Mahama Wayo

The Collapse of Enron Corporation: Fraud Perspective

Electronic copy available at: http://ssrn.com/abstract=1691830

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Mahama Wayo

Contents

SWISS MANAGEMENT CENTER UNIVERSITY

The Collapse of Enron Corporation: Fraud Perspective

Mahama Wayo (0001870-01) July 16, 2010

July 16, 2010

Electronic copy available at: http://ssrn.com/abstract=1691830

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Mahama Wayo

ABSTRACT The paper examines the red flags that might have signaled the collapse of Enron Corporation which an astute reader should have noted. Various financial models that can detect earnings manipulation and inflation of assets and revenues have been applied in this examination. The paper links the collapse of Enron to the massive manipulation of earnings, some of which was carried out by the use of activities of Special Purpose Entities (SPEs).

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THE COLLAPSE OF ENRON CORPORATION: A FINANCIAL PERSPECTIVE 1.0 INTRODUCTION Enron Corporation was formed in 1985 by Kenneth Lay. This was after the merger of Huston Natural Gas and InterNorth. The company was based in Houston, Texas. Enron originally was involved in transmitting and distributing electricity and natural gas throughout the United States. The company was engaged in developing, building and operating power plants and pipelines within the legal framework. It owned a large network of natural gas pipelines that stretched from borders to borders including Northern Natural Gas, Florida Gas Transmission, Transwestern Pipeline Company and a partnership in Northern Border Pipeline from Canada. Enron ventured into water in 1998 by creating Azurix Corporation. It was also engaged in communication, pulp and paper production. Enron was the seventh largest Company in the Unites States of America and was named Americas Most Innovative Company by Fortune Magazine for six consecutive years, from 1996 to 2001. Enrons sterling performance pushed its stock price to $83.19 by December 31, 2000. The stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a 10% decline for the index during the same years. The company filed for bankruptcy protection in December 2001. Unknowingly, the excellent performance of Enron was as a result of crafted fraudulent activities of the Companys executives. Enrons revenues had hit $101 billion by the year 2000 and it employed about 22,000 staff. A revelation of the Enron scandal in October 2001 with its stock price dropping from $90.00 to less than $1.00 by the end of November, 2001 caused a loss to shareholders of about $11 billion and resulted in the investigation of the companys operations by the U. S. Securities and Exchange Commission (SEC). The company then filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code on December 2, 2001 in the Southern District of New York.
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1.1 ASSESSMENT OF THE FINANCIAL PERFORMANCE OF ENRON CORPORATION: 1997 TO 2000 A critical examination of the financial statements of Enron from 1997 to 2000 depicts a massive manipulation of revenues and earnings used to sustain the companys perceived excellent performance. Accounting loopholes were plucked; and the use of Special Purpose Entities (SPEs) and poor financial reporting were used to hide billions of dollars in debts from failed deals and projects. A number of Enrons recorded assets and profits were inflated, or even wholly fraudulent or nonexistent. Beneish (as cited in Feroz, Park, and Pastena, 1991) indicates that manipulation becomes public on average 19 months after the end of the fiscal year of the first reporting violation. Enron went longer! Enron violated the intent of Generally Accepted Accounting Principles (GAAP) in its reporting system. According to McLean and Elkid in their book The Smartest Guys in the Room, the Enron scandal grew out of a steady accumulation of habits, values and actions that began years before and finally spiraled out of control. A careful scrutiny of the financial statements of Enron suggests that from late 1997 until its collapse in December 2001, the primary motivations from Enrons accounting and financial transactions seemed to have been to keep reported income and reported cash flows up, assets values inflated, and liabilities off the books. In fact, income smoothing was at its peak in the operations of Enron, and Executives of the company and their allies and families were those who profited while the company was going into the doldrums. According to Albrecht (2001), an entitys financial statements tell a story and the story should make sense, if not, its possible the story is untrue. Enron Corporations financial statements for the four years ending December 31, 2000 prior to its collapse in 2001, were comprised of massive inflation of revenues, manipulation of income and inflation of assets whilst suppressing its debt through the use Special Purposes Entities (SPEs) located offshore.

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2.0 ANALYSIS OF ENRON CORPORATION FINANCIAL STATEMENTS Various financial and accounting models and principles can be employed to analyze the financial statements of a company to determine red flags, its health or whether it is manipulating income, inflating revenues and assets, and also manipulating General Accepted Accounting Principles in its financial reporting. Included amongst the various models and principles are: revenue recognition policies,

converging/diverging gross margin slope analysis1, sales/accounts receivable slope analysis, Modified Altmans Z-score inflection point and bankruptcy analysis, Beneishs Model for Determining Earnings Manipulation2, Chanos Discriminate Function Algorithm Model3, Igor Pustylnicks Combined Algorithm of Detection of Manipulation in Financial Statements 4, ratio analysis and other available models. Collectively, these models signaled trouble. 2.1 REVENUE RECOGNITION Revenue recognition criteria according Nugent (2010) include: the existence of a valid contract, assurance of payment, the work is complete or essentially complete, and title passes between the parties. The fulfillment of these criteria mandates the recognition of revenue within any financial reporting period. Enron earned its profits by providing services such as wholesale trading and risk management, in addition to developing electric power plants, natural gas pipelines, and storage and processing facilities. Service providers, when considered as an agent, report only trading and brokerage fees as revenues as against the merchant model which reports the total selling price as revenues and the product costs as cost of goods sold.
1

Altman, Edward I. Corporate Financial distress: A Complete Guide to Predicting, Avoiding, And Dealing with Bankruptcy. John Willey and Sons, 1983.
2 3

