good enron fraud paper

Electronic copy available at: http://ssrn.com/abstract=1691830

Mahama Wayo

The Collapse of Enron Corporation: FraudPerspective

Electronic copy available at: http://ssrn.com/abstract=1691830

SMC Working Papers Mahama Wayo

July 16, 2010 2

Contents

SWISS MANAGEMENT CENTER UNIVERSITY

The Collapse of EnronCorporation: FraudPerspectiveMahama Wayo

(0001870-01)

July 16, 2010


July 16, 2010 3

ABSTRACT

The paper examines the red flags that might have signaled the collapse of Enron Corporation which

an astute reader should have noted. Various financial models that can detect earnings manipulation

and inflation of assets and revenues have been applied in this examination. The paper links the

collapse of Enron to the massive manipulation of earnings, some of which was carried out by the use

of activities of Special Purpose Entities (SPEs).


July 16, 2010 4

THE COLLAPSE OF ENRON CORPORATION: A FINANCIAL PERSPECTIVE

1.0 INTRODUCTION

Enron Corporation was formed in 1985 by Kenneth Lay. This was after the merger of Huston Natural Gas

and InterNorth. The company was based in Houston, Texas. Enron originally was involved in transmitting

and distributing electricity and natural gas throughout the United States. The company was engaged in

developing, building and operating power plants and pipelines within the legal framework. It owned a large

network of natural gas pipelines that stretched from borders to borders including Northern Natural Gas,

Florida Gas Transmission, Transwestern Pipeline Company and a partnership in Northern Border Pipeline

from Canada. Enron ventured into water in 1998 by creating Azurix Corporation. It was also engaged in

communication, pulp and paper production.

Enron was the seventh largest Company in the Unites States of America and was named “America’s Most

Innovative Company” by “Fortune Magazine” for six consecutive years, from 1996 to 2001. Enron’s sterling

performance pushed its stock price to $83.19 by December 31, 2000. The stock increased by 56% in 1999

and a further 87% in 2000, compared to a 20% increase and a 10% decline for the index during the same

years. The company filed for bankruptcy protection in December 2001.

Unknowingly, the excellent performance of Enron was as a result of crafted fraudulent activities of the

Company’s executives. Enron’s revenues had hit $101 billion by the year 2000 and it employed about

22,000 staff. A revelation of the Enron scandal in October 2001 with its stock price dropping from $90.00 to

less than $1.00 by the end of November, 2001 caused a loss to shareholders of about $11 billion and

resulted in the investigation of the company’s operations by the U. S. Securities and Exchange Commission

(SEC). The company then filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code on

December 2, 2001 in the Southern District of New York.


July 16, 2010 5

1.1 ASSESSMENT OF THE FINANCIAL PERFORMANCE OF ENRON CORPORATION: 1997 TO 2000

A critical examination of the financial statements of Enron from 1997 to 2000 depicts a massive

manipulation of revenues and earnings used to sustain the company’s perceived excellent performance.

Accounting loopholes were plucked; and the use of Special Purpose Entities (SPEs) and poor financial

reporting were used to hide billions of dollars in debts from failed deals and projects. A number of Enron’s

recorded assets and profits were inflated, or even wholly fraudulent or nonexistent. Beneish (as cited in

Feroz, Park, and Pastena, 1991) indicates that manipulation becomes public on average 19 months after

the end of the fiscal year of the first reporting violation. Enron went longer! Enron violated the intent of

Generally Accepted Accounting Principles (GAAP) in its reporting system. According to McLean and Elkid in

their book “The Smartest Guys in the Room,” the Enron scandal grew out of a steady accumulation of

habits, values and actions that began years before and finally spiraled out of control.

A careful scrutiny of the financial statements of Enron suggests that from late 1997 until its collapse in

December 2001, the primary motivations from Enron’s accounting and financial transactions seemed to

have been to keep reported income and reported cash flows up, assets values inflated, and liabilities off

the books. In fact, income smoothing was at its peak in the operations of Enron, and Executives of the

company and their allies and families were those who profited while the company was going into the

doldrums.

According to Albrecht (2001), an entity’s financial statements tell a story and the story should make sense,

if not, it’s possible the story is untrue.

Enron Corporation’s financial statements for the four years ending December 31, 2000 prior to its collapse

in 2001, were comprised of massive inflation of revenues, manipulation of income and inflation of assets

whilst suppressing its debt through the use Special Purposes Entities (SPEs) located offshore.


July 16, 2010 6

2.0 ANALYSIS OF ENRON CORPORATION FINANCIAL STATEMENTS

Various financial and accounting models and principles can be employed to analyze the financial

statements of a company to determine red flags, its health or whether it is manipulating income, inflating

revenues and assets, and also manipulating General Accepted Accounting Principles in its financial

reporting.

Included amongst the various models and principles are: revenue recognition policies,

converging/diverging gross margin slope analysis1, sales/accounts receivable slope analysis, Modified

Altman’s Z-score inflection point and bankruptcy analysis, Beneish’s Model for Determining Earnings

Manipulation2, Chanos’ Discriminate Function Algorithm Model3, Igor Pustylnick’s Combined Algorithm of

Detection of Manipulation in Financial Statements4, ratio analysis and other available models. Collectively,

these models signaled trouble.

2.1 REVENUE RECOGNITION

Revenue recognition criteria according Nugent (2010) include: the existence of a valid contract, assurance

of payment, the work is complete or essentially complete, and title passes between the parties. The

fulfillment of these criteria mandates the recognition of revenue within any financial reporting period.

Enron earned its profits by providing services such as wholesale trading and risk management, in addition

to developing electric power plants, natural gas pipelines, and storage and processing facilities. Service

providers, when considered as an agent, report only trading and brokerage fees as revenues as against the

merchant model which reports the total selling price as revenues and the product costs as cost of goods

sold.

1Altman, Edward I. Corporate Financial distress: A Complete Guide to Predicting, Avoiding, And Dealing with Bankruptcy. JohnWilley and Sons, 1983.

2Beneish, Messod D. The Detection of Earnings Management, 1999 Indiana University, Kelley School Of Business

3chanos, J. Discriminate Function Algorithm 2010. Algorithm Presented By Dr. John Nugent CPA, CFE, CFF, CISM, FCPA At 2010SMC Doctorate Of Finance Residency Course Vienna, Austria.

