The Rise and Fall of Enron

Main focus of this article is to summarize the rise and fall of Enron, as well as changes in financial reporting, auditing and corporate governance proposed in response by Big Five accounting firms. Main reason to fall is company’s lack of transparency in financial reporting. Company hired consultant named Skilling to make new strategies.  Skilling instituted the performance review committee in this underperforming employees are fired within six months. Enron added lot of product lines and attained success. Company used its own models on the basis of their own assumption for long future contracts. FASB interrupted by asking company to disclose all assumptions and estimates. Due to new market entrant’s success, fall in energy prices and recession, Enron profit margins started falling by the end of 2000. In order to maintain ratings Enron used “Special Purpose Entities” to hedge risk. In turn, this increased ROA and reduced debt/Total Assets ratio. FASB requires that only 3% of the SPE be owned by outside investor. Enron added more complexity by keeping losses in Books. Company also increased notes receivable and shareholders’ equity to reflect transaction of stocks in exchange of notes receivables violating GAAP.  Due to Misrepresentation Company start losing trust and reputation in market. As a result both Lay and skilling announced retirement and after consolidation with SPEs restatements resulted in $591million in loss and stock price of Enron felt to 26 cents. Question rose on the integrity of independent auditor process.  Andersen, Enron’s external and internal auditor; also controller of internal accountants was dismissed by Enron. Andersen admitted that he destroyed thousands of documents and electronic files. Collapse of Enron leads to suicide of former vice-chairman, end of 4500 individual’s carrier. SEC responded and called for joint response from public and private sectors. The CEOs of Five accounting firms wants modernization of procedure to make sure about transparency, timely and relevant presentation. AICPA responded by issuance of an exposure draft “consideration of fraud in Financial Statements audit” to restore confidence in profession. AICPA also supported prohibitions that prevent audit firms from internal audit outsourcing for public audit clients.  Management Frauds outlined in SAS no 82 are as follows-

1)      Competition based on Financial, management compensation and earning targets.

2)      Use of aggressive accounting practices to maintain Price to Earnings trend.

3)      Balance Sheet and Income statements on the basis of assumptions.

The collapse of Enron has had lot of political and financial implications which have resulted in review of corporate regulation. Unethical reporting based on assumptions by Enron corporation e.g. for SPEs consolidation of financial statements and balance sheet reporting lead to a loss of trust by investors and financiers. Questions arisen regarding adequacy of accounting standards, SEC disclosure requirements and market disclosure rules. The regulation committees responded by instituting inquiries and reviews by the SEC and AICPA. Sarbanes- Oxley act was enacted in 2002 to make sure and restore faith in the market by ensuring that financial information issued by corporations is truthful. Under this act companies should give full disclosure of financial statements to stockholders and interested parties (Investors). Also company should have adequate internal controls for reporting purpose. The CEO or CFO has to certify that he established adequate internal controls. And if any unethical work is found he will be primarily responsible. The fact that Enron was global company and operated in approximately 40 countries, as such all countries got affected by the Enron collapse. Most of the countries started reviewing there accounting standards to ensure ethical reporting of financial statements.

US GAAP vs. IFRS

US GAAP set by FASB vs. IFRS(IASB) –

·         GAAP, different objectives for business and non-business firms. IFRS same objective.

·         GAAP emphasizes on going concern basis.

·         GAAP relevance and reliability, IFRS also includes comparability and understandability.

·         GAAP uses revenues, gains, losses, expenses and comprehensive income. IFRS uses revenue and expense.

·         GAAP, asset as future economic benefit, IFRS asset as a resource through which economic benefit is expected.

·         GAAP does not allow values of most assets to be adjusted upward.

·         Both require discontinued operations to be reported separately from continuing operations in Income Statement net of tax. Both allow capitalizing interest.

·         Fixed assets can be revalued in IFRS but not under US GAAP.

GAAP- % of completion method, IFRS recognizing after completion.

GAAP Does not use provision if contingency is probable and cost can be estimated loss in IS and liabilities in BS. IFRS allows.

Extraordinary Items- GAAP reported in IS, net to tax below income from continuing operations. No provisions in IFRS.

IFRS, disclosure in separate recurring and non-recurring items.

Management Discussion and Analysis

The Securities Exchange Commission (SEC) requires this section to be included with the financial statements of a public company and is prepared by management.
This includes description of the company's primary business segments and future trends.

• A review of the company's revenues and expenses
• Discussions pertaining to the sales and expense trends
• Review of cash flow statements and future cash flow needs including current and future capital expenditures
• A review of current significant balance sheet items and future trends, such as differed tax liabilities, among others.
• A discussion and review of major transactions (acquisitions, divestitures) that may affect the business from an operational and cash flow point of view.
• A discussion and review of discontinued operations, extraordinary items and other unusual or infrequent events.
• Investors should keep in mind that this section is unaudited.

