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Earnings Management

and Earnings Quality


Prospect Theory
Test 1:
An 80% chance to win $4,000, 20% win nothing
A certain gain of $3,000

Test 2:
An 80% chance to lose $4,000, 20% to lose nothing
A certain loss of $3,000

Experimental economists found most of people
choose B over A; and C over D. Therefore the value
function can be demonstrated as follows.
Gain Loss
Value
Implications for the Prospect Theory:
People seem to respond to perceived gains
or losses rather than to their hypothetical
final wealth positions, the latter of which is
assumed by expected utility theory.
There is a diminishing marginal sensitivity
to changes, regardless of the sign of the
changes; and
Loss looms larger than gains.
What is Earnings Management?
Arthur Levitt: practices by which earnings
reports reflect the desires of management
rather than the underlying financial
performance of the company.
Earnings management (or income smoothing)
is often defined as the planned timing of
revenues, expenses, gains and losses to
smooth out bumps in earnings. In most cases,
earnings management is used to increase
income in the current year at the expense of
income in future years. Earnings management
can also be used to decrease current earnings
in order to increase income in the future.
The Public Perception of Earnings
Management
Earnings management has a negative effect on the
quality of earnings if it distorts the information in a
way that it less useful for predicting future cash flows.
The term quality of earnings refers to the credibility of
the earnings number reported. Earnings management
reduces the reliability of income.
The investing public does not necessarily view minor
earnings management as unethical, but in fact as a
common and necessary practice in the everyday
business world. It is only when the impact of
earnings management is great enough to affect the
investors portfolio that they feel fraud has been
committed.
How company smoothes earnings Check list
Does level discretionary cost conform to past
Is there a drop in trend of discretionary costs as
percentage of sales
Does cost cutting program involve significant cut
in discretionary costs
Does cost cutting program eliminate fat?
Do discretionary costs show fluctuations relative
to sales
Is there a sizable jump in discretionary costs?
The Impact of Earnings Management
The practice of earnings management damages
the perceived quality of reported earnings over
the entire market, resulting in the belief that
reported earnings do not reflect economic reality.
This will eventually lead to unnecessary stock
price fluctuation. This uncertainty ultimately has
the potential to undermine the efficient flow of
capital thereby damaging the markets as a whole.
Incentives to Manage Earning
A. EXTERNAL FORCES
Analyst Forecasts
Debt markets and contractual obligations
Competition -
B. INTERNAL FACTORS
Potential mergers -
Management Compensation -
Planning and budgets -
Unlawful transactions -
C. PERSONAL FACTORS
Personal bonuses -
Promotions and job retention
SEC Response to Earnings Management
SAB 99 regarding Materiality in August of 1999: A
favorite practice of corrupt management is to justify
earnings management by claiming it is immaterial.
SAB 100 was released in November of 1999 in an
attempt to eradicate the common earnings
management practice of taking a big bath through
the use of restructuring and impairment charges.
SAB 101A concerning Revenue Recognition was
released at March of 2000, and later SAB 101B.
The issuance of SAB 102 concerning Loan Loss
Allowances, which is another preferred tool of
earnings management, July of 2001.
Types of Earnings Management and Manipulation
(by Scott McGregor)
a. "Cookie-jar" Reserves
b. Capitalization practices-Intangible assets,
software capitalization, research and
development.
c. "Big bath" one-time charges
d. Operating activities
e. Merger and acquisition activities
1. Pooling on interests
2. Purchase accounting and goodwill
f. Revenue Recognition
g. Immaterial misapplication
h. Reserve one-time charges

Examples of Fraudulent
Earnings Management (I)
Aug.22, 2005: The SEC filed civil fraud charges
against former officers of BMS
Fraudulent Earnings Management Scheme
Deceiving investors about the true performance,
profitability and growth trends of the company
Sold excessive amounts of its products to
wholesalers ahead of demand and improperly
recognized revenue of $1.5 billion
Used cookie jar reserves to further inflate its
earnings