4Pustylnick I. Combined Algorithm of Detection of Manipulation in Financial Statements 2009. www.ssrn.com

www.ssrn.com


July 16, 2010 7

Enron, however, in contrast to practice developed an aggressive approach to reporting revenues by

adopting the merchant model where the entire value of its trade was reported as revenue instead of

process employed in the agent (fee only) model. This inflated Enron’s reported revenue astronomically

from 1997 to 2000.

Enron Corporation’s net revenues were: $20,273 million for 1997, $31,260 million for 1998, $40,112

million for 1999 and $100,789 million for the year 2000. (Source: Enron Corporation: 1998, 1999 and

2000). In percentage terms, Enron’s sales increased by 53% in 1997, 54% in 1998, 28% in 1999 and 151% in

2000, each from the previous year. Astronomical by anyone’s measure.

These increases in revenues without significant acquisitions were meteoric and resulted from the

manipulation of revenue recognition policies that Enron adopted during these reporting periods. Enron’s

revenue growth on average was 72% from 1997 to 2000. This growth was unprecedented where the

energy industry’s growth on average was 2 – 3% per year5.

Akin to the revenue recognition policies of Enron was also the fact that it adopted mark-to-market

accounting for its complex long-term contracts. Mark-to-market accounting as employed by Enron

required that once a long-term contract was signed, income was estimated as the present value of net

future cash flows. Unfortunately, due to the complex nature of Enron’s contracts, the viability of these

contracts and their related costs were difficult to estimate. In using this method, income from projects

could be recorded presently, which increased financial earnings. However, in future years, the profits could

not be included, so new and additional income had to be shown from more projects to develop additional

growth. By advancing revenues to current periods via the ‘marked to market’ Enron inflated its revenues.

For example, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on

demand entertainment to various United States of America cities by year end.

5Enron Scandal. http://en.wikipedia.org/wiki/Enron_Scandal


July 16, 2010 8

After several pilot projects, Enron recognized estimated profits of more than $110 million from the deal.

When the network failed to work, Blockbuster pulled out of the contract. But Enron continued to recognize

future profits, even though the deal resulted in a loss.

2.2 GROSS MARGIN ANALYSIS

Nugent (2003) defines “gross margin as simply the difference between net sales and cost of goods or

services sold”. It measures the operational efficiency of an organization.

By employing the concept of converging/diverging gross margin slope analysis one is trying to determine if

gross margin is increasing as a percentage, or decreasing as a percentage of net sales over the reporting

period. If gross margin slope is converging with that of the net sales slope, then it implies that gross margin

is increasing as a percentage of net sales. It means that each additional sale is more profitable

operationally than the preceding sale. On the other hand, if the gross margin slope is diverging from the

net sales slope, it means that each successive sale is less operationally profitable than the preceding one.

Table 1 below indicates the sales and gross margins of Enron for the various periods under-review.

TABLE: 1

ENRON NET SALES AND GROSS MARGINS

YEAR 1997 1998 1999 2000

($ Million) ($ Million) ($ Million) ($ Million)

GROSS MARGIN 15 1,378 802 1,953

SALES 20,273 31,260 40,112 100,782

PERCENT .07 4.4 2.0 1.94

(Source: Enron Corporation 1997, 1998, 1999 & 2000).

http://en.wikipedia.org/wiki/Enron_Scandal


July 16, 2010 9

From the table, Gross Margin Slope Analysis can be used to determine whether Enron was becoming more

or less operationally profitable using converging/diverging slope analysis.

Chart 1

Chart 2


July 16, 2010 10

Chart 4

Chart 3


July 16, 2010 11

The graphs indicate the net sales lines and the gross margin lines for 1997, 1998, 1999 and 2000. It can be

seen that the gross margin lines for all the years diverged greatly from the net sales lines, which means

that Enron was not becoming operationally efficient.

Table: 2

Chart 5: ENRON GROSS MARGIN % CURVE

From the graph it can be seen that Enron’s gross margin went up in 1998 from a very low point in 1997. It

further dropped in 1999 and up in 2000 creating a “porpoising” gross margin graph (up, down, up, down).

This is an indication of earnings and revenue manipulation as discussed earlier. An analysis of this situation

should have given an earlier indication that Enron was manipulating its financials and possibly heading

towards collapse, which, eventually happened in the year 2001 when the company files for bankruptcy

protection.

ENRON GROSS MARGINS

Year Gross Margin Percentage1997 .071998 4.41999 2.02000 1.94


July 16, 2010 12

From the Gross Margin Slope Analysis above, it is evident that Enron for the preceding four years prior to

its collapse in 2001 was operationally inefficient as the slopes indicated wide diverging gross margin slopes

from those of the net sales. The implication is that each successive sale was less profitable operationally

than the one preceding it in certain periods.

While diverging gross margins are the norm in competitive industries due to pricing competition, the

porpoising of gross margins is often the telltale sign the numbers are being manipulated. Moreover,

diverging gross margins in and of themselves do not tell the whole financial story since they do not take

into consideration indirect (below the line) expenses

2.3 MODIFIED ALTMAN’S Z-SCORE DISTRIMINANT FUNCTION ALGORITHM.

Altman’s Z-score for predicting bankruptcy is another model that an astute reader could have used to

analyze the financial information of Enron Corporation to determine the existence of any red flags6. The

formula was published in 1968 by Edward I. Altman which sought to predict corporate bankruptcy. The

model is a linear combination of five common business creations, weighted by co-efficient. According to

Bennett (2008), that Altman’s model is based on analyzing the financial strength of a company using five

ratios built on key numbers mainly taken from a firm’s balance sheet, along with few from the profit and

loss account.

The initial test of Altman’s Z-score was found to be 95% accurate 1 year preceding bankruptcy and 72%

accurate in predicting bankruptcy two years prior to the event, with a Type II error (false positives) of 6%,

(Altman, 1968). Each ratio is weighted to reflect its relative importance before the five ratios are added

together to generate a Z-score, usually a single digit.

6Nugent, J. Plan to Win: Modified Altman Basic Model to determine changes in scores as against absolute scores. 2003


July 16, 2010 13

Altman’s Modified Z-score model is stated below (in Altman’s original bankruptcy model the decimal points

for X1 to X4 would have to be moved to places to the left for each).