Beneish, Messod D. The Detection of Earnings Management, 1999 Indiana University, Kelley School Of Business

chanos, J. Discriminate Function Algorithm 2010. Algorithm Presented By Dr. John Nugent CPA, CFE, CFF, CISM, FCPA At 2010 SMC Doctorate Of Finance Residency Course Vienna, Austria. Pustylnick I. July 16, 2010 Combined Algorithm of Detection of Manipulation in Financial Statements 2009. www.ssrn.com
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Enron, however, in contrast to practice developed an aggressive approach to reporting revenues by adopting the merchant model where the entire value of its trade was reported as revenue instead of process employed in the agent (fee only) model. This inflated Enrons reported revenue astronomically from 1997 to 2000. Enron Corporations net revenues were: $20,273 million for 1997, $31,260 million for 1998, $40,112 million for 1999 and $100,789 million for the year 2000. (Source: Enron Corporation: 1998, 1999 and 2000). In percentage terms, Enrons sales increased by 53% in 1997, 54% in 1998, 28% in 1999 and 151% in 2000, each from the previous year. Astronomical by anyones measure. These increases in revenues without significant acquisitions were meteoric and resulted from the manipulation of revenue recognition policies that Enron adopted during these reporting periods. Enrons revenue growth on average was 72% from 1997 to 2000. This growth was unprecedented where the energy industrys growth on average was 2 3% per year5. Akin to the revenue recognition policies of Enron was also the fact that it adopted mark-to-market accounting for its complex long-term contracts. Mark-to-market accounting as employed by Enron required that once a long-term contract was signed, income was estimated as the present value of net future cash flows. Unfortunately, due to the complex nature of Enrons contracts, the viability of these contracts and their related costs were difficult to estimate. In using this method, income from projects could be recorded presently, which increased financial earnings. However, in future years, the profits could not be included, so new and additional income had to be shown from more projects to develop additional growth. By advancing revenues to current periods via the marked to market Enron inflated its revenues. For example, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on demand entertainment to various United States of America cities by year end.

Enron Scandal. http://en.wikipedia.org/wiki/Enron_Scandal 7

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After several pilot projects, Enron recognized estimated profits of more than $110 million from the deal. When the network failed to work, Blockbuster pulled out of the contract. But Enron continued to recognize future profits, even though the deal resulted in a loss. 2.2 GROSS MARGIN ANALYSIS Nugent (2003) defines gross margin as simply the difference between net sales and cost of goods or services sold. It measures the operational efficiency of an organization. By employing the concept of converging/diverging gross margin slope analysis one is trying to determine if gross margin is increasing as a percentage, or decreasing as a percentage of net sales over the reporting period. If gross margin slope is converging with that of the net sales slope, then it implies that gross margin is increasing as a percentage of net sales. It means that each additional sale is more profitable operationally than the preceding sale. On the other hand, if the gross margin slope is diverging from the net sales slope, it means that each successive sale is less operationally profitable than the preceding one. Table 1 below indicates the sales and gross margins of Enron for the various periods under-review. TABLE: 1 ENRON NET SALES AND GROSS MARGINS YEAR 1997 ($ Million) GROSS MARGIN SALES PERCENT 15 20,273 .07 1998 ($ Million) 1,378 31,260 4.4 1999 ($ Million)
802

2000 ($ Million)
1,953

40,112 2.0

100,782 1.94

(Source: Enron Corporation 1997, 1998, 1999 & 2000).

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From the table, Gross Margin Slope Analysis can be used to determine whether Enron was becoming more or less operationally profitable using converging/diverging slope analysis. Chart 1

Chart 2

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Chart 4

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The graphs indicate the net sales lines and the gross margin lines for 1997, 1998, 1999 and 2000. It can be seen that the gross margin lines for all the years diverged greatly from the net sales lines, which means that Enron was not becoming operationally efficient. Table: 2
ENRON GROSS MARGINS Year 1997 1998 1999 2000 Gross Margin Percentage .07 4.4 2.0 1.94

Chart 5:

ENRON GROSS MARGIN % CURVE

From the graph it can be seen that Enrons gross margin went up in 1998 from a very low point in 1997. It further dropped in 1999 and up in 2000 creating a porpoising gross margin graph (up, down, up, down). This is an indication of earnings and revenue manipulation as discussed earlier. An analysis of this situation should have given an earlier indication that Enron was manipulating its financials and possibly heading towards collapse, which, eventually happened in the year 2001 when the company files for bankruptcy protection.
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From the Gross Margin Slope Analysis above, it is evident that Enron for the preceding four years prior to its collapse in 2001 was operationally inefficient as the slopes indicated wide diverging gross margin slopes from those of the net sales. The implication is that each successive sale was less profitable operationally than the one preceding it in certain periods. While diverging gross margins are the norm in competitive industries due to pricing competition, the porpoising of gross margins is often the telltale sign the numbers are being manipulated. Moreover, diverging gross margins in and of themselves do not tell the whole financial story since they do not take into consideration indirect (below the line) expenses 2.3 MODIFIED ALTMANS Z-SCORE DISTRIMINANT FUNCTION ALGORITHM. Altmans Z-score for predicting bankruptcy is another model that an astute reader could have used to analyze the financial information of Enron Corporation to determine the existence of any red flags 6. The formula was published in 1968 by Edward I. Altman which sought to predict corporate bankruptcy. The model is a linear combination of five common business creations, weighted by co-efficient. According to Bennett (2008), that Altmans model is based on analyzing the financial strength of a company using five ratios built on key numbers mainly taken from a firms balance sheet, along with few from the profit and loss account. The initial test of Altmans Z-score was found to be 95% accurate 1 year preceding bankruptcy and 72% accurate in predicting bankruptcy two years prior to the event, with a Type II error (false positives) of 6%, (Altman, 1968). Each ratio is weighted to reflect its relative importance before the five ratios are added together to generate a Z-score, usually a single digit.

