Red Flags of Enron’s of

Revenue and Key Financial

Measures
Introduction

Although Enron went bankrupt and

disappeared ten years ago, the impacts it
has made on the ethical standards never
faded. It took Enron 16 years to go from
about ten billion dollar assets to more than
sixty-five billion dollar assets, and took twenty-
four days to go bankrupt. (McLean & Elkind,
2004)
Summary

Enron used revenues – not profit – as its

primary financial objective, performance
driver, and measure of success. Enron’s use
of distorted, “hyper-inflated” revenues was
more important to it in creating the
impression of innovation, high growth and
spectacular business performance than the
masking of debt in special purpose entities.
What overlooked by past discussion about
Enron accounting scandal was the used of
“mark to market” (MTM) accounting rule and
other revenue-boosting accounting methods
as a business strategy to create an allusion of
being a “larger firm”.
Annual revenues can be an important
psychological measure that carries a lot of
weight among investors and the public as an
indicator of success and economic size that
is why it led to Enron to focus on boasting its
total revenue figures.
To grow large, Enron adapted a different
strategy for growth. Enron grew by exploiting
2 revenue accounting rules:
1)Mark to Market accounting for its energy
contract.
2)Adaptation of an aggressive accounting
interpretation called “Merchant Model”.
2 basic criteria for revenue recognition are
that revenue is reported after:
1)Service has been provided and
2)Cash collections has taken place or is
reasonably certain.
As for Eron's segment disclosures, it provided
further red flags regarding the true profitability of
the company. Enron's reported profit came
mainly from gains in derivatives while the non-
derivative business & trading was growing
rapidly but generated no profits.
The Enron's cash flow presentation indicates a
sign of poor earning quality. However, Enron is
very aware of the importance of CFO to attain
a positive earnings quality. That's why Enron did
a fraudulent act to make the CFO exceed the
net income.
The Enron's free cash flow is consistently
negative from 1997 to 1999. But in 2000, Enron
reported large positive cash flow to cover up
the negative free cash flow from previous years.
This indicated that Enron made a capital market
for equity & debt issuance but according to the
hedge fund manager, he could not explain how
Enron actually made money.
Forensic Accounting: Other Red Flags

 An article in the Texas edition of the Wall Street Journal

on September 20, 2000, was one of the first to raise
concerns about the inflated revenues and profits of
energy traders. The article referred to the soaring stock
prices of Enron, El Paso Corp., and Dynegy Inc.
Frequently, these profits depend on assumptions and
estimates about future market factors, the details of
which the companies do not provide, and which time
may prove wrong.
Forensic Accounting: Other Red Flags

An analyst report in February 2001 from John S.

Herold, Inc. written by Lou Gagliardi and John
Parry, also expressed concerns about Enron’s
reported profitability. The report observed that
Enron’s trading profits had been steadily
declining from 6.5% in 1995 to 2.7% by 2000.
Forensic Accounting: Other Red Flags
 The Herold report observed that Enron’s profits for
its Wholesale Energy Division had been steadily
declining from 6.5% in 1995 to 2.7% by 2000 and
that a realistic Enron valuation would be $53.20
per share.
 Herold also contrasted the average profit margins
of Goldman Sachs, Merrill Lynch, and Lehman
Brothers of 66% with Enron’s low 3.6% profit margin,
pointedly asking whether Enron’s market premium
was warranted, based solely on future super-
revenue growth.
Profitability Measures

The rapid decline in Enron’s gross profit margin

revealed a major red flat – the increasing use of
the merchant model of revenue accounting by
Enron to report both revenues and costs from
energy trading, and the application of MTM
accounting to increasing volumes of gas and
electricity sold.
Conclusion

Enron was entered as one of the largest

companies in the America because of well-
planned fraudulent done in the investing
community. In 2001, Enron devastated more
than $60 billion of shareholder value which
marked itself to be the largest corporate
scandal in history. Thus, after a series of
unethical plans involving irregular accounting
techniques, Enron's more than $60 billion assets
made it the largest bankruptcy ever. From the
mid-2000 until to the announcement of its
bankruptcy, Enron's stock declined from $90 to
less than $1.
Conclusion

What Enron has done was extremely rich in

lessons. One of the important lessons is that the
company should provide itself with high
management integrity, wherein investors still
encourage from continuing to invest moving
forward. Investors can determine its integrity
through assessment of their character and the
competence must be done at arm's length.
What has been done by Enron should be
viewed as an opportunity to refrain other ill
governed companies from causing the same
losses to investors and society.
Ethical Issues in Accounting –
Manipulation of data
The company’s books, records, accounts or
financial statements have not been maintained
reasonably or they inappropriately reflect the
Company’s transactions and legal requirements.
One example is intentionally mischarging expenses
record.
Ethical Issues in Accounting – Bribery

The acts of offering money or gifts influence

the recipients’ behavior in ways not consistent
with the duties of the recipients or in breach of
law.
Ethical Issues in Accounting – Conflict
of Interest
The interest or benefits of one person or entity
conflict with the interest or benefits of the
Company.
The directors, CEO and other senior
management or officers have to avoid situations
involving actual or potential conflicts of interest.
Recommendations - Investors
 When a company had every complicated
business model, don't invest.
 Avoid businesses engaging fancy derivatives.
 Be careful to businesses with a bit much leverage.
 Understand and assess the risk of parties involved
in the financial transaction.
 Sustain a high-quality management.
Recommendations – Action Plan
 First, bend the corporate culture from harsh competition
to a smarter and a friendlier one.
 Eliminate those people who are fraudulent and selfish
through evaluation, even those who are in the top
management. The corporation needs a new set of
honest officers.
 The next thing to do is to change its accounting policy.
Even though the first one covers major losses, still, it is not
effective on the long run, so changing the accounting
policy will cover losses in a slower but a surer manner.
Recommendations – Action Plan
 Attract investors, prove to them that Enron is still on the
hook, hanging tightly, needing to be trusted once again.
 Convince Dynergy once again to purchase Enron even just
for $5 billion; lower than the $10 billion that was once
negotiated.
 Change the auditing firm it is in partnership with.
 Lastly, Skilling must utilize the strengths of his corporation,
since it is an energy distributor, it can once more become
one of the biggest companies in the world specializing in
energy.
Alternative Courses of Actions

 A more complete system is needed for owners of a

company to supervise the executives and operators and
then get the idea of the company’s operating situation.
The boards of directors should pay closer attention on the
behavior of management and the way of making money.
 In addition, Enron’s fall also had strikingly bad influence on
the whole U.S. economy. Maybe the government should
make better regulations or rules in the economy.
Alternative Courses of Actions

 The next thing to do is to think of another way of

accounting. “Mark to market” is 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 “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.