Z = 1.2*X, + 1.4*X2 + 3.3*X3 + 0.6X4 + 1.0*X5, Where:

X1 = Working Capital/Total Assets

X2 = Retained Earnings/Total Assets

X3 = EBIT/Total Assets

X4 = Market Value of Equity/ Book Value of Total Debt

X5 = Sales/Total Assets

According to Altman, financially strong small to mid-sized, manufacturing companies have a Z-score above

2.99 in his bankruptcy model, whilst companies in serious trouble have Z-score below 1.81, and those with

scores in between could go either way (Altman’s basic algorithm).

Altman’s Modified bankruptcy model (shown above) is also relevant for determining inflection points.

According to Nugent (2003), inflection points are defined as “points of major change in any being, one

relative to another”. Inflection point analysis looks for changes in scores rather than the absolute score

itself. By applying a modified Altman Z score Model (changed from the Altman bankruptcy model as to

scale and intent), and applying one additional change made by Nugent relative to the weighting of the X4

factor relative to negative changes in gross margin, it can also be seen that Enron signaled trouble (an

inflection) before it entered into bankruptcy.

Working capital is the difference between current assets and current liabilities. In short, it is the capital

which a firm can use internally without acquiring additional financing to address short term liquidity.


July 16, 2010 14

Earnings before interest and income tax (EBIT), or “operating profit”, it is more or less real earnings of the

firm. Retained earnings are the cumulative profitability of the firm over the years. Market Value of Equity

is the value of all outstanding company’s shares at market value at the end of the financials. Book

Value of total debt is the sum of all liabilities both current and long-term excluding equities as they are

recorded at the date of the financials. Net sales are the total sales less any other taxes and returns during

the financial year. Total Assets is the sum of long-term and short-term assets.

Nugent (2003) prefers the use of an adjusted Altman Z-score to determine inflection points relative to

negative changes in gross margins. This model lays emphasis on the weight assigned to X4 in the Altman’

algorithm concerning debt as gross margin declines. Nugent further writes that as an entity becomes less

operationally efficient, gross margins decline, the servicing of debt becomes significantly more onerous.

The adjustment is made on the weight assigned to X4 relative to negative declines in gross margins. That is

the weight is lowered as gross margins decline.

The table below indicates adjusted Altman’s Z- score based on gross margin decline.

Table 3:

Annual % Decline in Gross Margin Decline X4Weighting

of (0.6) by

X4 Value

.5% < 2% 100% 0

> 2% < 5% 200% -0.6

> 5% < 10% 300% -1.2

> 10% < 20% 600% -3.6

> 20% 1,000% -0.6

(Source: Nugent 2003)


July 16, 2010 15

The explanation to this table is that the percentage decline in gross margin is shown in the first column.

Nugent (2003) indicates that once gross margin declines, it may require a reduction in X4 factor weighting,

Nugent states such a reduction is weight is needed because the servicing of debt becomes more onerous

as gross margin declines. The negative weighting in one period once required, is carried forward to future

periods until improvement in gross margin is made or there is the need for a further reduction.

Table: 4

1996 1997 1998 1999 2000(US$Mi l l ions ) (US$Mi l l ions ) (US$Mi l l ions ) (US$Mi l l ions ) (US$Mi l l ions )

Current As s ets 4,113.00 5,933.00 7,255.00 30,381.00Tota l As s ets 22,552.00 29,350.00 33,381.00 65,503.00Current Lia bi l i ties 3,856.00 6,107.00 6,759.00 28,406.00Reta ined Ea rnings 1,852.00 2,226.00 2,698.00 3,226.00Accounts Receva ble 1,372.00 2,060.00 3,030.00 10,396.00Tota l Debt 14,794.00 19,158.00 20,381.00 50,715.00W orkign Ca pi ta l 257.00 (174.00) 496.00 1,975.00EBIT 1,238.00 565.00 1,582.00 1,995.00 2,482.00Net Revenues /Sa les 13,289.00 20,273.00 31,260.00 40,112.00 100,789.00Gros s Ma rgin/Profi t 690.00 15.00 1,378.00 802.00 1,953.00Ma rket Va lue of Equi ty 6,614.00 9,509.00 32,080.00 62,523.00Sha reholders ' Equi ty 5,618.00 7,048.00 9,570.00 11,470.00Net Ca s h Flow (59.00) (86.00) 177.00 1,086.00Cos t ga s electri c i ty,meta l s a nd others 1,731.00 26,381.00 34,761.00 94,517.00Outs ta nding Sha res (innumbers )

318,297,276.00 335,547,276.00 716,865,081.00 752,205,112.00Ma rket Va lue Per Equi ty $20.78 $28.34 $44.75 $83.12

7

(Source:Enron Corporation, 1998, 1999 & 2000)

SUMMARY OF ENRON CORPORATION FINANCIAL STATEMENTS

From table 4, the gross margins and gross revenues or sales of Enron Corporation are derived as shown in

table 5 below:

7Enron Annual Report. 1997, 1998, 1999 and 2000. http://picker.uchicago.edu/Enron/EnronAnnualReport.pdf

Table 5 Enron Corporation Gross Margins and Revenues/Sales

http://picker.uchicago.edu/Enron/EnronAnnualReport.pdf


July 16, 2010 16

Year 1997 1998 1999 2000

Gross Revenue $20,273m $31,260m $40,112m $100,782m

Gross Margin $15m $1,378m $802m $1,95m

Gross Margin% 0.074% 4.4% 1.99% 1.93%

Percent Change 0 4.33% -2.41% -0.06%

From table 5, it can be inferred that Enron’s gross margins had a nose-dive in the years 1999 and a further

decline in 2000, and (therefore the X4 weighting will in reference to Table 3 be assigned -0.6 when

determining the inflection points using Adjusted Altman’s Z-score as modified by Nugent.

Computing the Z-scores using Modified Altman’s Adjusted Z-score Discriminant function algorithm.