Nugent, J. Plan to Win: Modified Altman Basic Model to determine changes in scores as against absolute scores. 2003

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Altmans Modified Z-score model is stated below (in Altmans original bankruptcy model the decimal points for X1 to X4 would have to be moved to places to the left for each). Z = 1.2*X, + 1.4*X2 + 3.3*X3 + 0.6X4 + 1.0*X5, Where: X1 = Working Capital/Total Assets X2 = Retained Earnings/Total Assets X3 = EBIT/Total Assets X4 = Market Value of Equity/ Book Value of Total Debt X5 = Sales/Total Assets According to Altman, financially strong small to mid-sized, manufacturing companies have a Z-score above 2.99 in his bankruptcy model, whilst companies in serious trouble have Z-score below 1.81, and those with scores in between could go either way (Altmans basic algorithm). Altmans Modified bankruptcy model (shown above) is also relevant for determining inflection points. According to Nugent (2003), inflection points are defined as points of major change in any being, one relative to another. Inflection point analysis looks for changes in scores rather than the absolute score itself. By applying a modified Altman Z score Model (changed from the Altman bankruptcy model as to scale and intent), and applying one additional change made by Nugent relative to the weighting of the X4 factor relative to negative changes in gross margin, it can also be seen that Enron signaled trouble (an inflection) before it entered into bankruptcy. Working capital is the difference between current assets and current liabilities. In short, it is the capital which a firm can use internally without acquiring additional financing to address short term liquidity.
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Earnings before interest and income tax (EBIT), or operating profit, it is more or less real earnings of the firm. Retained earnings are the cumulative profitability of the firm over the years. Market Value of Equity is the value of all outstanding companys shares at market value at the end of the financials. Book Value of total debt is the sum of all liabilities both current and long-term excluding equities as they are recorded at the date of the financials. Net sales are the total sales less any other taxes and returns during the financial year. Total Assets is the sum of long-term and short-term assets. Nugent (2003) prefers the use of an adjusted Altman Z-score to determine inflection points relative to negative changes in gross margins. This model lays emphasis on the weight assigned to X4 in the Altman algorithm concerning debt as gross margin declines. Nugent further writes that as an entity becomes less operationally efficient, gross margins decline, the servicing of debt becomes significantly more onerous. The adjustment is made on the weight assigned to X4 relative to negative declines in gross margins. That is the weight is lowered as gross margins decline. The table below indicates adjusted Altmans Z- score based on gross margin decline. Table 3: Annual % Decline in Gross Margin Decline X4Weighting of (0.6) by .5% < 2% > > > > 2% < 5% 5% < 10% 10% < 20% 20% 100% 200% 300% 600% 1,000% 0 -0.6 -1.2 -3.6 -0.6 X4 Value

(Source: Nugent 2003)

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The explanation to this table is that the percentage decline in gross margin is shown in the first column. Nugent (2003) indicates that once gross margin declines, it may require a reduction in X4 factor weighting, Nugent states such a reduction is weight is needed because the servicing of debt becomes more onerous as gross margin declines. The negative weighting in one period once required, is carried forward to future periods until improvement in gross margin is made or there is the need for a further reduction.
Table: 4 SUMMARY OF ENRON CORPORATION FINANCIAL STATEMENTS 1996
Current As s ets Tota l As s ets Current Li a bi l i ti es Reta i ned Ea rni ngs Accounts Receva bl e Tota l Debt W orki gn Ca pi ta l EBIT Net Revenues /Sa l es Gros s Ma rgi n/Profi t Ma rket Va l ue of Equi ty Sha rehol ders ' Equi ty Net Ca s h Fl ow Cos t ga s el ectri ci ty, meta l s a nd others O uts ta ndi ng Sha res (i n numbers ) Ma rket Va l ue Per Equi ty 1,238.00 13,289.00 690.00

1997
4,113.00 22,552.00 3,856.00 1,852.00 1,372.00 14,794.00 257.00 565.00 20,273.00 15.00 6,614.00 5,618.00 (59.00) 1,731.00

1998
(US$Mi l l i ons ) 5,933.00 29,350.00 6,107.00 2,226.00 2,060.00 19,158.00 (174.00) 1,582.00 31,260.00 1,378.00 9,509.00 7,048.00 (86.00) 26,381.00

1999
(US$Mi l l i ons ) 7,255.00 33,381.00 6,759.00 2,698.00 3,030.00 20,381.00 496.00 1,995.00 40,112.00 802.00 32,080.00 9,570.00 177.00 34,761.00 (US$Mi l l i ons )

2000
30,381.00 65,503.00 28,406.00 3,226.00 10,396.00 50,715.00 1,975.00 2,482.00 100,789.00 1,953.00 62,523.00 11,470.00 1,086.00 94,517.00

(US$Mi l l i ons ) (US$Mi l l i ons )

318,297,276.00 $20.78

335,547,276.00 $28.34

716,865,081.00 $44.75

752,205,112.00 $83.12
7

(Source:Enron Corporation, 1998, 1999 & 2000)

From table 4, the gross margins and gross revenues or sales of Enron Corporation are derived as shown in table 5 below:

Enron Annual Report. 1997, 1998, 1999 and 2000. http://picker.uchicago.edu/Enron/EnronAnnualReport.pdf

Table 5 Enron Corporation Gross Margins and Revenues/Sales

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Year Gross Revenue Gross Margin Gross Margin% Percent Change

1997 $20,273m $15m 0.074% 0

1998 $31,260m $1,378m 4.4% 4.33%

1999 $40,112m $802m 1.99% -2.41%

2000 $100,782m $1,95m 1.93% -0.06%

From table 5, it can be inferred that Enrons gross margins had a nose-dive in the years 1999 and a further decline in 2000, and (therefore the X4 weighting will in reference to Table 3 be assigned -0.6 when determining the inflection points using Adjusted Altmans Z-score as modified by Nugent. Computing the Z-scores using Modified Altmans Adjusted Z-score Discriminant function algorithm. 1997 Z = 1.2 (0.1139) + 1.4 (0.0821) + 3.3 (0.0250) + 0.6 (0.4470) + 1.0 (0.8989) Z = 1.50 1998 Z = 1.2 (0.0059) + 1.4 (0.0758) + 3.3 (0.0539) + 0.6 (0.4963) + 1.0 (1.0650) Z = 1.64 1999 Z = 1.2 (0.0148) + 1.4 (0.0808) 3.3 (0.0597) 0.6 (1.5740) + 1.0 (1.2016) Z = 0.59

