Enron Case

Enron was always looking to create new markets. Therefore, Enron found a new way to create money as it acted as a bank for commodities: buying commodities and then selling it to buyers. These types of future contracts are among those called derivatives. In order to fulfill this duty, they had to have sound credit and high liquidity since they had to deliver cash when buy transactions were settled. Therefore, it became important for Enron to generate cash flow and report cash flow internally.

Enron faced business risks such as a complex business model, extensive use of derivatives and special purpose entities, aggressive transaction structuring and accounting, rapid expansion of business through complex and unconventional ventures, extensive reliance on credit rating, and limitations in GAAP.

The complex nature of the business model of Enron increased the likelihood of material misstatements. It enabled the management to overstate its revenue while not disclosing the actual value of its debt. The risk of fraud by management was high. The transactions involving SPE's essentially involved Enron receiving borrowed funds that were shown as revenue without recording liabilities. Also, the amount of misstatements was huge as Enron had hundreds of such SPE's. Complex financial derivative transactions were used to hide enormous amounts of debt. Huge increases in borrowing were made to look like hedges for commodity trades rather than new debt financing. The network of SPE's along with complicated speculations and hedges kept an enormous amount of debt off the balance sheet. The accounting standards were inadequate in providing for the proper accounting of these transactions. The loopholes in the standards were used to structure transactions in such a way that hundreds of SPE's were excluded from consolidation. Also, the management took advantage of the complexity of accounting standards to shroud the actual economic substance