Let us now look at how Enron endeavored in each of the above. In trying to overstate this revenue and boost stock prices, Enron adopted a revenue recognition model of agent model instead of merchant model. To understand this, one should first understand how Enron earn this revenue and then consider how such were recognized in accounting. Enron businesses involved many trading of assets and provision of Risk Management Services. Initially, Enron traded assets export prices. Meaning, that the company bought assets from sellers and sold them to buyers at prices agreed at the time of purchase and sell. The selling prices are recognized as revenues and the difference between revenues and purchase prices become the company's profits. This is considered as the merchant model of revenue recognition. When Enron business grew and became a financial trader, the company started to trade not only the actual assets, but also financial contracts for future delivery of assets. As such, Enron purchased contract from sellers who promise to deliver the asset to Enron at a future time at a price agreed on the contract date, but to be paid in future. The same is done with buyers to whom Enron contracted to sell the asset at a future time at a price agreed on the contract date, but the revenue to be received in future. By these financial trading mode, Enron can deal in much larger quantities of assets with greater flexibility without having to transact with physical assets. But at the same time, matching between buy and sell contract prices became a crucial matter of risk management. For otherwise, Enron would be exposed to uncertainty in unfavorable changes of asset prices against the contract prices. Companies usually manage such risks by using risk management services provided by another financial institution. In the case of Enron, you provide risk management services for other companies as well as itself by dealing with it's related companies set up by Enron. This created problems of complex of interests and maybe even fraudulent transactions which will be explained later. But there was also a problem of improper revenue recognition by Enron. For revenue earned from providing services, companies like investment banks usually use the agent model where only the surface or brokerage fees will be reported as revenues. The fees are set at a percentage of the total value of the subject matter of the surface. For example, when a property agent complete a deal of sale and purchase of property worth $10 million, the property agent earns a commission of only say one percent of the property value, that is $100,000 and not the property value of $10 million. But in the case of Enron, it tried to use the merchant model for recognizing [inaudible] service revenues based on the entire value of each transaction. By doing this, Enron was able to boost its revenue substantially. Between 1996 and 2000, Enron's revenue increased by more than 750 percent or 65 percent per year. Not only this, apart from using merchant model for recognizing revenues from services provided, Enron also boosted value of their long-term contracts by using mark-to-market methods. Mark-to-market is a common accounting method permitted to be used typically for financial assets such as shares, bonds which are usually held by financial institutions. Let's see what the method is about and how it was employed by Enron to boost the values of its assets. For assets acquired by company, they are usually recorded at the acquisition cost paid by the company to acquire them. This is what we called historical costs. Under the mark-to-market method, we have permitted assets will bring long-term contractual cash roles in future years, such as years of interest income from bonds. The value of the assets are calculated as the total value of the stream of future cash flows, which are first discounted into their present values by adjusting for changes of value of money over time, due to say, inflation and other factors. As such, the total present value of the asset vary from the acquisition costs, thus resulting in value differences which company usually allocate over the years of assets lives. In Enron's case, when contracts are signed and mark-to-market method was used, the value differences became earnings from the contracts even though the future profits have not yet been received. One example was when Enron and Blockbuster Video signed a 20-year agreement in July 2000 to provide video on demand services in the US, where Enron immediately recorded an estimated profits of more than $110 million. The project ended up a failure later, but Enron did not remove the recorded profits. Incidentally, Enron was the first non-financial company to use the mark-to-market method to account for its long-term contract. This can be regarded as a form of creative accounting by cooking the books. Yet, they did these with the approval of the US SEC, and later on did the same to other transactions of the company. Apart from cooking the books, Enron also tried to portray itself as a financially healthy company by way of hiding liabilities and other transactions that could have tarnished the company's profiles, particularly in the eyes of investors and banks. One of the ways they did this was to undertake and manage transactions not under Enron's name but by setting up other companies as his Special Purpose Entities SPEs. SPEs are usually set up as limited partnerships or limited liability companies. The SPEs were just shell companies with no prior business histories, no assets and controlled by only a few individuals assigned by Enron. By using hunger's of SPEs, up to 2001, Enron was able to conduct a lot of transactions which were not required to be disclosed in Enron's financial statements, because they were not connected with Enron by any official definitions. These became so-called off-balance sheet transactions. At the same time, Enron also use those SPEs to do businesses with itself, therefore enhancing their revenues, and overcoming a lot of regulatory requirements by say, managing risks of Enron financial trades by engaging with his SPEs. Besides, SPE were often used to borrow loans and then using the moneys to uphold investments on behalf of Enron. In making these loans, Enron had to provide financial guarantees which apparently added risks to Enron and ultimately everyone's shareholders. But since all these were done by SPEs and therefore not disclose on Enron's financial statements, the true amount of liabilities and the related financial risks in Enron were never revealed. This can be a form of window-dressing by using off-balance sheet financing which at that time were not specifically banned by accounting standards. Why do you think SPEs were usually set up as limited partnerships or limited liability companies? Because limited liabilities of the limited partnerships or limited liability companies could ensure that losses are restricted when the purposes of SPEs failed. Apart from creative accounting practices, Enron's corporate culture has also induced it's management and other parties to corroborate into scandal. Sarcastically, In year 2000, Enron was elected as having one of the five best board by chief executive for it's model Board of Directors comprising predominantly of outsiders with significant ownership stakes, and a talented audit committee. Yet, as investigations later revealed, the management constantly emphasized Enron stock price, because they will compensate extensively with stock options, which are rights given to employees to buy Enron shares at a predetermined price after a certain period. Also, the incentive mechanism of the company was dysfunctional. By having sales target denominator by revenues and not by profits. This had driven it's sales team to focus on short-term achievement of sales targets, by trying to close as many deals as they can to get the revenues, and therefore their commissions. Even though some of those deals may bring only little or even no profits. Besides, even though there were expertise on this audit committee, the board fail to monitor and detect the financial problems relating to Enron and his SPEs. When asked, the board claimed that the board meetings we're open to brief and his Audit Committee did not have the technical knowledge to question the auditors or the complex financial trade and the related accounting issues. In fact, Enron's aggressive accounting practices and uses of SPEs were approved by the board. The Finance Committee and board did not have enough experience with derivatives to understand what they were being told. Enron's auditor firm Arthur Andersen, was accused of conflicts of interests over the significance consulting fees generated by Enron. The auditor had not demonstrated the abilities to reveal Enron's revenue recognition transactions with SPEs, and other accounting practices. They were also questioned as not doing an adequate job but simply to secure their annual fees. After news of SEC investigation of Enron were made public, Arthur Anderson later shred tongues of relevant documents, and deleted 30,000 emails and computer files. The firm was later charged with and found guilty of obstruction of justice. On August 31st, 2002, Arthur Anderson surrendered his CPA license and went out of business permanently.