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2000 Z = 1.2 (0.0301) + 1.4 (0.0492) + 3.3 (0.0378) 0.6 (1.2328) + 1.0 (1.5358) Z = 1.03 Table 6 Enrons Adjusted Z-scores Year Adjusted Z-score 1997 1.50 1998 1.64 1999 0.59 2000 1.03

Table 6 indicates Enrons Adjusted Z-scores for 1997 to 2000. Enrons operations had taken a nose-dive in 1999 when its adjusted inflection point Z-score decreased from 1.64 to 0.59 within a year. This was a major inflection point for Enron which signifies a red flag, and, if these computations of adjusted Z- score were made, then Enron would have realized that its operations were becoming more unprofitable. Moreover, just as indicated above that a porpoising gross margin is usually a sign of something that is not right, so too is a porpoising Modified Altman Z score. The porpoising natures (up, down, up, down) of the adjusted Z-scores (and gross margins) were enough indication that Enron was likely manipulating its financials and possibly heading towards difficulty if not collapse. This is depicted in the graph below. Chart 6. Enrons Porpoising Adjusted Z-Scores Graph

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From the graph, the Z-score went up in 1998 from 1997, but fell drastically in 1999 depicting a major inflection point and, in 2000 it went up a little. These were all indications that Enrons operations were likely being manipulated. This Altman method has also a number of drawbacks. It must be used with a degree of caution when applied to firms from different industries. Different industries have different degrees of capitalization and different liquidity needs. It would be unreasonable to compare Z-scores of different companies from software development industries where capitalization is relatively low, according to Pustylnick (as cited in Nowak and Grantham 2000), with oil and gas industries, which have to capitalize all exploration and refinery equipment and operations. Moreover, Pustylnick (as cited in Nugent, 2008), the degree of entity asset wealth can mitigate Altmans time line to bankruptcy. That is, the more asset rich an enterprise is the more time the entity has to solve its problems by selling assets or further leveraging the enterprise. The implication is that a Modified Altman Z-score may not show us the whole picture of the state of the company, but only the trend of results and position. It would therefore not be realistic if one bases ones assumption on a companys performance solely on a Modified Altman Z-score only. Nugent (2003) indicates that it is important to use multiple methods in addition to a Modified Altmans Z-score to validate ones findings. 2.4 COMBINED ALGORITHM OF DETECTION OF MANIPULATION IN FINANCIAL STATEMENTS Another dimension of detecting earnings manipulation is the Combined Algorithm of Manipulation in Financial Statements by Pustylnick. Pustylnick formulated the P-score formula which applies the variables of Altmans Z-score but with a change in the numerator for the X1 weight. According to Pustylnick (2009), the P-score/Z-score approach give 82.76% chance of detecting manipulation 8.
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Pustylnick, I. Combined Algorithm of Detection of Manipulation in Financial Statements. SMC University. 2009

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As indicated earlier, P-score computation is similar to Z-score but with only a slight modification in the X1. P-score is computed using the following formula: P = 1.2*X+1.4*X2+3.3*X3+0.6*X4+1.0*X5, where, X1 = Shareholders Equity Total Assets X2 = Retained Earnings Total Assets X3 = EBIT Total Assets X4 = Marketing Value of Equity Book Value of Total Debt X5 = Revenue Total Assets According to Pustylnick (2009), that Altman Z-score is created to estimate corporate bankruptcy; and therefore it uses two important net indicators, such as net sales (net income) and working capital which clearly indicates the financial position of a firm in terms of its robustness and solvency. Pustylnick (2009) indicates that according to Deloitte (2008) report on fraud over 50% of the cases of manipulation are based on improperly recognized revenues or manipulation with non-current assets such as goodwill. P-score formula considers this fact and better reflects the dynamics of changes in areas where fraud occurs most. Pustylnick substituted shareholders Equity for Working Capital in X1 calculation 9.
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Pustylnick, I. Combined Algorithm of Detection of Manipulation in Financial Statements. SMC University. 2009

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Computing the P-scores for Enron for 1997, 1998, 1999 and 2000 using Pustylnicks formula above with reference to table 4.

1997 P = P = 1998 P = P = 1999 P = P = 2000 P = P = 1.2(0.751) + 1.4(0.0492) + 3.3 (0.0378) 0.6 (1.2328) + 1.0 (1.5358) 1.89 Enrons P-scores 1997 1.66 1.50 1998 1.93 1.64 1999 0.91 0.59 2000 1.89 1.03 1.2(0.2866) + 1.4 (0.0808) + 3.3(0.0597) 0.6 (1.5740) + 1.0 (1.2016) 0.91 1.2(0.2401) + 1.4 (0.0758) + 3.3 (0.0539) + 0.6 (0.4963) +1.0 (1.0650) 1.93 1.2(0.2491) + 1.4(0.0821) + 3.3(0.0250) + 0.6(0.4470) + 1.0(0.8989) 1.66

Table 7: Year P-Score Z-score

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From table 7 above, Enron Corporation hit a major inflection point in 1999 with a P-score value of 0.91. This confirms Adjusted Altman Z-score of 0.59 also in 1999. However, in 2000, both Z-score and P-score inched up but, still pointed to signs of earnings manipulation. Chart 7 Enrons Porpoising P-score and Z-score Graphs

1997

1998

1999

2000

From the graph above, both Z-score and P-score indicates a common pattern of behavior. In 1998 both scores went up, but rather fell drastically in 1999 sending a warning of Enron having reached a major inflection point in its operations.