1997

Z = 1.2 (0.1139) + 1.4 (0.0821) + 3.3 (0.0250) + 0.6 (0.4470) + 1.0 (0.8989)

Z = 1.50

1998

Z = 1.2 (0.0059) + 1.4 (0.0758) + 3.3 (0.0539) + 0.6 (0.4963) + 1.0 (1.0650)

Z = 1.64

1999

Z = 1.2 (0.0148) + 1.4 (0.0808) 3.3 (0.0597) – 0.6 (1.5740) + 1.0 (1.2016)

Z = 0.59


July 16, 2010 17

2000

Z = 1.2 (0.0301) + 1.4 (0.0492) + 3.3 (0.0378) – 0.6 (1.2328) + 1.0 (1.5358)

Z = 1.03

Table 6 Enron’s Adjusted Z-scores

Year 1997 1998 1999 2000

Adjusted Z-score 1.50 1.64 0.59 1.03

Table 6 indicates Enron’s Adjusted Z-scores for 1997 to 2000. Enron’s operations had taken a nose-dive in

1999 when it’s adjusted inflection point Z-score decreased from 1.64 to 0.59 within a year. This was a

major inflection point for Enron which signifies a red flag, and, if these computations of adjusted Z- score

were made, then Enron would have realized that its operations were becoming more unprofitable.

Moreover, just as indicated above that a porpoising gross margin is usually a sign of something that is not

right, so too is a porpoising Modified Altman Z score.

The “porpoising” natures (up, down, up, down) of the adjusted Z-scores (and gross margins) were enough

indication that Enron was likely manipulating its financials and possibly heading towards difficulty if not

collapse. This is depicted in the graph below.

Chart 6. Enron’s “Porpoising” Adjusted Z-Scores Graph


July 16, 2010 18

From the graph, the Z-score went up in 1998 from 1997, but fell drastically in 1999 depicting a major

inflection point and, in 2000 it went up a little. These were all indications that Enron’s operations were

likely being manipulated.

This Altman method has also a number of drawbacks. It must be used with a degree of caution when

applied to firms from different industries. Different industries have different degrees of capitalization and

different liquidity needs. It would be unreasonable to compare Z-scores of different companies from

software development industries where capitalization is relatively low, according to Pustylnick (as cited in

Nowak and Grantham 2000), with oil and gas industries, which have to capitalize all exploration and

refinery equipment and operations. Moreover, Pustylnick (as cited in Nugent, 2008), “the degree of entity

asset wealth can mitigate Altman’s time line” to bankruptcy. That is, the more asset rich an enterprise is

the more time the entity has to solve its problems by selling assets or further leveraging the enterprise.

The implication is that a Modified Altman Z-score may not show us the whole picture of the state of the

company, but only the trend of results and position. It would therefore not be realistic if one bases one’s

assumption on a company’s performance solely on a Modified Altman Z-score only. Nugent (2003)

indicates that it is important to use multiple methods in addition to a Modified Altman’s Z-score to validate

one’s findings.

2.4 COMBINED ALGORITHM OF DETECTION OF MANIPULATION IN FINANCIAL STATEMENTS

Another dimension of detecting earnings manipulation is the Combined Algorithm of Manipulation in

Financial Statements by Pustylnick. Pustylnick formulated the P-score formula which applies the variables

of Altman’s Z-score but with a change in the numerator for the X1 weight. According to Pustylnick (2009),

the P-score/Z-score approach give 82.76% chance of detecting manipulation8.

8Pustylnick, I. Combined Algorithm of Detection of Manipulation in Financial Statements. SMC University. 2009


July 16, 2010 19

As indicated earlier, P-score computation is similar to Z-score but with only a slight modification in the X1.

P-score is computed using the following formula:

P = 1.2*X+1.4*X2+3.3*X3+0.6*X4+1.0*X5, where,

X1 = Shareholders Equity

Total Assets

X2 = Retained Earnings

Total Assets

X3 = EBIT

Total Assets

X4 = Marketing Value of Equity

Book Value of Total Debt

X5 = Revenue

Total Assets

According to Pustylnick (2009), that Altman Z-score is created to estimate corporate bankruptcy; and

therefore it uses two important net indicators, such as net sales (net income) and working capital which

clearly indicates the financial position of a firm in terms of its robustness and solvency. Pustylnick (2009)

indicates that according to Deloitte (2008) report on fraud over 50% of the cases of manipulation are based

on improperly recognized revenues or manipulation with non-current assets such as goodwill. P-score

formula considers this fact and better reflects the dynamics of changes in areas where fraud occurs most.

Pustylnick substituted shareholders Equity for Working Capital in X1 calculation9.

9Pustylnick, I. Combined Algorithm of Detection of Manipulation in Financial Statements. SMC University. 2009


July 16, 2010 20

Computing the P-scores for Enron for 1997, 1998, 1999 and 2000 using Pustylnick’s formula above with

reference to table 4.

1997

P = 1.2(0.2491) + 1.4(0.0821) + 3.3(0.0250) + 0.6(0.4470) + 1.0(0.8989)

P = 1.66

1998

P = 1.2(0.2401) + 1.4 (0.0758) + 3.3 (0.0539) + 0.6 (0.4963) +1.0 (1.0650)

P = 1.93

1999

P = 1.2(0.2866) + 1.4 (0.0808) + 3.3(0.0597) – 0.6 (1.5740) + 1.0 (1.2016)

P = 0.91

2000

P = 1.2(0.751) + 1.4(0.0492) + 3.3 (0.0378) – 0.6 (1.2328) + 1.0 (1.5358)

P = 1.89

Table 7: Enron’s P-scores

Year 1997 1998 1999 2000

P-Score 1.66 1.93 0.91 1.89

Z-score 1.50 1.64 0.59 1.03


July 16, 2010 21

From table 7 above, Enron Corporation hit a major inflection point in 1999 with a P-score value of 0.91.

This confirms Adjusted Altman Z-score of 0.59 also in 1999. However, in 2000, both Z-score and P-score

inched up but, still pointed to signs of earnings manipulation.

Chart 7 Enron’s “Porpoising” P-score and Z-score Graphs

From the graph above, both Z-score and P-score indicates a common pattern of behavior. In 1998 both

scores went up, but rather fell drastically in 1999 sending a warning of Enron having reached a major

inflection point in its operations.

1997 1998 1999 2000


July 16, 2010 22

2.5 CHANOS’ DISCRIMINANT FUNCTION MODEL

Chanos’ Discriminant Function model is used to assess a company’s financial health similar to Modified

Altman’s Z-score algorithm. The model makes use of income statement and balance sheet items to

calculate the score.