Examples of Fraudulent
Earnings Management (II)
Nov.30, 2004: The SEC announced filing and
settling charges against AIG
Offer and sale of an Earnings Management
product
Special Purpose Entities to enable the buyer to
remove troubled or other potentially volatile
assets from its balance sheet
Enabling the buyer to avoid charges to its
reported earnings from declines in the value of
theses assets

Examples of cases of earnings manipulation
a. Cendant
b. Manhattan Bagel
c. Sunbeam
d. Tyco
e. Sensormatic
f. 3Com
g. W.R. Grace
h. MicroStrategy
i. Lucent

Cendant
Cendant was created in 1997 by merge of equals
between CUC and HFS.
HFS later found CUC recorded 500M phony profit
before merger.
This is driven by managements determination to meet
Wall Street analysts expectations.
CUC management maintained an annual schedule
setting forth opportunities that were available to inflate
operating income.
Top down approach. Top management allocate the
amount that each subsidiary needs to come up with the
earnings. Then the management make additional
adjustment to ensure the earnings and expenses ratios
are similar to that of previous year.
Cendant
1996 CUC established merger reserve that is double its
cost, simply view as opportunity the viability of future
earnings at CUC.
1997 CUC used merger with HFS as another chance to
cover up its shortfall of earnings.
In April 1998, Cendant suited 7 former CUC executives
for accounting fraud. SEC brought similar charges in
June 1998.
The day after fraudulent financial reporting was
announced in April 1998, Cendants stock price drop
46.5%, eliminating $14 billion in market capitalization.
1998 December, Ernst and Young, CUCs auditors
agreed to pay $335M to Cendant stockholders.

MicroStrategy
MicroStrategy's reporting failures were primarily the
result of premature recognition of revenue.
Management did not sign contracts received near the
end of quarters until after it determined how much
revenue was required to achieve desired quarterly
results.
MicroStrategy engage in complex transactions
involving the sale of software as well as extensive
software application development and consulting
services. The nature of the multiple element deals at
MicroStrategy gave rise to accounting practices that
were not in accordance with GAAP.
MicroStrategy
SEC documents detail a transaction in which
MicroStrategy negotiated a $4.5 million
transaction to provide software licenses and
extensive consulting and development
services. The majority of the software licenses
were to be used in conjunction with to-be
developed applications, indicating that the
product and service elements were
interdependent.
However, MicroStrategy recognized the entire
$4.5 million received in the transaction as
software product license revenue, allocating no
revenue to the extensive service obligations.
MicroStrategy
MicroStrategy also entered into an agreement
in which it agreed to provide software licenses,
maintenance and services to a large retailer. In
a side letter to the agreement, MicroStrategy's
sales staff promised the retailer future product
at no cost, although the product had not yet
been developed.
Under GAAP, the revenue should have been
deferred because the value of the future
product could not be determined.
MicroStrategy
MicroStrategy announced that it would restate
earnings for three years to comply with GAAP. After
the announcement, MicroStrategy stock fell 62
percent in one day. Its stock price dropped from a
high of $333 per share to $33 per share.
In April 2001, the company settled a class action suit
alleging fraud arising from its accounting practices.
Three of its executive officers at the time of the
restatement agreed to fraud injunctions and paid
penalties of $350,000 each.
The company agreed to undertake corporate
governance changes and implement a system of
internal controls.
Lucent
Lucent Technologies, an AT&T spin-off, started trading
publicly in 1996 with an initial public offering that was,
at the time, the largest in domestic history.
In December 1999, Lucent's stock was selling at
$77.78 and was the nation's fourth most widely held
stock. However, by July 2001, Lucent's stock was
trading at $6.43, the SEC was investigating its
accounting practices and several former, high-level
managers.
The decline in Lucent's stock value has been
attributed to a Nov. 21, 2000 announcement in which
Lucent said it had voluntarily reported accounting
irregularities to the SEC. As a result of its own internal
investigation, Lucent restated its Sept. 30, 2000
financial statements, reducing revenue by $679
million.
Lucent
According to a January 2000 Wall Street Journal
article, Lucent had used "a whole myriad of aggressive
accounting moves to boost its growth." One analyst
estimated that Lucent added about 27 cents a share to
its earnings through "deft accounting moves," including
creative acquisition accounting.
In October 1998, Business Week reported that Lucent
avoided some goodwill amortization by writing off $2.3
billion of in-process research and development as
companies were acquired. Lucent's earnings also
benefited from a $2.8 billion reserve for "big bath"
restructuring charges that were recorded as part of
Lucent's spin-off from AT&T. Some analysts believe
Lucent put aside far more than was needed to cover
restructuring expenses and used the excess reserves
to smooth earnings .
Lucent
Although revenue and accounts receivable increased in
fiscal 1999, Lucent lowered its bad-debt reserves. In
addition, some observers believe that Lucent improperly
lowered its reserves for obsolete inventory in 1999.
Lucent's December 2000 restatement in which revenues
were reduced by $679 million, created doubt. Two-thirds of
the $679 million reduction in revenue, or $452 million, was
attributed to "channel stuffing" sales, in which transfers of
products to distributors are recorded as sales although the
products are not yet sold to end-users.
The restatement also reduced revenues by $199 million
because customers were promised discounts, credits and
rights of return.
Lucent also nullified $28 million in revenue recognized on a
partial shipment of equipment.
The Cendant, MicroStrategy and Lucent cases
share several common characteristics
1. The earnings management activities took place over
extended periods of time, escalating from questionable and
improper revenue recognition practices to other forms of
earnings management;
2. The earnings management practices were initiated "at the
top," but eventually involved high-level managers and their
subordinates; and
3. The earnings management practices were not uncovered by
external auditors or audit committees.

