Let us now look at how Enron endeavoured 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 earned this revenue and then consider how such were recognised in accounting. Enron businesses involved mainly trading of assets and provision of risk management services. Initially, Enron traded assets at spot 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 promised 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 this financial trading mode, Enron can deal in much larger quantity 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, it provided risk management services for other companies as well as itself by dealing with its related companies set up by Enron.
This created problems of conflicts of interest 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 service or brokerage fees will be reported as revenues. The fees are set at a percentage of the total value of the company.
of the subject matter of the service. For example, where a property agent completes a deal of sell and purchase of a property worth $10 million, the property agent earns a commission of only, say, 1% 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 its 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% or 65% 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 call historical costs. Under the mark-to-market method, where permitted assets will bring long-term contractual cash rolls 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 rolls, 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 companies usually allocate over the years of assets lives. In Enron's case, when contracts are signed and marked 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 where 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 and estimated profits of more than 110 million dollars. 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 contracts. This can be regarded as a form of creative accounting by cooking the books.
Yet, they did this 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 its Special Purpose Entities. SPEs are usually set up as limited partnerships for limited liability companies. The SPEs were just shell companies with no prior business histories nor assets, and controlled by only a few individuals assigned by Enron. By using hundreds 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 used those SPEs to do businesses with itself, therefore enhancing their revenues and overcoming a lot of regulatory requirements by, say, managing risk of Enron financial trades by engaging with its SPEs. Besides, SPE were often used to borrow loans and then using the monies to hold investments on behalf of Enron.
In making these loans, Enron had to provide financial guarantees. which apparently added risks to Enron and ultimately Enron's shareholders. But since all these were done by SPEs and therefore not disclosed 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 SBEs 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 SBEs failed. Apart from creative accounting practices, Enron's corporate culture has also induced its management and other parties to corroborate in the scandal.
Sarcastically, in year 2000, Enron was elected as having one of the five best boards by chief executive for its 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 were compensated 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 denominated by revenues and not by profits, this had driven its 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 profit.
Besides, even though there were expertise in his audit committee, the board failed to monitor and detect the financial problems relating to Enron and its SPEs. When asked, the board claimed that the board meetings were often too brief, and its audit committee did not have the technical knowledge to question the auditors on 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 Anderson, was accused of conflicts of interest over the significant 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 strained tons 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 31, 2002, Arthur Anderson surrendered his CPA license and went out of business permanently.