Chanos’ algorithm is stated below:

Working Capital + Retained Earnings + 12 Month Trailing EBIT + 12 Month Trailing Revenues

12 Month Average Total Assets.

This algorithm assumes that twelve (12) month trailing EBIT, revenues and average total assets are the

figures stated in the financial statements for the period. The reason being that the financial statements are

constructed at the end of the year which spans for a twelve month period. (or any other selected 12 month

period for which financial information is available). In this later regard, where one would have to annualize

certain Altman metrics to run his algorithm, this is not so with the Chanos algorithm which may be applied

more easily with accumulated and available quarterly numbers for public companies.

What is found is that as Modified Altman scores increase so do Chanos’, and as Modified Altman scores

decrease, so do Chanos’. Chanos’ does not publish absolute scores like Altman; however Nugent has

informally made guesses regarding absolute Chanos’ scores. For the purpose of this paper, it is only

important to see that Chanos’ algorithm validates changes in the Modified Altman scores.

It is also interesting to note that Pustylnick’s scores trend in concert with Modified Altman’s and Chanos’.

Reference to Table 4 above which gives the summary of Enron Corporation’s financials for 1997 to 2000

and using Chanos’ algorithm, we see the scores for the four years are given below (notice again the

porpoising effect).


July 16, 2010 23

Table: 8 Chanos’ Discriminant Model Scores

Year 1997 1998 1999 2000

Score 1.01 1.18 1.13 1.66

Table 8 indicates Chanos’ Discriminant Model Scores from 1997 to 2000. As seen again, the score are

porpoising.

2.6 BENEISH FRAUD STATEMENT INDICES

In examining Enron’s financial statements from 1997 to 2000 using Beneish’s fraud statement indices, we

see they reveal some level of possible financial statement manipulation. Beneish (1999), states that if

financial statement manipulations take place and the entity’s numbers surpass his manipulation means

without major acquisitions or divestitures, the likelihood of financial statement manipulation is very high.

Beneish has shown that accounting data can be used to detect earnings manipulation.

Beneish examined other indicators of financial health such as sales margins, asset quality, and time in

receivables, gross margins indicators, etc. The objective was to determine whether other parameters

included in the corporate financial reports might be used to discover manipulation in the financial

statements. Harrington (2005), indicates, that the probability of earnings manipulation goes higher with

unusual increases in receivables, deteriorating gross margins, decreasing asset quality, sales growth, and

increasing accruals. Beneish (as cited in Harrington, 2005), indicate that certain results point to where

there is most likely a problem. Feroz et al (1991), notes that manipulation becomes public on average 19

months after the end of the fiscal year of the first reporting violation.

Beneish developed a set of ratios based on empirical testing derived from the company’s financial

statements which when surpassed; indicate a likelihood of manipulation in the financial statements.


July 16, 2010 24

Days’ Sales in Receivables Index=

Receivables current year/sales current year

Receivables prior year/sales prior year

This ratio measures whether receivables and revenues are in out-of-balance in two consecutive years. If

the ratio detects an abnormal rise in receivables the change might result from revenue inflation.

Otherwise, it could be a change in credit policy. This has a non-manipulation mean of 1.030.

Gross Margin Index =

(Sales prior year minus cost of goods sold prior year)/sales prior year

(Sales current year minus cost of goods sold current year)/sales current year

It is the ratio of gross margin in current year to gross margin prior year. When the gross margin index is

greater than one (1) it means that gross margins have deteriorated and management is motivated to show

better numbers. This has a non-manipulation mean index of 1.010.

Sales Growth Index = Sales Current Year

Sales Prior Year.

It is the ratio of prior year sales to current year sales.

High sales growth might not imply manipulation. However, managers are highly motivated to commit fraud

when the trend reverses. Sales growth index has a non-manipulation mean of 1.130.

Asset Quality Index = Total Assets – PP&E Current year/ Total Assets Current year

Total Assets- PP&E Prior year/ Total Assets Prior year


July 16, 2010 25

Asset quality is the ratio of non-current assets other than property, plant and equipment (PP&E) to total

assets and measures the proportion of total assets for which future benefits are potentially less certain. If

asset quality index is greater than one (1), then it indicates that the firm has potentially increased its

involvement in cost deferral. This index has a non-manipulation mean of 1.040.

Total Accruals to Total Assets (TATA) Index is calculated as the change in working capital accounts other

than cash less depreciation to total assets. The index tends to look at the proportion of accruals which

represent current assets less current liabilities and depreciation to the total value of assets. The growth of

this index usually indicates that goodwill numbers in the financial statements of the company have been

tampered with.

Total Accruals to Total Assets=

Working Capital – Depreciation Current Year/ Total Assets Current year

Working Capital – Depreciation Prior Year/ Total Assets Prior year

This index has a non-manipulation mean of 0.18

Enron’s fraud statement indices for 1997, 1998, 1999 and 2000 are given below.

Table: 9 Enron Fraud Statement Indices

1997 1998 1999 2000Days’ Sales inReceivables

- 0.973 1.146 1.365

Gross MarginIndex

70.17 0.0167 2.205 1.032

Asset QualityIndex

- 1.397 1.214 2.368

Sales GrowthIndex

1.526 1.542 1.283 2.513

Total Accruals toTotal Assets

- 1.666 0.523 0.195


July 16, 2010 26

Enron’s receivables and sales exceeded Beneish’s thresholds from 1999 to 2000 as the days’ sales in

receivable index had exceeded the non-manipulation mean of 1.030. There was an increase of 11% and

33% in days’ sales in receivables for 1999 and 2000 respectively over the non-manipulation mean. The

implications are that the increase could be as a result of legitimate factors such as liberalized credit policies

from one period to the next, or the company’s receivables are not properly being reported. In the case of

Enron, the receivables were not properly being reported and therefore could not be verified, hence, the

filing for bankruptcy in 2001.

In relation to gross margin index, Enron Corporation’s indices for 1997, 1999 and 2000 were greater than

one (1) indicating deteriorating gross margins. The indices for 1997 and 1999 were higher than Beneish’s is

non-manipulation mean of 1.190. The deteriorating gross margins are confirmed by the “porpoising “ (up,

down, up, down) gross margin curve.

