Enron: A Financial Reporting Failure?

Abstract

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.

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 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. 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.

Keywords: accounting, earnings management, financial reporting, fraud

JEL Classification: M40, M41, M42, M43, K22