These characteristics and the SEC's announced policy of
enforcing action against companies engaging in abusive
earnings management suggest that accountants and
auditors should be vigilant in their attempts to identify
earnings management activity in its early stages.
A survey of fraudulent accounting management --
When earnings management becomes fraud?
Done by Internal Auditing, Sept./Oct. 2002
1. In most cases, top management is involved
with perpetrating the fraud.
2. Those industries in Computer Software,
Medical Service, and Telecommunications are
most likely to conduct fraudulent accounting
management.
3. Improper revenue recognition is the most often
seen violation of GAAP.


Corporate Mechanisms to avoid fraudulent
Earnings Management (by Raymund Breu)
Board oversight
External Audit
Internal Audit reporting to Audit Committee
of Board
Accounting manuals
Training
Whistleblower procedures
Code of Conduct
Code of Ethics of Financial Officer
Special Purpose Entity (SPE)
SPEs typically are defined as entities created for a limited
purpose, with a limited life and limited activities, and
designed to benefit a single company. They may take
form of a partnership, corporation, trust, or joint venture.
The financial risk of the sponsor is limited to its investment
or explicit recourse obligation in the SPE or SPV. In many
instances, creditors of a bankrupt SPE or SPV cannot
seek additional assets from the sponsor beyond what was
invested or contracted for by that sponsor.
The net assets of the SPE or SPV may be protected from
creditors of its sponsors such that the SPE or SPV is not
the deep pockets in the event that any sponsor goes
bankrupt.
Cash Flow Structure (Sponsors Receive
Cash for Asset Sales to the SPE)
Each sponsor factors (sells) ownership of actual assets
(e.g., receivables "factoring") to the structure. Assets are
deleted from the sponsor's balance sheet.
The sponsors record the transfer of the assets as a sales
under FAS 140 or other GAAP rules. Gains and losses
are based upon estimated fair value at the time of the
transfer.
The transferred assets are protected from lawsuits
against the sponsor, although the sponsors may have to
add more "assets" based upon contractual trigger events.
Enron corporation estimate fair values well above
realistic fair values and, thereby, beef up their own
earnings per share with questionable levels of
recorded sales to SPEs.
Cash Flow Structure
The transferred assets may serve as security
(securitization) for borrowing by the SPE, and the cash
flows from the assets and borrowings may be used to
purchase additional assets from the sponsors.
Some SPEs may purchase equity shares of the
sponsor for cash, or equity shares may be directly
transferred to cover trigger event declines in an SPE's
net asset value.
It is alleged that the collapse of Enron would not have
arisen in late 2001 had Enron share prices not fallen
below $80. Plunging share prices hit SPE trigger
points that allowed the SPEs' creditors to demand early
collections on an SPEs' debt.
Derivatives Financial Instrument
Structure in Lieu of an Asset Transfer
Enron enters forward energy contracts with a new power
plant built by Enron. Suppose the plant is originally financed
with floating rate, short-term debt until the plant begins to
generate electricity.
Once the plant is operational, the sponsor's forward contracts
can be transferred to an SPE that in turn uses these forward
contracts as collateral to borrow on fixed rate notes at lower
rates than the sponsor could otherwise obtain on its own.
After using the sale proceeds to pay off construction loan, the