The sales growth index of Enron averaged 1.716 over and above Beneish non-manipulation mean of 1.130

that is 52% above normal sales increase with no major acquisitions. For example, sales had increased by

151% from 1999 to 2000. Enron was creating fictitious sales and this was a sign of financial manipulation.

This index can only detect manipulation when sales have increased.

Enron Corporation inflated its assets during the period under review by capitalizing costs which could have

been written off in one financial year. The average manipulated asset quality index of Enron was 1.66

against Beneish non-manipulation mean of 1.040, which is a 60% difference.

Total accruals to total assets ratio of Enron Corporation had increased beyond the non-manipulation mean

as well. This was an indication of management’s manipulation of earnings by using its discretionary

authority of accrual policy. Enron’s accruals increased year after year whilst cash decreased. In this case,

management was attempting internally to finance its losses.


July 16, 2010 27

2.7 HORIZONTAL ANALYSIS OF ENRON CORPORATION FINANCIAL STATEMENTS.

Horizontal financial statements analysis is a procedure where analysts compare ratios or line items in

financial statements over a period of time. The decision on items selected is discretional. Horizontal

analysis is highly useful for analyzing the effects of a single event on the financial statements period over

period.

In the case of Enron Corporation, the balance sheets of the year 1997, 1998, 1999 and 2000 are used for

the analysis. A comparison will be made between 1997 and 1998, while 1999 is compared to 2000. The

base figures for computation will be 1997 and 1999.

Table 10

ENRON CORPORATION HORIZONTAL ANALYSIS: 1997- 2000

1997 1998 Diffe re n ce % C h an ge s(US$M ) (US$M ) (US$M )

C ash /C ash Eq u iv ale n ts 170 111 [59] [35% ]A cco u n ts Re ce iv ab le 1,826 2,898 1,072 59%O th e rs 635 514 [121] [19% ]To tal C u rre n t A sse ts 4,113 5,933 1,820 44%W o rk in g C ap ital 254 174 80 31%Lo n g Te rm A sse ts 18,439 23,417 4,978 27%To tal A sse ts 22,552 29,350 6,798 30%C u rre n t Liab i l i tie s 3,856 6,107 2,251 50%Lo n g Te rm Liab i l i tie s 6,254 7,357 1,103 18%To tal Liab i l i tie s 14,794 19,158 4,364 29%

1999 2000 Diffe re n ce % C h an ge sC ash /C ash Eq u iv ale n ts 288 1,374 1,086 377%A cco u n t Re ce iv ab le 3,548 12,270 8,722 245%O th e rs 616 1,333 717 116%To tal C u rre n t A sse ts 7,255 30,381 23,126 319%W o rk in g C ap ital 496 1,975 1,479 298%Lo n g Te rm A sse ts 26,126 35,122 8,996 34%To tal A sse ts 33,381 65,503 32,122 96%C u rre n t Liab i l i tie s 6,759 28,406 21,647 320%Lo n g Te rm Liab i l i tie s 7,151 8,550 1,399 20%


July 16, 2010 28

From Table 9 above, Enron Corporation’s cash and cash equivalents decreased by $59M, from 1997 to

1998, that is a 35% decline. Contrarily, current liabilities also increased by $2,251M which represents a 50%

increase during the period of comparison. This means Enron may not be able to settle its current liabilities

if they are called upon. This is manifested in the reduction of working capital by $80M from $254M to

$174M, for 1997 and 1998, which is 31% reduction.

Long term liabilities which are represented here as long-term debt also increased by $1,103M, which is an

18% increase. Accounts receivables increased astronomically by $1,072M, which is 59%. This is a material

increase and there is the likelihood that Enron’s accounts receivable could have been manipulated or that

policies had become too liberal. Total assets and total liabilities are just neck-to-neck in percentage terms

that is 30% and 29% respectively. Total assets increased by $6,798M while total liabilities also increased by

$4,364M.

For the period 1999 and 2000, Enron’s cash and cash equivalents increased by $1,086M, that is a leap of

377%. This seem extraordinary and for that matter possibly manipulative. Accounts receivable also went

up by $8,722M depicting a 245% increase- a much larger increase than the increase in revenues. Working

capital increased by $1,479M, which is 298% increase, while current liabilities went up by $21,647M, giving

320% increase. Total liabilities increased by $30,334M, which is 149% increase.

The implication is that Enron might be in good position to pay outstanding creditors in a timely manner

given the increase in working capital stated above.

The analysis above indicates a likely massive manipulation of balance sheet items by Enron within the

period under review. And more especially, manipulation appears to be present starting as early as 1999

and 2000.


July 16, 2010 29

2.8 VERTICAL ANALYSIS OF ENRON FINANCIAL STATEMENTS

Vertical analysis reports each amount on a financial statement as a percentage of another item. It is called

vertical because each year’s figures are listed vertically on a financial statement.

Table: 11

ENRON CORPORATION VERTICAL ANALYSIS

1998 % of

Revenue

1997 % of

Revenue

Category

% Column

change

Category (US$M) (US $M)

Revenue 31,260 100 20,273 100

Cost of Goods Sold 29,882 96 20,258 99.9 (3.9)

Gross Margin 1,378 4 15 0.074 3.9

Sales, General and Administrative

Expenses

2,352 8 1,406 7 1.0

Depreciation and Amortization 827 3 600 3 0

Interest Expenses 550 2 401 2 0

2000 % of

Revenue

1999 % of

Revenue

Category

% Column

change

Category (US$M) (US$M)

Revenue 100,789 100 40,112 100

Cost of Goods Sold 98,836 98 39,310 98 0

Gross Margin 1,953 2 802 2 0

Sales, General and Administrative

Expenses

3,184 3 3,045 7.6 4.6

Depreciation and Amortization 855 0.8 870 2.0 (1.2)

Interest Expenses 838 0.83 656 1.6 (0.77)


July 16, 2010 30

In Enron’s case, vertical analysis is carried on some items in the income statements with sales revenue as

the base figure. The computation spans from 1997 to 2000.

Enron Corporation’s cost of goods sold as a percentage of sales in 1997 stood at 99.9% while in 1998 it was

96% given a decrease of 3.9%. Gross margin went up by 3.9% in 1998 from a very low figure of 0.074 in

1997. This was an appreciable increase. Also a marginal one (1) percent increase in operating expenses

achieved coupled with a 3.9% reduction in cost of goods sold shows that Enron was controlling costs

effectively. Depreciation and interest expense in terms of percentage did not increase.