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2.5 CHANOS DISCRIMINANT FUNCTION MODEL Chanos Discriminant Function model is used to assess a companys financial health similar to Modified Altmans Z-score algorithm. The model makes use of income statement and balance sheet items to calculate the score. Chanos algorithm is stated below: Working Capital + Retained Earnings + 12 Month Trailing EBIT + 12 Month Trailing Revenues 12 Month Average Total Assets. This algorithm assumes that twelve (12) month trailing EBIT, revenues and average total assets are the figures stated in the financial statements for the period. The reason being that the financial statements are constructed at the end of the year which spans for a twelve month period. (or any other selected 12 month period for which financial information is available). In this later regard, where one would have to annualize certain Altman metrics to run his algorithm, this is not so with the Chanos algorithm which may be applied more easily with accumulated and available quarterly numbers for public companies. What is found is that as Modified Altman scores increase so do Chanos, and as Modified Altman scores decrease, so do Chanos. Chanos does not publish absolute scores like Altman; however Nugent has informally made guesses regarding absolute Chanos scores. For the purpose of this paper, it is only important to see that Chanos algorithm validates changes in the Modified Altman scores. It is also interesting to note that Pustylnicks scores trend in concert with Modified Altmans and Chanos. Reference to Table 4 above which gives the summary of Enron Corporations financials for 1997 to 2000 and using Chanos algorithm, we see the scores for the four years are given below (notice again the porpoising effect).

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Table: 8 Year Score

Chanos Discriminant Model Scores 1997 1.01 1998 1.18 1999 1.13 2000 1.66

Table 8 indicates Chanos Discriminant Model Scores from 1997 to 2000. As seen again, the score are porpoising. 2.6 BENEISH FRAUD STATEMENT INDICES In examining Enrons financial statements from 1997 to 2000 using Beneishs fraud statement indices, we see they reveal some level of possible financial statement manipulation. Beneish (1999), states that if financial statement manipulations take place and the entitys numbers surpass his manipulation means without major acquisitions or divestitures, the likelihood of financial statement manipulation is very high. Beneish has shown that accounting data can be used to detect earnings manipulation. Beneish examined other indicators of financial health such as sales margins, asset quality, and time in receivables, gross margins indicators, etc. The objective was to determine whether other parameters included in the corporate financial reports might be used to discover manipulation in the financial statements. Harrington (2005), indicates, that the probability of earnings manipulation goes higher with unusual increases in receivables, deteriorating gross margins, decreasing asset quality, sales growth, and increasing accruals. Beneish (as cited in Harrington, 2005), indicate that certain results point to where there is most likely a problem. Feroz et al (1991), notes that manipulation becomes public on average 19 months after the end of the fiscal year of the first reporting violation. Beneish developed a set of ratios based on empirical testing derived from the companys financial statements which when surpassed; indicate a likelihood of manipulation in the financial statements.
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Days Sales in Receivables Index= Receivables current year/sales current year Receivables prior year/sales prior year This ratio measures whether receivables and revenues are in out-of-balance in two consecutive years. If the ratio detects an abnormal rise in receivables the change might result from revenue inflation. Otherwise, it could be a change in credit policy. This has a non-manipulation mean of 1.030. Gross Margin Index = (Sales prior year minus cost of goods sold prior year)/sales prior year (Sales current year minus cost of goods sold current year)/sales current year It is the ratio of gross margin in current year to gross margin prior year. When the gross margin index is greater than one (1) it means that gross margins have deteriorated and management is motivated to show better numbers. This has a non-manipulation mean index of 1.010. Sales Growth Index = Sales Current Year Sales Prior Year. It is the ratio of prior year sales to current year sales. High sales growth might not imply manipulation. However, managers are highly motivated to commit fraud when the trend reverses. Sales growth index has a non-manipulation mean of 1.130. Asset Quality Index = Total Assets PP&E Current year/ Total Assets Current year Total Assets- PP&E Prior year/ Total Assets Prior year

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Asset quality is the ratio of non-current assets other than property, plant and equipment (PP&E) to total assets and measures the proportion of total assets for which future benefits are potentially less certain. If asset quality index is greater than one (1), then it indicates that the firm has potentially increased its involvement in cost deferral. This index has a non-manipulation mean of 1.040. Total Accruals to Total Assets (TATA) Index is calculated as the change in working capital accounts other than cash less depreciation to total assets. The index tends to look at the proportion of accruals which represent current assets less current liabilities and depreciation to the total value of assets. The growth of this index usually indicates that goodwill numbers in the financial statements of the company have been tampered with. Total Accruals to Total Assets= Working Capital Depreciation Current Year/ Total Assets Current year Working Capital Depreciation Prior Year/ Total Assets Prior year This index has a non-manipulation mean of 0.18 Enrons fraud statement indices for 1997, 1998, 1999 and 2000 are given below. Table: 9 Enron Fraud Statement Indices Days Sales in Receivables Gross Margin Index Asset Quality Index Sales Growth Index Total Accruals to Total Assets
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1997 70.17 1.526 -

1998 0.973 0.0167 1.397 1.542 1.666

1999 1.146 2.205 1.214 1.283 0.523

2000 1.365 1.032 2.368 2.513 0.195

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Enrons receivables and sales exceeded Beneishs thresholds from 1999 to 2000 as the days sales in receivable index had exceeded the non-manipulation mean of 1.030. There was an increase of 11% and 33% in days sales in receivables for 1999 and 2000 respectively over the non-manipulation mean. The implications are that the increase could be as a result of legitimate factors such as liberalized credit policies from one period to the next, or the companys receivables are not properly being reported. In the case of Enron, the receivables were not properly being reported and therefore could not be verified, hence, the filing for bankruptcy in 2001. In relation to gross margin index, Enron Corporations indices for 1997, 1999 and 2000 were greater than one (1) indicating deteriorating gross margins. The indices for 1997 and 1999 were higher than Beneishs is non-manipulation mean of 1.190. The deteriorating gross margins are confirmed by the porpoising (up, down, up, down) gross margin curve. The sales growth index of Enron averaged 1.716 over and above Beneish non-manipulation mean of 1.130 that is 52% above normal sales increase with no major acquisitions. For example, sales had increased by 151% from 1999 to 2000. Enron was creating fictitious sales and this was a sign of financial manipulation. This index can only detect manipulation when sales have increased. Enron Corporation inflated its assets during the period under review by capitalizing costs which could have been written off in one financial year. The average manipulated asset quality index of Enron was 1.66 against Beneish non-manipulation mean of 1.040, which is a 60% difference. Total accruals to total assets ratio of Enron Corporation had increased beyond the non-manipulation mean as well. This was an indication of managements manipulation of earnings by using its discretionary authority of accrual policy. Enrons accruals increased year after year whilst cash decreased. In this case, management was attempting internally to finance its losses.

