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Analysis of Hp Financial Statement Essay Kenneth Lay formed Enron in 1985, when InterNorth acquired Houston Natural Gas. It was once the seventh largest company the United States of America. Enron branched into many non-energy-related fields over the next several years, including such areas as Internet bandwidth, risk management, and weather derivatives (a type of weather insurance for seasonal businesses). Although their core business remained in the transmission and distribution of power, their phenomenal growth was occurring through their other interests. Fortune Magazine selected Enron as Americas most innovative company for six straight years from 1996 to 2001. Then came the investigations into their complex network of offshore partnerships and accounting practices. The Enron scandal was revealed in October 2001 that eventually led to the bankruptcy of the Enron Corporation and the de facto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was attributed as the biggest audit failure. Several years after it inception when, in 1992, Jeffrey Skilling was hired as the President of the company, he developed a staff of executives that, by the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions of dollars in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives not only misled Enrons board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues. From the early 1990s until 1998, the stock prices of Enron rose by 311%, only slightly higher than the rate of growth in the Standard Poor’s 500. But, after which the stocks shot up. They increased by 56% in 1999 and another 87% in 2000, compared to a 20 percent increase and a 10 percent decline for the index during the same years. As on December 31, 2000, Enron’s stock was priced at $83.13, with market capitalization exceeded $60 billion, that was 70 times earnings and six times book value, an indication of the stock market’s high expectations about its future prospects. Enron was rated the most innovative large company in America in Fortune magazine’s survey of Most Admired Companies. Despite of which within a year, Enron’s image was in tatters and its stock price had tanked nearly to zero. The Enron Scandal was a legend of document shredding, restatements of earnings, regulatory investigations, an unsuccessful merger and Enron filling for bankruptcy. Notwithstanding an elaborate corporate governance network, Enron was able to magnetize large sums of capital to source a moot business model, masking its actual performance through a series of accounting and financing ploys, and increasing its stock prices to unmaintainable levels. Shareholders lost nearly $11 billion when Enrons stock price plummeted to less than $1 per share, by the end of November 2001, from a high of US$90 per share during mid-2000. As the Securities and Exchange Commission (SEC) initiated an investigation, rival Houston competitor Dynegy bid to purchase the company at a very low price. The deal failed, and on December 2, 2001, Enron filed for bankruptcy, with $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history. How it happened? Enron had a rather complicated business model, stretching across many products, incorporating physical assets and trading operations, and crossing national borders. This element stretched the limits of accounting. Enron took full advantage of accounting limitations in managing its earnings and balance sheet to portray a rosy picture of its performance. The trading business of Enron involved complex long-term contracts. The accounting rules then, used the present value framework to record these transactions, requiring management to make forecasts of future earnings. This approach, known as mark-to-market accounting, was significant to Enron’s income recognition and resulted in its management making forecasts of energy prices and interest rates well into the future. Enron relied expansively on structured finance transactions that involved setting up special purpose entities. These transactions shared ownership of specific cash flows and risks with outside investors and lenders. Traditional accounting that focuses on arms-length transactions between independent entities faces challenges in dealing with such transactions. Unconscious resolutions were used to record these transactions, creating a discrepancy between economic realities and accounting numbers. (Healy Palepu, 2003) Financial Reporting Issues Trading Business and Mark to Marketing Definitions: * A measure of the fair value of accounts that can change over time, such as assets and liabilities. Mark to market aims to provide a realistic appraisal of an institutions or companys current financial situation. (Investopedia) * The accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value. (Investopedia) In Enron’s original natural gas business, the accounting had been fairly straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, Enron’s trading business adopted mark-to-market accounting, which meant that once a long-term contract was signed, the present value of the stream of future in flows under the contract was recognized as revenues and the present value of the expected costs of fulfilling the contract were expensed. Unrealized gains and losses in the market value of long-term contracts (that were not hedged) were then required to be reported later as part of annual earnings when they occurred. Enron’s primary challenge in using mark-to-market accounting was estimating the market value of the contracts, which in some cases ran as long as 20 years. Income was estimated as the present value of net future cash flows, even though in some cases