  Footnotes- US GAAP and SEC wants footnotes for-

·         Non Cash transactions

·         Provide information about accounting methods, assumption and estimates used by management. They are audited.

·         Conversion of bonds into common stock.

·         Accounting policies used.

·         Management discussion and analysis.

·         Should disclose change in accounting policies. Public companies should also disclose impact of newly adopted policies.

  International Accounting Standards IAS 1

International Accounting Standard (IAS) No. 1 defines which financial statements are required and how they must be presented. The required financial statements are:

• Balance sheet.

• Income statement.

• Cash flow statement.

• Statement of changes in owners’ equity.

•      Explanatory notes, including a summary of accounting policies.

•      Disclosures of material events that affect and accounting policies of the company are required by the Securities and Exchange Commission (Form 8-K) not by IAS 1 for firms that are publicly traded in the United States.

Board Of director Duties-

·         In general, the board makes decisions on shareholders' behalf.

·         Board of directors should be a fair representation of both managementand shareholders' interests.

·         Making decisions on issues include the hiring/firing of executives, dividend policies, options policies and executive compensation.

            Cash Flows Operations, Investing and Financing-

Asset expensed at time of purchasehigh OCF and low CFI.

Cash Flow from Operations=Inflows and Outflows of cash affecting Net Income.

Net sales – purchases – change in accounts receivables – other operating expenses.

US GAAP – CFO - Interest, Dividends Received, coupon payments and taxes paid.

IFRS – CFO- Interest, Dividends received.

           CFI- Interest, Dividends received

      Interest, Dividends paid CFO or CFF.

    Deferred tax liability- reversing in future liability if not than equity.

  Net Realizable Value= Price – Estimated selling price

NRV, less than,in Balance Sheet inventory is written down to NRV and loss in Income Statement.
Write up of inventory not allowed in US GAAP.

   Lease- inOperating lease entire lease PMT is operating cash outflow. In Financing or capital lease only depreciation is subtracted. Operating Income in Capital lease is greater than operating lease. Net Income initially is greater for operating lease than capital lease. Capital lease has low CFF as compared with operating lease.

Both IFRS and US GAAP require both type of leases requires disclosure of minimum lease payment more than 5 years in future. No effect on cash flow statements by both leases.

  Asset Impairment- Acquisition Cost – Accumulated Depreciation

When, useful life and salvage value of equipment is cut short, leads to change in accounting estimates not in accounting principle. No need to restate loss or gain. Right down to itsreconciled value and should be reported as operating loss.US GAAP asset is impaired if the book value is greater than sum of its undiscounted cash flows.

 Foreign Currency translation affects owners’ equity not the Income statement.

 FIFO ending inventory = LIFO ending inventory + LIFO reserve

FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 – t)

Financial Statements& Analysis

Financial Statements Analysis


Steps to a Basic Company Financial Analysis-
Analyze companies footnotes and management discussion and analysis to find the adjustments in financial statements reported.


·          In order to do a thorough job, you must understand something about the company’s business and strategies, and its industry.  Financial indicators vary from industry to industry; the ratios can only be interpreted when compared and contrasted with other companies in that industry.  For example, financial indicators are (and should be) different among financial institutions, manufacturing companies, companies that provide services, and technology and computer information and services companies.

Step 1.  Acquire the company’s financial statements for several years.  These may be found in in a recent annual report; in the company’s 10K filing on the SEC’s EDGAR database; or from other sources found at my LINKS website.  As a minimum, get the following statements, for at least 5 years.

·          Balance sheets

·          Income statements

·          Shareholders equity statements

·          Cash flow statements

Step 2.  Quickly scan all of the statements to look for large movements in specific items from one year to the next.  For example, did revenues have a big jump, or a big fall, from one particular year to the next?  Did total or fixed assets grow or fall?  If you find anything that looks very suspicious, research the information you have about the company to find out why.  For example, did the company purchase a new division, or sell off part of its operations, that year?

Step 3.  Review the notes accompanying the financial statements for additional information that may be significant to your analysis.

Step 4.  Examine the balance sheet.  Look for large changes in the overall components of the company's assets, liabilities or equity.
For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities?  Has the proportion of debt grown rapidly, to reflect a new financing strategy?  If you find anything that looks very suspicious, research the information you have about the company to find out why.

Step 5.  Examine the income statement.  Look for trends over time.  Calculate and graph the growth of the following entries over the past several years.

- Revenues (sales)
- Operating Profit
- Gross Profit
·  Net income (profit, earnings)

Are the revenues and profits growing over time?  Are they moving in a smooth and consistent fashion, or erratically up and down?  Investors value predictability, and prefer more consistent movements to large swings.