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2.7 HORIZONTAL ANALYSIS OF ENRON CORPORATION FINANCIAL STATEMENTS. Horizontal financial statements analysis is a procedure where analysts compare ratios or line items in financial statements over a period of time. The decision on items selected is discretional. Horizontal analysis is highly useful for analyzing the effects of a single event on the financial statements period over period. In the case of Enron Corporation, the balance sheets of the year 1997, 1998, 1999 and 2000 are used for the analysis. A comparison will be made between 1997 and 1998, while 1999 is compared to 2000. The base figures for computation will be 1997 and 1999.

Table 10 ENRON CORPORATION HORIZONTAL ANALYSIS: 1997- 2000

1997 ( US $M ) C ash / C ash Eq u iv ale n ts A cco u n ts R e ce iv ab le O th e rs To tal C u rre n t A sse ts W o rk in g C ap ital Lo n g Te rm A sse ts To tal A sse ts C u rre n t Liab ilitie s Lo n g Te rm Liab ilitie s To tal Liab ilitie s 170 1,826 635 4,113 254 18,439 22,552 3,856 6,254 14,794 1999 288 3,548 616 7,255 496 26,126 33,381 6,759 7,151 1998 D iffe re n ce % C h an ge s ( US $M ) 111 [ 59] [ 35% ] 2,898 1,072 59% 514 [ 121] [ 19% ] 5,933 1,820 44% 174 80 31% 23,417 4,978 27% 29,350 6,798 30% 6,107 2,251 50% 7,357 1,103 18% 19,158 4,364 29% 2000 D iffe re n ce % C h an ge s 1,374 1,086 377% 12,270 8,722 245% 1,333 717 116% 30,381 23,126 319% 1,975 1,479 298% 35,122 8,996 34% 65,503 32,122 96% 28,406 21,647 320% 8,550 1,399 20%

( US $M )

C ash / C ash Eq u iv ale n ts A cco u n t R e ce iv ab le O th e rs To tal C u rre n t A sse ts W o rk in g C ap ital Lo n g Te rm A sse ts To tal A sse ts C u rre n t Liab ilitie s Lo n g Te rm Liab ilitie s

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From Table 9 above, Enron Corporations cash and cash equivalents decreased by $59M, from 1997 to 1998, that is a 35% decline. Contrarily, current liabilities also increased by $2,251M which represents a 50% increase during the period of comparison. This means Enron may not be able to settle its current liabilities if they are called upon. This is manifested in the reduction of working capital by $80M from $254M to $174M, for 1997 and 1998, which is 31% reduction. Long term liabilities which are represented here as long-term debt also increased by $1,103M, which is an 18% increase. Accounts receivables increased astronomically by $1,072M, which is 59%. This is a material increase and there is the likelihood that Enrons accounts receivable could have been manipulated or that policies had become too liberal. Total assets and total liabilities are just neck-to-neck in percentage terms that is 30% and 29% respectively. Total assets increased by $6,798M while total liabilities also increased by $4,364M. For the period 1999 and 2000, Enrons cash and cash equivalents increased by $1,086M, that is a leap of 377%. This seem extraordinary and for that matter possibly manipulative. Accounts receivable also went up by $8,722M depicting a 245% increase- a much larger increase than the increase in revenues. Working capital increased by $1,479M, which is 298% increase, while current liabilities went up by $21,647M, giving 320% increase. Total liabilities increased by $30,334M, which is 149% increase. The implication is that Enron might be in good position to pay outstanding creditors in a timely manner given the increase in working capital stated above. The analysis above indicates a likely massive manipulation of balance sheet items by Enron within the period under review. And more especially, manipulation appears to be present starting as early as 1999 and 2000.

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2.8 VERTICAL ANALYSIS OF ENRON FINANCIAL STATEMENTS Vertical analysis reports each amount on a financial statement as a percentage of another item. It is called vertical because each years figures are listed vertically on a financial statement.

Table: 11 ENRON CORPORATION VERTICAL ANALYSIS Category 1998 % Revenue Category Revenue Cost of Goods Sold Gross Margin Expenses Depreciation and Amortization Interest Expenses 827 550 2000 3 2 % Revenue Category Revenue Cost of Goods Sold Gross Margin Expenses Depreciation and Amortization Interest Expenses
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of 1997 (US $M)

of % Column

Revenue change 20,273 20,258 15 1,406 600 401 of 1999 (US$M) 100 99.9 0.074 7 3 2 % (3.9) 3.9 1.0 0 0 Category of % Column Revenue change 40,112 39,310 802 3,045 870 656 100 98 2 7.6 2.0 1.6 0 0 4.6 (1.2) (0.77)
29

(US$M) 31,260 29,882 1,378 100 96 4 8

Sales, General and Administrative 2,352

(US$M) 100,789 98,836 1,953 100 98 2 3 0.8 0.83

Sales, General and Administrative 3,184 855 838

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In Enrons case, vertical analysis is carried on some items in the income statements with sales revenue as the base figure. The computation spans from 1997 to 2000. Enron Corporations cost of goods sold as a percentage of sales in 1997 stood at 99.9% while in 1998 it was 96% given a decrease of 3.9%. Gross margin went up by 3.9% in 1998 from a very low figure of 0.074 in 1997. This was an appreciable increase. Also a marginal one (1) percent increase in operating expenses achieved coupled with a 3.9% reduction in cost of goods sold shows that Enron was controlling costs effectively. Depreciation and interest expense in terms of percentage did not increase. In 1999 and 2000, cost of goods sold stool at 98% apiece and gross margin stood at 2% respectively. Operating expenses decreased by 4.6% likewise depreciation 0.8% from 1999 2%. In effect, there was 1.2% decrease in depreciation comparing 1999 to 2000. Interest expense also dropped by 0.77% within the same period.