there were serious questions about the viability of these contracts and their associated costs. â€Å"Mark to market† was a plan that Jeffrey Skilling and Andrew Fastow proposed to pump the stock price, cover the loss and attract more investment. But it is impossible to gain in a long-term operation in this way, and so it is clearly immoral and illegal. However, it was reported that the then US Security and Exchange Commission allowed them to use â€Å"mark to market† accounting method. The ignorance of the drawbacks of this accounting method by SEC also caused the final scandal. Thus, an accounting system, which can disclose more financial information, should be created as soon as possible. Reporting Issues for Special Purpose Entities The accounting rule, then, allowed a company to exclude a special purpose entity (SPE) from its own financial statements if an independent party has control of the SPE, and if this independent party owns at least 3% of the SPE. Enron need to find a way to hide the debt since high debt levels would lower the investment grade and trigger banks to recall money. Using the Enron’s stock as collateral, the SPE, which was headed by the CFO, Fastow, borrowed large sums of money. And this money was used to balance Enron’s overvalued contracts. Thus, the SPE enable the Enron to convert loans and assets burdened with debt obligations into income. In addition, the taking over by the SPE made Enron transferred more stock to SPE. However, the debt and assets purchased by the SPE, which was actually burdened with large amount of debts, were not reported on Enron’s financial report. The shareholders were then misled that debt was not increasing and the revenue was even increasing. (Li, 2010) Enron had used hundreds of special purpose entities by 2001. Many of these were used to fund the purchase of forward contracts with gas producers to supply gas to utilities under long-term fixed contracts. Other Accounting Problems Enron’s accounting problems in late 2001 were compounded by its recognition that several new businesses were not performing as well as expected. In October 2001, the company announced a series of asset write-downs, including after tax charges of $287 million for Azurix, the water business acquired in 1998, $180 million for broadband investments and $544 million for other investments. Enron’s gas trading idea was probably a reasonable response to the opportunities arising out of deregulation. Conversely, extensions of this idea into other markets and international expansion were unsuccessful. Accounting games allowed the company to hide this reality for several years. The capital markets largely ignored red flags associated with Enron’s spectacular reported performance and aided the company’s pursuit of a flawed expansion strategy by providing capital at a remarkably low cost. Investors seemed willing to assume that Enron’s reported growth and profitability would be sustained far into future, despite little economic basis for such a projection. Governance and Intermediation Failures at Enron Most of the blame for failing to recognize Enron’s problems has been assigned to the firm’s auditors, Arthur Andersen, and to the analysts who work for brokerage, investment banking and research firms, and sell or make their research available to retail and professional investors. Role of Top Management Compensation As in most other U.S. companies, Enron’s management was heavily compensated using stock options. Heavy use of stock option awards linked to short-term stock price may explain the focus of Enron’s management on creating expectations of rapid growth and its efforts to puff up reported earnings to meet Wall Street’s expectations. Role of Audit Committees Corporate audit committees usually meet just a few times during the year, and their members typically have only a modest background in accounting and finance. As outside directors, they rely extensively on information from management as well as internal and external auditors. If management is fraudulent or the auditors fail, the audit committee probably won’t be able to detect the problem fast enough. Enron’s audit committee had more expertise than many. But Enron’s audit committee seemed to share the common pattern of a few short meetings that covered huge amounts of ground. Enron’s Audit Committee was in no position to second-guess the auditors on technical accounting questions related to the special purpose entities. Nor was it in a position to second-guess the validity of top management representations. However, the Audit Committee did not challenge several important transactions that were primarily motivated by accounting goals, was not skeptical about potential conflicts in related party transactions and did not require full disclosure of these transactions. (Healy Palepu, 2003) Role of External Auditors Enron’s auditor, Arthur Andersen, had been accused of applying lax standards in their audits because of a conflict of interest over the significant consulting fees generated by Enron. In 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees. It is difficult to determine whether Andersen’s audit problems at Enron arose from the financial incentives to retain the company as a consulting client, as an audit client or both. However, the size of the audit fee alone is likely to have had an important impact on local partners in their negotiations with Enron’s management. Enron’s audit fees accounted for roughly 27% of the audit fees of public clients for Arthur Andersen’s Houston office. When the credit risks at the special purpose entities became clear, the auditors apparently succumbed to pressure from Enron’s management and permitted