would benefit both companies and consumers. Washington began to lift controls on who could produce energy and how it was sold. New suppliers came to the market and competition increased. But the price of energy became more volatile in the free market. Enron saw its chance to make money out of these fluctuations. It decided to act as middleman and guarantee stable prices – taking its own cut along the way. Because Enron operated in unregulated markets, it was not classified as a bank, an insurer or fund manager and purposely tried to escape all forms of regulation. Enron was a great supporter of the Charter of the Commodities Futures Trading Commission (CCFTC), the futures market regulator. Instead this act ensured that Enron’s activities fell outside the regulators terms of reference.
In a few short years, Enron became a massive player in the US energy market, controlling at its height a quarter of all gas business. Buoyed by the success, the company went on to create markets in myriad energy-related products. Enron began to offer companies the chance to hedge against the risk of adverse price movements in a range of commodities including steel and coal. By the end of the decade it had expanded its trading arm to include hedging against external factors such as weather risk.
Enron was not the only company in the game but through its Enron online trading arm it was becoming the biggest on what was dubbed Energy Alley – 90% of its income came from trades. Jeff Skilling wanted to rid Enron of its last physical assets but the company was also expanding internationally, moving into water in the UK and power generation in India. One question that was already being asked before Enron crashed was : how much influence did it have on Capitol Hill, how many contacts did the company have with the Bush Administration?
To date the Bush administration has failed to provide a comprehensive account of its contacts with Enron. Prior to the collapse of Enron in December 2001,the company appeared to have wide access to officials in the White House and federal agencies.3 Enron certainly wasn’t the only company lobbying for energy deregulation, but deregulation helped Enron establish the trading markets that became its core business. The Bush administration has championed some issues Enron considered important, such as deregulating utilities and limiting compensation awards. He has also favored more oil exploration and drilling in spite of opposition from environmentalists.
Directors built relationships with both Democrats and Republicans. Kenneth Lay himself had strong personal ties to two Republican presidents, George Bush Snr and his son George W Bush. Enron and its executives were the largest source of financial support for Bush’s gubernatorial campaigns, giving more than $500,000.Further according to a study by the Center for Public Integrity as well as lending corporate jets for the presidential campaign. As Bush assumed the presidency, Enron had unusual access to the new administration’s deliberations about energy policy and appointments to important posts.
Kenneth Lay served on the Bush transition team and helped interview candidates for the Federal Energy Regulatory Commission. The influence of Enron over this Commission was of strategic importance because the Commission supervised the gas pipelines and electricity grids.4 Enron executives had six meetings with the vice-president, Dick Cheney, and his staff when he was drawing up the administration’s energy plan, a fact that has surfaced only since the company went bust. As Enron expanded, there was little scrutiny of how it was managing the expansion. But when it began to unravel, the questions began to asked.
Accounting Discrepancies within Enron
The accounting for a global trading company like Enron is a mind-bogglingly complex. But it’s crucial to learning how the company fell so deep so fast, taking with it the jobs and pension savings of thousands of workers and inflicting losses on millions of individual investors. At the heart of Enron’s demise was the creation of partnerships with shell companies, many with names like Chewco and JEDI. These shell companies, run by Enron executives who profited richly from them, allowed Enron to keep hundreds of millions of dollars in debt off its books. But once stock analysts and financial journalists heard about these arrangements, investors began to lose confidence in the company’s finances. The results: a decreasing trend in stock prices, lowered credit ratings and insolvency.
The Enron controversy involves several issues. One concerns the rules governing whether the financial statements of Special Purpose Entities (SPEs) established by the corporation should be consolidated with the corporation’s financial statements; for certain SPE partnerships at issue, consolidation is not required if among other things an independent third party invests as little as 3% of the capital, a threshold some consider too low.
Many companies that have used SPEs are likely to bring assets and liabilities on the balance sheet with negative effects on their debt-to-equity ratios, return on assets, operating and profitability metrics and cost of financing. On the other hand companies argue that off-balance-sheet vehicles (like the SPEs) benefit investors because they enable management to tap extra sources of financing and hedge trading risks that could roil earnings. Return on capital looks better than it is because balance sheets understate the amount employed and investors and regulators don’t panic as corporate debt balloons.