Enron and the How Companies Dupe Investors Case Study

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party transactions reported on by Arthur Andersen & Co.

Related party transactions are essential transactions between closely related parties or individuals. Although not blatantly wrong in isolation, they can be particularly harmful if the practice is abused. The error with Enron's disclosure is that it was not clear enough. Investors, analysts and creditors could not properly ascertain the extent of the related party transactions at Enron. This was particularly true as the company did not want anyone to know about it. As a result the company was able to hid billions of dollars of off balance sheet debt from investors. This resulted in large, unknown exposures to investors. Arthur Anderson looked the other way in regards to informing investors about these exposures. They classified many of the entities that held the excessive amount of debt as special purpose entities. With the help of Arthur Anderson, Enron avoided consolidated the results of the special purpose entities.

Generally, related party transactions partnerships with Andrew Fastow, were largely ignored as the company was able to fool auditors. However, after the eventual implosion of Enron, nearly 3000 partnerships were discovered. Many of these partnerships were hidden and used a variety of schemes to enrich senior executives at the expense of shareholders. In addition these joint ventures created phantom profits which were then used to meet Wall Street expectations. By meeting these expectations, the company's share price was inflated; resulting is still further use of the joint ventures. The joint ventures reported by Arthur Andersen involved three separate entities. Each was distinct but all three served to mislead investors by using fraudulent accounting. The three primary entities were Chewco Investments, JEDI, and LJM Cayman. These three partnerships inflated Enron's earnings by over $500 million. Many of these inflated profits pertained to Enron's lack of consolidation on its balance sheet.

Under Andre Fastow's leadership the complexity of these partnerships began to increase exponentially. The company parked troubled assets into these partnerships and SPE's to leave their deteriorating value off the financial statements. Investors began to become worried about the deteriorating quality of these assets. To assuage investors' concerns and to compensate partnership investors for downside risk, Enron promised issuance of additional shares of its stock. This seemed like a win-win situation as the stock was rising very quickly in the market. Investors, both retail and institutional, loved the stock. The bid the share price higher and higher which provided reassurance to the investors in the Special Purpose Entities. As the value of the assets in these partnerships fell, Enron began to incur larger and larger obligations to issue its own stock later down the road. This caused the company to substantial increase its reliance on related party transactions. These related party transactions helped to mask trouble within the company by inflating profits. These inflated profits would appease Wall Street skeptics and keep the stock price afloat. With the stock price afloat, Enron could then transfer the bad assets into the special purpose entities, thereby leaving the transactions off-balance sheet.

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This would make the company look better to investors to further increase the stock price.

The key component of this scheme was the related party transactions between company partnerships and SPE's. Without them, the overall plan would fail. These related party transactions included material and significant sales. For example, in December 1999, the company LJM Cayman paid $30 million for a 75% equity stake in an Enron power project in Poland. Enron subsequently, booked $16 million in investment gains. The same thing accrued in September 1999, but this time with a power project in Brazil. Enron again booked a gain of $65 million in revenue. These transactions were conducted with related parties and thus were not legitimate sources of recurring revenue. These transactions were then used to prop up the company's stock to help assuage investors who invested in the risky assets of the partnership.

Description and evaluation of the flaw in the accounting firm's logic

The firm's logic was flawed for a litany of reasons. First the accounting firm did not analyze the transactions thoroughly. They simply skimmed over the transactions in an effort to complete the audit. They also did not properly inform management regarding the extent of off-balance-sheet debt. Second, the accounting firm characterized many of these transactions as economic hedges. In reality these transactions were designed to circumvent accounting rule and regulations. Through the SPE's Enron never actually hedged the risk of loss. In fact, a significant amount of the loss risk still remained with the company.

In addition, the three primary joint ventures had significant related party transactions that influenced financial performance. For example, Enron shifted expenses related to LJM Cayman by providing administrative assistance and office space to the owners of the company. In addition, JEDI recorded revenues that were allocated to Chewco, consisting entirely of the appreciation in value of Enron's stock. The related party transactions even involved Enron itself. In June 2000, the company sold fiber optic cable to LJM Cayman for $100 million and added the after tax amount to earnings. That same year, Enron recognized $20 million in income for maintenance and marketing of these products to LJM Cayman. These transactions between related parties are not indicative of the underlying performance of the company. Arthur Andersen however mad the incorrect assumption that these revenues and earnings were legitimate. In reality however, they were not.

Proposed checklist for special projects performed by external auditors to limit errors and risks

1. Does the information reported accurately reflect the economic significance and performance of the company

2. If you prepared the financial statements yourself, what changes would you have made to the actually reporting. These differences should be material and immaterial

3. If the auditor were an investor, could you clearly understand the financial performance of the company?

4. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

5. Is the auditor aware of any actions -- either.....

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