Part C: Financial Statements as Evidence of Fraud

ENRON: FINANCIAL STATEMENT EVIDENCE OF FRAUD

It was a large energy corporation established in the United States that went bankrupt in 2001

and became one of the shocking failures to the investors, business people and citizens all over

the world. Sadly, it brought untimely failure for this big energy company due to pyramid

schemes most especially in the area of financial management. The complex financial records

formulated by Enron were instrumental in keeping the investors in the dark on the

accumulating debts by the company. The company engaged in fraudulency simulation

and<this list includes off-balance-sheet financing, mark-to-market accounting and Special

Purpose Entities (SPEs).

Among other methods, Enron used special purpose entities (SPEs) as one of the most

dangerous tools in the manipulation of their financial statements. Leveraging on the article by

LearnSignal, to deceive its shareholders and the public, Enron created shell companies

through which it floated its assets and debts succeeded in inflating its profits while struggling

with the rising costs of debts. These SPEs were set up in such a manner that Enron was

legally able to exclude them from its consolidated financial statements and in this way

remained capable of concealing more than $Billions worth of debt from the shareholders. It is

through these entities that Enron was in a position to report fake revenues and make a show

of good health which was far from the actual sense.

This paper is based on an article which lists the major fraudulent accounting practices that

were used in Enron including the mark to market accounting. This method enabled Enron to
book anticipated future profits from long-term agreements as the current revenues no matter

the fact that the company did not receive the stake. Although this is a legal accounting

method, the company used it to the highest level, which led to gross exaggeration of the

earnings of Enron Corporation. For example, Enron had future projections of this future

growth and for 1999 recently had a $40 billion revenue and for 2000 had a $100 billion in

revenue. This issue occurred when the intended gains were not realized, yet they remained as

revenues on Enron’s balance sheets because/booked as income inflating its size. Apart from

this, the manipulation also inflated the company’s earnings forecasts, thus creating a wrong

impression that Enron was in a far much better shape than it really was.

Besides, Enron prepared and issued its financial statements with the certification by Arthur

Andersen LLP; which was one of the biggest accounting companies of that period. However,

with all the discrepancies noted on the financial statements, Arthur Andersen approved these

statements, which helped Enron find credibility which it needed. This affair was a clear

example of a fraudulent partnership which contribute to the prolongation of the fraud until the

truth was revealed. The consequences were tragic not only for Enron but also for Arthur

Andersen Who lost rights to practice and later ceased to exist as soon as the scandal with

Enron became public.

The actuality of the matter was, however, much different; by the time the fraud was

discovered, Enron’s actual losses were staggering; its 2000 consolidated financial statement

reflected a net income of over $1 billion. Enron filed for bankruptcy in December 2001, and

other inspections exposed the real state of affairs that has been concealing for several years. It

was then when one could observe certain evidences of financial statements manipulation,

such as structures apt to hide some information and deceive the investors, regulators, and the
public.

In conclusion, Enron employed the schemes such as Special Purpose Entities, mark-to-market

accounting and other means of fraud in addition to the consent of its auditors to become one

of the greatest embezzlements in history. The inflated financial statements were especially

significant in masking the financial position of the company, contributed highly to the failure

of the company and billions of dollars loss to the investors. This case has been traditional in

illustrating the effect of improper corporate governance and financial statement fraud in not

only consuming a company but its shareholders and the economy.

One such company that lost its way was the WorldCom that was once a giant in the

telecommunications industry; WorldCom filed for bankruptcy in 2002, after it was uncovered

to have been involved in one of the biggest accounting frauds in the U.S. There are clear

cases of financial statement fraud which include reclassification of operating expenses as

capital expenditure done by the company. This practice enabled WorldCom to show

improved revenues, which were in actuality not there and hence cheating investors on the

actual financial position of the corporation. The misuse is a testimony to the fact that

manipulations of financial reporting can hide a company’s problems to give dreadful results

which in this case affected investors and employees.

Consequently, WorldCom’s executives opted for improper capitalization of operating

expenses as one of the most effective ways to manage their firm’s financial statements. In the

article by Investopedia entitled the WorldCom scandal, the corporate management of the

company directed the company’s employees to reclassify close to three billion dollars. Eight

billion of recurrent cost of operation as capital costs. This fraudulent activity skewed

WorldCom’s net expenses on the income statement a lot, which of course, resulted to inflated

profits. To capitalize these expenses, WorldCom was able to make the expenses incurred last

longer than they actually are, which gave the company a better appearance of ernings per

quarter and per year. This was squarely against accounting conventions where operating costs

have to be reported at the period in which they were accrued because they represent amount
spent during the period.

What terrible effect did this manipulation have? As you will recall before the revelation of

this fraud, WorldCom had been reporting decent earnings for several years and at the same

time the telecommunications industry in which it operated was in trouble. For example, while

keeping its financial records, in 2001 WorldCom touched on a net income of almost $1. 4

billion which gave an optimistic outlook of the company’s performance. However, a major

part of this figure was inflated by having reported it under changed expense categories. When

the fraud was discovered, WorldCom had alleged that it had been in losses thus having to

restatement of financial statement.

This fraudulent activity did not only mislead investors, but also helped WorldCom to keep

the stock price high that enabled the company to borrow and acquire other companies. Senior

management and primarily the Chief Executive Officer Bernie Ebbers were able to leveraged

the over valued stocks to obtain personal loans as well as to fund the firm’s expansion. The

financial statements were also inflated, thereby providing the firm with an unfair competitive

edge in the market despite the fact that this firm,WorldCom at one point was already in

financial problems.

The fraudulent schemes were later detected by the internal auditor and this led to the SEC

investigations on the financial activities of the company. Finally the truth was revealed, the

org anization was in much deeper water that has been thought by the public through the

financial outlook provided by WorldCom. The company filed for Chapter 11 in 2002 and it

was ranked as the largest bankruptcy in U.S withod over $100 billion of assets. The exposure

of the fraud led to astronomic loses for shareholders at about billions of dollars; thousand
employees lost their jobs as well as key executives of the company including the chief

executive officer Bernie Ebbers were imprisoned for the fraud.

Thus, the case of WorldCom involved the misuse of financial reporting policies by

capitalizing operating expenses that corresponds to such things as earnings per share and

diluted earnings per share which led to distorting the picture of success for as much as 5 years

for the company. By inflating the figures, WorldCom was able to maintain the image of

profitability although once the truth came out the company could not handle its losses as it

appeared to be. The scandal makes it possible to state that only the strict compliance with the

requirements concerning the financial reporting will help maintain the confidence of

investors and the stability of the financial markets.

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Reform (And It Just Might Work). Michigan Law Review, 102(7), 2202-2224.

2. Healy, P. M., & Palepu, K. G. (2003). The Fall of Enron. Journal of Economic

Perspectives, 17(2), 3-26.

3. Giroux, G. (2008). What Went Wrong? Accounting Fraud and Lessons from the

Recent Scandals. Social Research, 75(4), 1205-1238.

4. Investopedia. (2024). The Rise and Fall of WorldCom: Story of a Scandal. Retrieved

from https://www.investopedia.com/terms/w/worldcom.asp

5. Levinsohn, M. (2003). The Enron Collapse and Corporate Governance Reform.

Journal of Corporation Law, 28(2), 313-354.

6. LearnSignal. (2024). The Enron Scandal: A Comprehensive Overview. Retrieved

from https://www.learnsignal.com/blog/enron-scandal