How the Fraud Happened

The Enron fraud case is extremely complex. Some say Enron's demise is rooted in the fact that in 1992, Jeff Skilling, then president of Enron's trading operations, convinced federal regulators to permit Enron to use an accounting method known as "mark to market." This was a technique that was previously only used by brokerage and trading companies. With mark to market accounting, the price or value of a security is recorded on a daily basis to calculate profits and losses. Using this method allowed Enron to count projected earnings from long-term energy contracts as current income. This was money that might not be collected for many years. It is thought that this technique was used to inflate revenue numbers by manipulating projections for future revenue.

Use of this technique (as well as some of Enron's other questionable practices) made it

difficult to see how Enron was really making money. The numbers were on the books so the stock prices remained high, but Enron wasn't paying high taxes. Robert Hermann, the company's general tax counsel at the time, was told by Skilling that their accounting method allowed Enron to make money and grow without bringing in a lot of taxable cash.

Enron had been buying any new venture that looked promising as a new profit center. Their acquisitions were growing exponentially. Enron had also been forming off balance sheet entities (LJM, LJM2, and others) to move debt off of the balance sheet and transfer risk for their other business ventures. These SPEs were also established to keep Enron's credit rating high, which was very important in their fields of business. Because the executives believed Enron's long-term stock values would remain high, they looked for ways to use the company's stock to hedge its investments in these other entities. They did this through a complex arrangement of special purpose entities they called the Raptors. The Raptors were established to cover their losses if the stocks in their start-up businesses fell.

When the telecom industry suffered its first downturn, Enron suffered as well. Business analysts began trying to unravel the source of Enron's money. The Raptors would collapse if Enron stock fell below a certain point, because they were ultimately backed only by Enron stock. Accounting rules required an independent investor in order for a hedge to work, but Enron used one of their SPEs.

The deals were so complex that no one could really determine what was legal and what

Background

Once the seventh largest company in America, Enron was formed in 1985 when

InterNorth acquired Houston Natural Gas. The company 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 "America's most innovative company" for

six straight years from 1996 to 2001. Then came the investigations into their complex

network of off-shore partnerships and accounting practices.

How the Fraud Happened

The Enron fraud case is extremely complex. Some say Enron's demise is rooted in the

fact that in 1992, Jeff Skilling, then president of Enron's trading operations, convinced

federal regulators to permit Enron to use an accounting method known as "mark to

market." This was a technique that was previously only used by brokerage and trading

companies. With mark to market accounting, the price or value of a security is recorded

on a daily basis to calculate profits and losses. Using this method allowed Enron to

count projected earnings from long-term energy contracts as current income. This was

money that might not be collected for many years. It is thought that this technique was

used to inflate revenue numbers by manipulating projections for future revenue.

Use of this technique (as well as some of Enron's other questionable practices) made it

How Cooking the Books Works

Management & Organizational Behavior (MAN 2150)

Sinclair Community College

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How the Fraud Happened