sponsor (e.g., Enron) no longer has floating rate interest risk
and retains title to the plant, although the plant itself may have
to serve as additional collateral to obtain the fixed rate debt.
When the forward sales contracts mature over time, those
energy sales at forward prices are used to service the SPE
fixed rate debt.
Diamond Structure
A diamond structure arises when three or more sponsors
form an SPE where no one sponsor has control over the
SPE. Diamond structures may be separate corporations
that not even meet the definition of a SPE and yet function
exactly like an SPE.
Suppose three major oil companies (sponsors) want to build
a pipeline. A pipeline corporation is formed with each
sponsor owning a third of the voting shares. The sponsors
invest little if any cash in the pipeline company.
The pipeline company can borrow millions or even billions
based upon long-term throughput contracts signed by the
partners to purchase millions of gallons of fuel carried each
year in the completed pipeline.
The throughput contracts are essentially forward contracts to
purchase throughput, revenues from which go to service the
pipeline's debt and to operate the pipeline.
Defeasance (In Substance Defeasance)
Defeasance OBSF was invented over 20 years ago by Exxon in
order to report a $132 million gain on removing $515 million in
bond debt from its balance sheet.
An SPE was formed in a bank's trust department. The bond
debt was transferred to the SPE and the trustee purchased risk-
free government bonds that, at the future maturity date of the
bonds, would exactly pay off the balance due on the bonds as
well as the periodic interest.
At the time of the bond transfer, Exxon captured the $132
million gain that arose because the bond interest rate on the
debt was lower than the current market interest rates.
FASB Statement No. 125 requires de-recognition of a liability if
and only if either (a) the debtor pays the creditor and is relieved
of its obligation for the liability or (b) the debtor is legally
released from being the primary obligor under the liability.
Synthetic Lease Structure (sales and
lease back)
The sponsor sell the asset to the SPE and then lease it
back from the SPE.
A synthetic lease is structured under FAS 140 rules such
that a sale/leaseback transaction takes place where the
fair value of the assets "sold" can be reported by the
sponsor as "revenue" for financial reporting.
In a synthetic lease, this "revenue" does not have to be
reported up-front for tax purposes even though it is
reported up-front for financial reporting purposes.
Proceeds from the sale to an SPE in this instance are
generally long-term receivables rather than cash.
The synthetic leaseback terms are generally such that
the sponsor does not have to book the leased asset or
the lease liability under FAS 13 as a capital lease.
Enrons History
In 1985 after federal deregulation of natural gas pipelines,
Enron was born from the merger of Houston Natural Gas
and InterNorth, a Nebraska pipeline company.
Needed new and innovative business strategy Kenneth
Lay, CEO, hired McKinsey & Company to assist in
developing business strategy. They assigned a young
consultant named Jeffrey Skilling. His background was in
banking and asset and liability management.
His recommendation that Enron create a Gas Bank to
buy and sell gas. Lay created a new division in 1990
called Enron Finance Corp. and hired Skilling to run it.
Enron soon had more contracts than any of its
competitors and, with market dominance, could predict
future prices with great accuracy, thereby guaranteeing
superior profits.