the company to defer recognizing the charges. Two major changes in the 1970s in the legal system, created substantial pressure for audit firms to cut costs and seek alternative revenue sources. In response to the changes, the audit firms lobbied for mechanical accounting and auditing standards and developed standard operating procedures to reduce the variability in audits. This approach reduced the cost of audits and provided a defense in the case of litigation. But it also meant that auditors were more likely to view their job narrowly, rather than as matters of broader business judgment. Furthermore, while mechanical standards make auditing easier, they do not necessarily increase corporate transparency. Role of Fund Managers Investment fund managers failed to recognize or act on Enron’s risks because they had only modest incentives to demand and act on high-quality, long-term company analysis. These managers are typically rewarded on the basis of their relative performance. Flows into and out of a fund each quarter are driven by its performance relative to comparable funds or indices. If the manager reduces the fund’s holdings of Enron and the stock falls in the next quarter, the fund will show superior relative portfolio performance and will attract new capital. However, if Enron continues to perform well in the next few quarters, the fund manager will underperform the benchmark and capital will flow to other funds. In contrast, a risk-averse manager who simply follows the crowd will not be rewarded for foreseeing the problems at Enron, but neither will this manager be blamed for a poor investment decision when the stock ultimately crashes, since other funds made the same mistake. Role of Accounting Regulations Many U.S. accounting standards tend to be mechanical and in flexible. Clear-cut rules have some advantages, but the downside is that this approach motivates financial engineering designed specifically to circumvent these knife-edge rules, as is well understood in the tax literature. In accounting for some of its special purpose entities, Enron was able to design transactions that satisfied the letter of the law, but violated its intent such that the company’s balance sheet did not reflect its financial risks. The Sarbanes Oxley Act In 2002, President Bush passed the Sarbanes-Oxley Act into law to re-establish investor confidence in the integrity of corporate disclosures and financial reporting. The act was brought in as a result of the large number of corporate financial fraud cases (such as those of Enron, WorldCom, Tyco, Adelphia, AOL, and others) and by the end of the boom years for the stock market. The Act requires all public companies to submit both quarterly and annual assessments of the effectiveness of their internal financial auditing controls to the Securities and Exchange Commission. Each companys external auditors must also audit and report on the internal control reports of management and any other areas that may affect internal controls. The companys principal executive officer and principal financial officer must personally certify that the financial reports are true and that everything has been disclosed. Many of the Acts provisions apply to all companies, United States and foreign. However, some provisions apply only to companies that have equity securities listed on an exchange or NASDAQ. While refocusing public company management on shareholder interests was the central purpose of the Sarbanes-Oxley corporate governance reform law, years later there are sharp disagreements on both sides as to whether the effort has been a success. Did it help? Considering foreign firms that listed on either New York or London exchanges in addition to their home markets between 1990 and 2006, the researchers found that those firms were six percent less likely to choose New York over London after Sarbanes-Oxley was implemented. This suggests that foreign executives, accustomed to laxer regulatory environments at home, were convinced that the act’s deterrents against self-dealing and fraudulent accounting were serious. Those who criticize the Act claim that the Act is unnecessary and too expensive to implement. The most ardent criticizers of the bill claim that not only has Sarbanes – Oxley failed in its mission to ensure honest financial recordkeeping and disclosure but that it has also stifled new business development in the United States. Some criticizers point to the Madoff scandal as an example of the failure of the Sarbanes – Oxley Act. Yet, not all analysts share in this type of criticism. Many analysts believe that more precise financial statements are now being prepared for public companies and that shareholders have greater confidence in their investments as a result of Sarbanes – Oxley. In order for these benefits to be realized, however, the S.E.C. must ensure that all of the requirements of the Act are carefully and universally followed and that exceptions, such as those for certain accounting firms, are not permitted. Bibliography * Wikipedia. (2012, December 18). Enron Scandal. Retrieved December 26, 2012, from Wikipedia: http://en.wikipedia.org/wiki/Enron_scandal * Obringer, L. A. (n.d.). How cooking the books works? Retrieved December 26, 2012, from How Stuff Works?: http://money.howstuffworks.com/cooking-books7.htm * Healy, P. M., Palepu, K. G. (2003). The Fall Of Enron. Journal Of Economic Persepectives , 9. * Investopedia. (n.d.). Mark to Market MTM. Retrieved December 26, 2012, from Investopedia: http://www.investopedia.com/terms/m/marktomarket.asp#axzz2G9qt6COE * Li, Y. (2010). The Case Analysis of the Scandal of Enron. International Journal of Business and Management , 37-41.