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Table: 12 2.9 ENRON CORPORATION RATIO ANALYSES FOR 1997 2000 Category Current Ratio Quick Ratio /Acid Test Ratio Accounts Receivable Turns Accounts Receivable Collection Period Inventory Turns Total Assets to Total Debt Total Debt to Total Equity Sales to Total Assets Return on Total Assets Revenue Growth Net Income Growth Accounts Payable Turns Accounts Payable Payment Period Net Cash Flow Per Share 2000 1.07:1 0.95:1 15 times 24 days 1999 1.07:1 0.98:1 15.7 22.84 days 1998 0.97:1 0.88:1 11.8 times 30.50 days 1997 1.07:1 1.03:1 -

127 times 1.3:1 4.42:1 1.54:1 0.015:1 1.51:1 0.10:1 15.8 Times 22.8 days

70.70 times 1.63:1 2.13:1 1.20:1 0.021:1 0.28:1 0.27:1 15.3 Times 23.5 days

92 times 1.53:1 2.73:1 1.065:1 0.024:1 0.35:1 5.7:1 12.6 Times 28.6 days

1.52:1 2.63:1 0.90:1 -

$1.50

$0.30

-$0.30

Another area to detect manipulation and fraud on Enrons financial statements is by computing some relevant ratios. A ratio is a mathematical relation between one quantity and another. Financial ratio is a relative magnitude of two selected numerical values taken from an organizations financial statements. Ratios are categorized according to the financial aspect of the business which the ratio measures. This
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categorization include liquidity ratios which measures the availability of cash to pay debts, activity ratios measures how quickly a firm converts non-cash assets to cash assets, debt ratios looks at the firms ability to repay long-term debt, and profitability ratios measure the firms use of its assets and control of its expenses to generate an acceptable rate of return. Enron Corporations financial ratios leave much to be desired from 1997 to 2000. The company had a current ratio of 0.97 in 1998 and 1.07 for 1997, 1999 and 2000. Current ratio is measured as current assets divided by current liabilities. A good measure is a ratio of 2:1 which means the company has the ability to pay off its short-term liabilities with ease. In the case of Enron, a ratio of 1.07:1 puts the company into a difficult position in relation to its current liabilities. The quick ratios or acid test ratios of Enron were indicative of red flags. The ratios were 1.03:1, 0.88:1, 0.98:1 and 0.95:1 in 1997, 1998, 1999 and 2000 respectively. This ratio considers only fully or nearly liquid assets such as short term investments, cash and collectible accounts receivable divided by current liabilities. A quick ratio better than 1:1 is recommended. According to Nugent (2010), a better than 1:1 relationship will usually mean the entity will have not to operate hand to mouth. The accounts receivable collection period of Enron when compared with the accounts payable payment period depicts red flags in terms of the companys ability to pay its creditors promptly or on due dates. Whilst Enron has 24, 22.84 and 30.50 days to collect its receivables, contrarily it has 22.8, 23.5 and 28.6 days to pay its creditors within the same period. The additional days lagging on the payment could attract interest or charges to Enron. Enron Corporations inventory turns looked good with 92, 70.70 and 127 times respectively in 1998, 1999 and 2000. However, whether these translated into actual sales (and collectible receivables) and profit leaves much to be questioned. Sales growth at Enron was so large one must question whether they were likely fictitious given the percentage increase in sales during this period.
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Total assets to total debt ratio measures how much of a firms assets are financed by debt. In other words, it measures how highly leveraged a firms assets are. Enrons ratios in this regard indicated ratios of 1.3:1, 1.63:1, 1.53:1 and 1.5:1 respectively for 2000, 1999, 1998 and 1997 respectively. In this case, the firms assets were highly leveraged. Enron was highly leveraged as indicated in the debt-to-equity ratio. It is measured as total debt to total equity and how much of a companys assets are financed by debt. Enron had debt-to equity ratios of 2.63:1, 2.73:1, 2.13:1 and 4.42:1 for 1997, 1998, 1999 and 2000 respectively. The company was highly leveraged despite the fact that some of these debts were hidden in the Special Purpose Entities (SPEs) located off shore. This is a serious red flag as it increased the financial risk of Enron Corporation. Enrons assets did not generate the desired sales revenue as shown by the ratios of sales to total assets. The sales to total assets ratio is measured as sales divided by total assets. The ratios of 0.90:1, 1.065:1, 1.20:1 and 1.54:1 respectively for 1997, 1998, 1999 and 2000. This is confirmed by the revenue growth ratios of 0.35:1, 0.28:1 and 1.51 respectively for 1998, 1999 and 2000 and, the net income growth ratios of 5.7:1, 0.27:1 and 0.10:1 for the same period. Another confirmation is the return on total assets ratios of 0.024:1, 0.021:1 and 0.015:1 for 1998, 1999 and 2000. These ratios indicate performance difficulties at Enron Corporation.

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3.0 EVALUATING ENRONS FINANCIAL PERFORMANCE USING IBE, CFO, CI AND FCF Enrons financial performance took a bad turn commencing in 1997. Four financial indicators widely used to evaluate a companys performance are: i. ii. iii. iv. Income Before Extraordinary Items and Discontinued Operations (IBE); Cash flow from Operations (CFO); Comprehensive Income (CI); and Fresh Cash flow (FCF).