Enrons Strategy
Skilling began hiring the best and brightest
traders and rewarded them handsomelythey
were allowed to eat what they killed.
Started Enron Online Trading in late 90s
Created Performance Review Committee (PRC)
that became known as the harshest employee
ranking system in the countrybased on
earnings generated, creating fierce internal
competition.
Enrons core business (transportation) was
losing moneyshifted its focus from bricks-
and-mortar energy business to trading of
derivatives.

Enrons Strategy
Most derivatives profits were more imagined
than real with many employees lying and
misstating systematically their profits and
losses in order to make their trading
businesses appear less volatile than they were.
Enrons top management gave its managers a
blank order to just do it
Deals in unrelated areas such as weather
derivatives, water services, metals trading,
broadband supply and power plant were all
justified.

Enrons Strategy
Enron delivered smoothly growing earnings (but not
cash flows). In its last 5 years, Enron reported 20
straight quarters of increasing income.
Wall Street took Enron on its word, but didnt
understand its financial statements. Enron was a
trading company and Wall Street normally doesnt
reward volatile earnings of trading companies.
(Goldman Sachs is a trading company. Its stock price
was 20 times earnings while Enrons was 70 times
earnings.)
Enron, that had once made its money from hard assets
like pipelines, generated more than 80% of its earnings
from its vaguer business known as wholesale energy
operations and services.
Aggressive Nature of Enron
Because Enron believed it was leading a
revolution, it pushed the rules. Employees
attempted to crush not just outsiders but
each other.
Enron was built to maximize value by
maximizing the individual parts. Enron
traders were afraid to go to the bathroom
because the guy sitting next to them
might use information off their screen to
trade against them.
Enrons Arrogance
Those whom the Gods would destroy
they first make proud.
Enrons banner in lobby: Changed from
The Worlds Leading Energy Company
to THE WORLDS LEADING COMPANY
Older, stodgier companies will topple
over from their own weight (Jeff Skilling)
Conference of Utility Executives in 2000:
Were going to eat your lunch (Jeff
Skilling)
Special-purpose Entities (SPEs).
The parent can bankroll up to 97% of the initial
investment in an SPE without having to
consolidate it into its own accounts. Normally,
once a company owns >50% of another, it must
consolidate it under the 1959 rules. The
controversial exception: outsiders need invest
only 3% of an SPE's capital.

(it is changed to 10% by FASB on January, 2003)
Chewco
In 1993, Enron and the California Public Employees'
Retirement System ("CALPERS") entered into a joint
venture investment partnership called Joint Energy
Development Investments LP ("JEDI"). Enron was the
general partner of JEDI and contributed $250 million in
Enron stock; CALPERS was the limited partner and
contributed $250 million in cash.
In approximately the summer of 1997, Enron began to seek
a buyer for CALPERS share of the JEDI partnership so that
CALPERS would agree to invest additional funds in an even
larger partnership to be called JEDI II. CALPERS imposed
a deadline of November 6, 1997 for the buyout to occur at
the negotiated price of $383 million.
Chewco
Fastow proposed the formation of Chewco to buy out
CALPERS' JEDI interest.
Before the November 6, 1997 deadline, Fastow and
others arranged to fund the buyout temporarily through
"bridge" loans from Barclays Bank PLC ("Barclays") and
Chase Manhattan Bank ("Chase"). Each bank loaned
$191.5 million to Chewco, with repayment guaranteed by
Enron, and Chewco used those loan proceeds to buy
CALPERS' interest in JEDI.

Chewco
Fastow and others knew that Chewco failed to comply with SPE non-
consolidation rules because Chewco had no genuine outside equity
investment, and because Enron guaranteed Barclays and Chase
against risk of loss.
As a result, Enron's year-end financial statements for the years 1997,
1998, 1999, and 2000 were materially false and misleading. In
November 2001, Enron announced that it would consolidate Chewco
and JEDI retroactive to 1997. This resulted in a massive reduction in
Enron's reported net income and a massive increase in its reported
debt. The consolidation revealed the following effect, according to
Enron: reduction of net income in the amounts of $45 million (1997),
$107 million (1998), $153 million (1999), and $91 million (2000), and
debt increased in the amounts of $711 million (1997), $561 million
(1998), $685 million (1999), and $628 million (2000).