In 1999 and 2000, cost of goods sold stool at 98% apiece and gross margin stood at 2% respectively.

Operating expenses decreased by 4.6% likewise depreciation 0.8% from 1999 2%. In effect, there was 1.2%

decrease in depreciation comparing 1999 to 2000. Interest expense also dropped by 0.77% within the

same period.


July 16, 2010 31

Table: 12

2.9 ENRON CORPORATION RATIO ANALYSES FOR 1997 – 2000

Category 2000 1999 1998 1997Current Ratio 1.07:1 1.07:1 0.97:1 1.07:1Quick Ratio /AcidTest Ratio

0.95:1 0.98:1 0.88:1 1.03:1

AccountsReceivable Turns

15 times 15.7 11.8 times -

AccountsReceivableCollection Period

24 days 22.84 days 30.50 days -

Inventory Turns 127 times 70.70 times 92 times -Total Assets toTotal Debt

1.3:1 1.63:1 1.53:1 1.52:1

Total Debt toTotal Equity

4.42:1 2.13:1 2.73:1 2.63:1

Sales to TotalAssets

1.54:1 1.20:1 1.065:1 0.90:1

Return on TotalAssets

0.015:1 0.021:1 0.024:1 -

Revenue Growth 1.51:1 0.28:1 0.35:1 -Net IncomeGrowth

0.10:1 0.27:1 5.7:1 -

AccountsPayable Turns

15.8 Times 15.3 Times 12.6 Times -

AccountsPayable PaymentPeriod

22.8 days 23.5 days 28.6 days

Net Cash FlowPer Share

$1.50 $0.30 -$0.30

Another area to detect manipulation and fraud on Enron’s financial statements is by computing some

relevant ratios. A ratio is a mathematical relation between one quantity and another. Financial ratio is a

relative magnitude of two selected numerical values taken from an organization’s financial statements.

Ratios are categorized according to the financial aspect of the business which the ratio measures. This


July 16, 2010 32

categorization include liquidity ratios which measures the availability of cash to pay debts, activity ratios

measures how quickly a firm converts non-cash assets to cash assets, debt ratios looks at the firm’s ability

to repay long-term debt, and profitability ratios measure the firm’s use of its assets and control of its

expenses to generate an acceptable rate of return.

Enron Corporation’s financial ratios leave much to be desired from 1997 to 2000. The company had a

current ratio of 0.97 in 1998 and 1.07 for 1997, 1999 and 2000. Current ratio is measured as current assets

divided by current liabilities. A good measure is a ratio of 2:1 which means the company has the ability to

pay off its short-term liabilities with ease. In the case of Enron, a ratio of 1.07:1 puts the company into a

difficult position in relation to its current liabilities.

The quick ratios or acid test ratios of Enron were indicative of red flags. The ratios were 1.03:1, 0.88:1,

0.98:1 and 0.95:1 in 1997, 1998, 1999 and 2000 respectively. This ratio considers only fully or nearly liquid

assets such as short term investments, cash and collectible accounts receivable divided by current

liabilities. A quick ratio better than 1:1 is recommended. According to Nugent (2010), a better than 1:1

relationship will usually mean the entity will have not to operate “hand to mouth”.

The accounts receivable collection period of Enron when compared with the accounts payable payment

period depicts red flags in terms of the company’s ability to pay its creditors promptly or on due dates.

Whilst Enron has 24, 22.84 and 30.50 days to collect its receivables, contrarily it has 22.8, 23.5 and 28.6

days to pay its creditors within the same period. The additional days lagging on the payment could attract

interest or charges to Enron.

Enron Corporation’s inventory turns looked good with 92, 70.70 and 127 times respectively in 1998, 1999

and 2000. However, whether these translated into actual sales (and collectible receivables) and profit

leaves much to be questioned. Sales growth at Enron was so large one must question whether they were

likely fictitious given the percentage increase in sales during this period.


July 16, 2010 33

Total assets to total debt ratio measures how much of a firm’s assets are financed by debt. In other words,

it measures how highly leveraged a firm’s assets are. Enron’s ratios in this regard indicated ratios of 1.3:1,

1.63:1, 1.53:1 and 1.5:1 respectively for 2000, 1999, 1998 and 1997 respectively. In this case, the firm’s

assets were highly leveraged.

Enron was highly leveraged as indicated in the debt-to-equity ratio. It is measured as total debt to total

equity and how much of a company’s assets are financed by debt. Enron had debt-to equity ratios of

2.63:1, 2.73:1, 2.13:1 and 4.42:1 for 1997, 1998, 1999 and 2000 respectively. The company was highly

leveraged despite the fact that some of these debts were hidden in the Special Purpose Entities (SPEs)

located off shore. This is a serious red flag as it increased the financial risk of Enron Corporation.

Enron’s assets did not generate the desired sales revenue as shown by the ratios of sales to total assets.

The sales to total assets ratio is measured as sales divided by total assets. The ratios of 0.90:1, 1.065:1,

1.20:1 and 1.54:1 respectively for 1997, 1998, 1999 and 2000. This is confirmed by the revenue growth

ratios of 0.35:1, 0.28:1 and 1.51 respectively for 1998, 1999 and 2000 and, the net income growth ratios of

5.7:1, 0.27:1 and 0.10:1 for the same period. Another confirmation is the return on total assets ratios of

0.024:1, 0.021:1 and 0.015:1 for 1998, 1999 and 2000. These ratios indicate performance difficulties at

Enron Corporation.


July 16, 2010 34

3.0 EVALUATING ENRON’S FINANCIAL PERFORMANCE USING IBE, CFO, CI AND FCF

Enron’s financial performance took a bad turn commencing in 1997. Four financial indicators widely used

to evaluate a company’s performance are:

i. Income Before Extraordinary Items and Discontinued Operations (IBE);

ii. Cash flow from Operations (CFO);

iii. Comprehensive Income (CI); and

iv. Fresh Cash flow (FCF).

Comprehensive Income is the change in owners’ equity plus dividends net of capital contributions.

Free Cash flow is measured as cash flow from operations minus net capital expenditure plus net interest

payments.