Comprehensive Income is the change in owners equity plus dividends net of capital contributions. Free Cash flow is measured as cash flow from operations minus net capital expenditure plus net interest payments. Table: 13

ENRON FINANCIAL PERFORMANCE MEASURE 1997 - 2000 1996 (US$M) IBE CFO CI FCF 690 884 594 20 1997 (US$M) 15 211 67 -1,181 1998 (US$M) 1,378 1,640 689 -265 1999 (US$M) 802 1,228 314 -1,135 2000 (US$M) 1,953 4,779 672 2,398

ENRON FINANCIAL PERFORMANCE MEASURE 1997 - 2000 1996 690 884 594 20 1997 15 211 67 -1,181 1998 1,378 1,640 689 -265 1999 802 1,228 314 -1,135 2000 1,953 4,779 672 2,398 34

IBE CFO CI FCF July 16, 2010

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Chart 8:

ENRON CORPORATION IBE, CFO, CI AND FCF CURVES

From the graphs it can be seen that IBE, CFO, CI and FCF were close in 1996. However, in 1997 they began diverging through to 2000. The four measures began decoupling in 1997 with Comprehensive Income (CI) and Fresh Cash Flow (FCF) actually diverging. Catanach Jnr. and Rhoades (2003) indicated that this decoupling indicated an early warning of the earnings games that Enron had begun to play in 1997. In fact, Fresh Cash Flow (FCF) showed negative numbers from 1997 through to 1999.

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4.0 CONCLUSION The financial statements of Enron Corporation from 1997 to 2000 depicted large amounts of manipulation of earnings, assets and revenues. Costs were deferred from the asset quality index. Financial statement manipulation practices by over-stepping Generally Accepted Accounting Principles (GAAP) in revenue recognition and the non-consolidation of the Special Purpose Entities (SPEs) set up by Enron were detectible. Again, the exchange of stock for notes from the SPEs by Enron meant that the company was effectively borrowing from itself because the SPEs were set up by Enron and collateralized with Enron stock. From the write up and the analysis of Enrons financial statements, the revenue recognition policy of Enron was not compatible with the intent of GAAP or industry practice. Again, the Company had hit a number of inflection points with the major one being 1999 with a Modified Z-score of 0.59 using Adjusted Altmans Zscore analysis. Using Beneishs analysis of fraud statement indices the statements revealed a high probability of earnings manipulation, with the evidence coming from Enrons own financial statements. Chanos model had indicated serious trouble for Enron from 1999 to 2000. Invariably, both horizontal and vertical financial analysis carried-out on Enrons financial statements pointed to a series of financial irregularities that one could discern that the company was heading for significant operating difficulty. Ratio analysis of the financial statements corroborated such findings with the pattern seen in the income before extra-ordinary items (IBE), comprehensive income (CI), cash flow from operations (CFO) and fresh cash flow (FCF). All of these manipulations and likely fraud took place under the glaring eyes of Arthur Andersen, Enrons auditors and the U.S. Securities and Exchange Commission. It was therefore not surprising that Arthur Andersen was charged with and initially found guilty of obstruction of justice. The onetime big auditing

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firm also collapsed after the collapse of Enron in 2001. Subsequently, Andersen was found to have not obstructed justice in this case, but by this time the firm had already failed. Enrons collapse affected all its stakeholders who lost $74 billion. It must be noted that financial statements analysis can be of great immense importance to stakeholders of an organization. However, one should not rely on any single model or form of analysis. Rather, parties should employ a number of proven models to discern irregularities and patterns that signal likely problems. However, consistent and collective use of the tools discussed herein coupled with other analytical models, should provide an early warning system that something might be remiss in an entitys reporting paradigm.

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SMC Working Papers REFERENCES

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Altman, Edward, I. Corporate Financial Distress: A complete Guide to Predicting, Avoiding, and Dealing with Bankruptcy. John Willey Sons, 1983. Beneish M. D. 1999. The Detection of Earnings Manipulation. Indiana University, Kelly School of Business, Bloomington, Indiana, 47405. Retrieved May 30, 2010 from http://www.baner.uh.edu/swhisenant/beneish earnings mgmt score.pdf Beneish M. D. 2001. Earnings Management: A. Perspective. Indiana University, Kelly school of Business, Bloomington, Indiana 47401, Vol. 27 (12). Retrieved May 30, 2010 form http://emeraldinsight.com/journals.htm?articleid=8657768show=abstract Bennett T. 2008. How Z-Scores can help you beat the slump. Retrieved June 6, 2010 from http://www.moneyweek.com/investment-advice/how-z-scores-can-help-you-beat-the-slump Catanach Jr. A. H. and Rhoades. S. C. 2003. Enron: A Financial Reporting Failure? Retrieved May 30, 2010 from www.ssru.com Enron Annual Report, 1997, 1998, 1999 and 2000. http://picker.uchicago.edu/Enron/EnronAnnual Report1998.pdf Enron Creditors Recovery Corporation. http://en.wikipedia.org/wiki/enron Enron. Retrieved June 6, 2010 2010 from form

Retrieved

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30,

Enron Scandal. Retrieved May 30, 2010 from http://en.wikipedia.org/wiki/enron_scandal Harrington, C. 2005 Analysis ratios for detecting financial statement fraud. Retrieved June 6, 2010 from http://www.acfe.com/resources/view.asp?ArticleID=416 Nugent, J. H. 2001. Plant to win. Pustylnick, I. Combined Algorithm of Detection of Manipulation in Financial Statements. SMC University. Also can be found in www.ssrn.com Van Horney, Y. C. Financial Management and Policy, 12 Ed New Delhi, PHI Learning Private Limited, 2008. Wells, J. T. 2001 Irrational Ratios. Journal of Accountancy 192, 2. Retrieved June 6, 2010 from http://ruby.fgcu.educ/courses/common/irrationatratios.pdf

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