Chewco SPE
The CEO of Andersen testified -the firm had performed
unspecified "audit procedures" on the transaction in
1997, was aware at the time that $11.4 million had
come from "a large international financial institution"
(presumably Barclays), and concluded that it met the
test for 3% residual equity.
Kopper received $2 million in "management" and
other fees relating to Chewco. The participation of
an Enron employee as a principal of Chewco
appears to have been accomplished without any
presentation to, or approval by, Enron's Board of
Directors.

JEDI Enron stock gains
From 1993 through the first quarter of 2000, Enron
picked up its share of income from JEDI using the equity
method of accounting.
Changes in fair value of the assets were recorded in
JEDI's income statement. JEDI held 12 million shares of
Enron stock, at fair value. Enron and Andersen
apparently developed a formula in 1996
The first quarter of 2000 - Enron recorded $126 million
in Enron stock appreciation
The third quarter of 2000 decision that income from
Enron stock held by JEDI could no longer be recorded
on Enron's income
JEDI Enron stock gains
In the first quarter of 2001, Enron stock held by
JEDI declined in value by approximately $94
million. Enron share $90 million.
Enron's internal accountants decided not to
record this loss based on discussions with
Andersen.
According to the Enron accountants, they were
told by Andersen that Enron was not recording
increases in value of Enron stock held by JEDI
and therefore should not record decreases.
LJM
In 1999, two partnerships in which Fastow was the manager
and an investor. LJM 1 and LJM 2. The purposes of the
LJMs
(1) manipulate Enron's financial results by fraudulently
moving poorly performing assets off-balance-sheet;
(2) manufacture earnings for Enron through sham
transactions with the LJM entities when Enron was having
trouble otherwise meeting its goals for a quarter; and
(3) improperly inflate the value of Enron's investments by
backdating transaction documents to dates advantageous to
Enron.
LJM
Near the end of the third and fourth quarters of
1999, Enron sold interests in seven assets to LJM1
and LJM2. The legitimacy of the sales
(1) Enron bought back five of the seven assets after
the close of the financial reporting period
(2) the LJM partnerships made a profit on every
transaction
(3) according to a presentation Fastow made to the
Board's Finance Committee, those transactions
generated, "earnings" to Enron of $229 million in
the second half of 1999
LJM
Fastow and the LJM entities engaged in these transactions
because:
(1) as CFO,Fastow readily could rid Enron of poorly
performing assets and thereby improve Enron's reported
financial results, which in turn would enable Fastow to earn
continued prestige, salary, bonuses, and other benefits from
Enron;
(2) the LJM entities would make money on their dealings with
Enron, since Enron illegally and secretly guaranteed that the
LJM entities would not lose money and, if they did, would be
made whole in future transactions; and
(3) Fastow and others at the LJM entities personally reaped
huge sums of money from such transactions, both in the form
of management fees and skimmed deal profits.

Raptor I/AVICI
Enron invested in other companies, including start-up ventures
that later did initial public offerings ("IPO") of their shares. At the
time of an IPO, Enron often owned millions of shares of the
newly public company. Following the IPO, Enron was at risk for
market price fluctuations in the shares.
Raptor I was created in April 2000 through an off-balance-sheet
SPE called Talon LLC ("Talon"). Talon was designed to generate
accounting gains which would offset Enron's significant mark to
market losses on certain investments. Talon would enter into
transactions with an Enron subsidiary that would lock in the
value of Enron's stock portfolio. If the price of Enron's stock
portfolio increased, Talon would be entitled to the upside gain,
and if the stock portfolio declined, Talon would be obligated to
pay the Enron subsidiary the amount of the loss.