Table: 13

ENRON FINANCIAL PERFORMANCE MEASURE 1997 - 2000

1996 1997 1998 1999 2000

(US$M) (US$M) (US$M) (US$M) (US$M)

IBE 690 15 1,378 802 1,953

CFO 884 211 1,640 1,228 4,779

CI 594 67 689 314 672

FCF 20 -1,181 -265 -1,135 2,398

ENRON FINANCIAL PERFORMANCEMEASURE 1997 - 2000

1996 1997 1998 1999 2000IBE 690 15 1,378 802 1,953CFO 884 211 1,640 1,228 4,779CI 594 67 689 314 672FCF 20 -1,181 -265 -1,135 2,398


July 16, 2010 35

Chart 8: ENRON CORPORATION IBE, CFO, CI AND FCF CURVES

From the graphs it can be seen that IBE, CFO, CI and FCF were close in 1996. However, in 1997 they began

diverging through to 2000. The four measures began decoupling in 1997 with Comprehensive Income (CI)

and Fresh Cash Flow (FCF) actually diverging. Catanach Jnr. and Rhoades (2003) indicated that this

decoupling indicated an early warning of the “earnings games” that Enron had begun to play in 1997. In

fact, Fresh Cash Flow (FCF) showed negative numbers from 1997 through to 1999.


July 16, 2010 36

4.0 CONCLUSION

The financial statements of Enron Corporation from 1997 to 2000 depicted large amounts of manipulation

of earnings, assets and revenues. Costs were deferred from the asset quality index. Financial statement

manipulation practices by over-stepping Generally Accepted Accounting Principles (GAAP) in revenue

recognition and the non-consolidation of the Special Purpose Entities (SPEs) set up by Enron were

detectible. Again, the exchange of stock for notes from the SPEs by Enron meant that the company was

effectively borrowing from itself because the SPEs were set up by Enron and collateralized with Enron

stock.

From the write up and the analysis of Enron’s financial statements, the revenue recognition policy of Enron

was not compatible with the intent of GAAP or industry practice. Again, the Company had hit a number of

inflection points with the major one being 1999 with a Modified Z-score of 0.59 using Adjusted Altman’s Z-

score analysis. Using Beneish’s analysis of fraud statement indices the statements revealed a high

probability of earnings manipulation, with the evidence coming from Enron’s own financial statements.

Chanos’ model had indicated serious trouble for Enron from 1999 to 2000. Invariably, both horizontal and

vertical financial analysis carried-out on Enron’s financial statements pointed to a series of financial

irregularities that one could discern that the company was heading for significant operating difficulty. Ratio

analysis of the financial statements corroborated such findings with the pattern seen in the income before

extra-ordinary items (IBE), comprehensive income (CI), cash flow from operations (CFO) and fresh cash

flow (FCF).

All of these manipulations and likely fraud took place under the glaring eyes of Arthur Andersen, Enron’s

auditors and the U.S. Securities and Exchange Commission. It was therefore not surprising that Arthur

Andersen was charged with and initially found guilty of obstruction of justice. The onetime big auditing


July 16, 2010 37

firm also collapsed after the collapse of Enron in 2001. Subsequently, Andersen was found to have not

obstructed justice in this case, but by this time the firm had already failed.

Enron’s collapse affected all its stakeholders who lost $74 billion.

It must be noted that financial statements analysis can be of great immense importance to stakeholders of

an organization. However, one should not rely on any single model or form of analysis. Rather, parties

should employ a number of proven models to discern irregularities and patterns that signal likely

problems. However, consistent and collective use of the tools discussed herein coupled with other

analytical models, should provide an early warning system that something might be remiss in an entity’s

reporting paradigm.


July 16, 2010 38

REFERENCES

Altman, Edward, I. Corporate Financial Distress: A complete Guide to Predicting, Avoiding, and Dealingwith Bankruptcy. John Willey Sons, 1983.

Beneish M. D. 1999. The Detection of Earnings Manipulation. Indiana University, Kelly School ofBusiness, Bloomington, Indiana, 47405. Retrieved May 30, 2010 fromhttp://www.baner.uh.edu/swhisenant/beneish earnings mgmt score.pdf

Beneish M. D. 2001. Earnings Management: A. Perspective. Indiana University, Kelly school of Business,Bloomington, Indiana 47401, Vol. 27 (12). Retrieved May 30, 2010 formhttp://emeraldinsight.com/journals.htm?articleid=8657768show=abstract

Bennett T. 2008. How Z-Scores can help you beat the slump. Retrieved June 6, 2010 fromhttp://www.moneyweek.com/investment-advice/how-z-scores-can-help-you-beat-the-slump

Catanach Jr. A. H. and Rhoades. S. C. 2003. Enron: A Financial Reporting Failure? Retrieved May 30,2010 from www.ssru.com

Enron Annual Report, 1997, 1998, 1999 and 2000. Retrieved June 6, 2010 fromhttp://picker.uchicago.edu/Enron/EnronAnnual Report1998.pdf

Enron Creditors Recovery Corporation. “Enron”. Retrieved May 30, 2010 formhttp://en.wikipedia.org/wiki/enron

Enron Scandal. Retrieved May 30, 2010 from http://en.wikipedia.org/wiki/enron_scandal

Harrington, C. 2005 Analysis ratios for detecting financial statement fraud. Retrieved June 6, 2010 fromhttp://www.acfe.com/resources/view.asp?ArticleID=416

Nugent, J. H. 2001. Plant to win.

Pustylnick, I. Combined Algorithm of Detection of Manipulation in Financial Statements. SMCUniversity. Also can be found in www.ssrn.com

Van Horney, Y. C. Financial Management and Policy, 12 Ed New Delhi, PHI Learning Private Limited,2008.

Wells, J. T. 2001 Irrational Ratios. Journal of Accountancy 192, 2. Retrieved June 6, 2010 fromhttp://ruby.fgcu.educ/courses/common/irrationatratios.pdf

http://www.baner.uh.edu/swhisenant/beneish

http://emeraldinsight.com/journals.htm

http://www.moneyweek.com/investment-advice/how-z-scores-can-help-you-beat-the-slump

www.ssru.com

http://picker.uchicago.edu/Enron/EnronAnnual

http://en.wikipedia.org/wiki/enron

http://en.wikipedia.org/wiki/enron_scandal

http://www.acfe.com/resources/view.asp

www.ssrn.com

good enron fraud paper

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