Earnings Management Techniques used by Enron
Enron's complex financial statements were confusing to shareholders and analysts. In addition, it’s complex business model and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet to indicate favorable performance.
Enron was originally Services providing company such as wholesale trading and risk management in addition to building and maintaining electric power plants, natural gas pipelines, storage, and processing facilities. The Business Model used by them to report their financial results should have been “Agent Model”. But they what they actually used was “Merchants Model”. When accepting the risk of buying and selling products, merchants are allowed to ...view middle of the document...
Thus Enron’s revenue took huge jump from $13.3 billion in 1996 to $100.8 billion in 2000 which make company among the top six of Fortune 500.
Market to Market accounting:
The Trading business company adopted the market to market accounting method instead of using Historical cost based method. Enron became the first non-financial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract was signed, income is estimated as the present value of net future cash flow. Often, the viability of these contracts and their related costs were difficult to estimate. If assets are revalued at market prices at each balance sheet date, the trader’s performance is not being judged purely by its ability to time buying and selling decisions correctly. Hence while using the method, income from projects could be recorded, although they might not have ever received the money, and in turn increasing financial earnings on the books.
Special Purpose Entities:
Enron created many special purpose entities and used limited partnerships to fulfill their specific purposes. These were financed by equity investors. What they actually do was convert their losses into the assets transferred to their special purpose entities. And the debt taken on the behalf of those entities show in the assets of parent company “Enron” which makes the stock prices of the company higher and higher. They hide the debts of their company by using those special purpose entities. Enron's balance sheet understated its liabilities and overstated its equity, and its earnings were overstated.
These all factors circumvent the original conditions of the company which led investors to misunderstandings because of high stock prices. The higher managers of the company sold their shares of the company knowing the fact that true financial condition of the company was really bad.