Raptor I/AVICI
Talon was funded mainly by Enron through a promissory note and
Enron's own stock. The remainder of Talon's funding, $30 million,
was from LJM2, representing the purported three percent outside
equity required for Talon to be off Enron's balance sheet.
Talon should have been consolidated on Enron's financial
statements because of an undisclosed side deal engineered by
Fastow. Pursuant to the side deal, Enron agreed that, prior to
conducting any hedging activity with Talon, Enron would return to
LJM2 its full investment in Talon plus a guaranteed return.
To conceal the side deal, Fastow and others devised a scheme to
manufacture a $41 million payment to LJM2. Fastow and others
made it appear that the payment represented the premium paid on a
"put option" on Enron shares. The put option was a bet by Enron
that its own stock price would decline. There was no true business
purpose for the put option other than to generate funds to pay LJM2
under the undisclosed side deal.


Raptor I/AVICI
One Raptor I hedges related to its attempt to lock in substantial
gains from its stock holdings in AVICI Systems, Inc., an Internet
company that had recently engaged in an IPO. The stock price
of AVICI had declined by the end of Enron's third quarter 2000,
Fastow engaged in a fraudulent scheme to backdate the AVICI
hedge to achieve a significant economic advantage for Enron.
Fastow caused the AVICI hedge to be backdated to August 3,
2000. Fastow chose this date because he knew it was the date
AVICI traded at an all time high price of $163.50. By back-dating
the AVICI hedge in this manner, Fastow and Enron fraudulently
locked in the recognition of a substantial gain and booked $75
million in additional mark to market gains that they otherwise
would not have recognized. To facilitate the fraud, the put option
was purportedly settled early, also on August 3, 2000, so that
Enron could use Raptor I for hedging purposes.

Rhythms/Southampton
Enron had an investment in an Internet company called Rhythms
NetConnections, Inc. ("Rhythms"). Enron owned 5.4 million
shares of Rhythms stock, and following an IPO in April 1999,
Enron was at risk for market price fluctuations in the stock.
Because Enron was restricted from selling its shares until
November 1999, it sought to reduce the impact on its financial
results of a possible dramatic decline in the share price of
Rhythms stock.
In June 1999, Enron devised a "hedge through LJM1 created a
subsidiary known as LJM Swap Sub, L.P. ("Swap Sub"), which
was funded with cash and Enron shares. Swap Sub thereafter
entered into a series of transactions These transactions included
a "put," which gave Enron the right to sell its Rhythms shares to
Swap Sub for a set price on certain future dates even if the
market value of the Rhythms Net shares was below the set price.

Rhythms/Southampton
In the third and fourth quarters 1999, the share price of
Rythms Net decreased significantly and Enron was able to
record gains from its transaction with Swap Sub to offset
losses it incurred on its Rythms Net investment.
In January-February 2000, both Enron and Rhythms shares
increased in price, making Swap Sub's main asset (its Enron
shares) more valuable while decreasing its potential liability
on the Rhythms put option. Thus, Swap Sub had significantly
more value than previously. Fastow was prohibited from
having any direct pecuniary interest in Enron's stock held by
LJM1. Nevertheless, in approximately February 2000, Fastow,
Kopper, and three NatWest bankers devised and later
executed a scheme to capture the increase in Swap Sub's
value for themselves.

Rhythms/Southampton
(i) causing Enron to pay $30 million to buy out, or
"unwind," the banks interests in Swap Sub;
(ii) causing NatWest to accept only $1 million for its
interest in Swap Sub, while representing to Enron that
NatWest was getting $20 million, and
(iii) splitting the $19 million balance among themselves
and certain Enron and LJM employees.

Enron Issues
Consolidation Issues
In 2001, Enron and Andersen concluded that
Chewco lacked sufficient outside equity at risk to
qualify for non-consolidation.
This retroactive consolidation decreased Enron's
reported net income by $95 million (of $893 million
total) in 1999 and by $8 million (of $979 million total)
in 2000.
Self-Dealing Issues
These related-party transactions facilitated
- accounting and financial reporting abuses by
Enron
- extraordinarily lucrative for Fastow and others.