For each of the key expense components on the income statement, calculate it as a percentage of sales for each year.  For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales.  Look for favorable or unfavorable trends.  For example, rising G&A expenses as a percent of sales could mean lavish spending.
Also, determine whether the spending trends support the company’s strategies.
For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development.

Look for non-recurring or non-operating items.  These are "unusual" expenses not directly related to ongoing operations.  However, some companies have such items on almost an annual basis.  How do these reflect on the earnings quality?

If you find anything that looks very suspicious, research the information you have about the company to find out why.

Step 6.  Examine the shareholder's equity statement.  Has the company issued new shares, or bought some back?  Has the retained earnings account been growing or shrinking?  Why?  Are there signals about the company's long-term strategy here?

If you find anything that looks very suspicious, research the information you have about the company to find out why.

Step 7.  Examine the cash flow statement, which gives information about the cash inflows and outflows from operations, financing, and investing.

While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about.

If you find anything that looks very suspicious, research the information you have about the company to find out why.

Step 8.  Calculate financial ratios in each of the following categories, for each year.  A summary of some useful ratios appears at the end of this document.

·          Liquidity ratios

·          Leverage (or debt) ratios

·          Profitability ratios

·          Efficiency ratios

·          Value ratios

Graph the ratios over time, to find the trends in the ratios from year to year.  Are they going up or down?  Is that favorable or unfavorable?  This should trigger further questions in your mind, and help you to look for the underlying reasons.

Step 9.  Obtain data for the company’s key competitors, and data about the industry.
For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied.  You can also get company and industry ratios from the

Quicken.com Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website.

Compare the ratios for the competitors and the industry to the company being studied.  Is the company favorable in comparison?  Do you have enough information to determine why or why not?  If you don’t, you may need to do further research.

Step 10.  Review the market data you have about the company’s stock price, and the price to earnings (P/E) ratio.

Try to research and understand the movements in the stock price and P/E over time.  Determine in your own mind whether the stock market is reacting favorably to the company’s results and its strategies for doing business in the future.

Review the evaluations of stock market analysts.  These may be found at any brokerage site, or from various locations on my LINKS website.

Step 11.  Review the dividend payout.  Graph the payout over several years.  Determine whether the company’s dividend policies are supporting their strategies.  For example, if the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends?  Based on your research into the industry, are you convinced that the company has sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends?  Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends?

Step 12.  Review all of the data that you have generated.  You will probably find that there is a mix of positive and negative results.

 Answer the following question:

“Based on everything I know about this company and its strategies, the industry and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term?”

                               Ratio Analysis

1) 52 week price change

Make sure the stock is trading closer to the 52-week low than the high and also has upward momentum.

2) Price/earnings

price/earnings ratio= price of the stock per share/earnings per share.

The price/earnings ratio is a good valuation method to use when comparing valuation versus peers and valuations from a historical standpoint. This plays role high is good but companies can manipulate this

Earning Multiplier -
Current Price / EPS 1
=( D 1 / EPS 1 )/ (R - G)

3) PEG ratio (Price to earnings growth ratio) –

PEG = (price/earnings ratio)  / expected annual earnings per share growth rate.
This is a great valuation method to use when considering whether a stock that is growing quickly is still a good value or not, but the method is also subject to objective guesses as to the growth rate.

4) Price/cash flow ratio Cash flow per share –

This method measures the ability of a company to provide cash flow on a per share basis. The ratio is calculated by taking the =

stock price per share / operating cash flow per share.

Cash flow per share should both be positive with positive growth over each quarter.

A top reason to use this method is it typically excludes possible accounting distortions that other investment ratios might not be able to exclude.

5) Price/book value -

 stock price per share / shareholders’ equity per share.

 Over the years the book value has lost importance in many circles due to its undervaluing of modern asset types.

6) Dividend Yield –

annual dividend amount per share / stock price per share.

Dividends are usually, but not always, a sign of good financial health.

A Dividend yielding stocks are typically more mature and more value related, as opposed to growth stocks which often yield nothing or almost nothing.

7) Earnings per share
= Net Earnings / Outstanding shares


EPSstock market series = [(sales)(OM) - depreciation - interest](1-tax)

Where:
Sales = sales per share of the estimated series is determined through regression.
OM = the operating margin is typically calculated as a percentage of sales
Depreciation = this is determined by either continuing the trend of the current depreciation or focusing on the expected capital expenditures and how that number relates to future dividends.
Interest = interest is determined by outstanding debt and the interest rate on that debt.


Company having higher EPS should be preferred but if the other company growth rate of EPS is more than the former then company with greater growth rate should be preferred.

Than company with higher growth rate should be preferred. Growth rate of 15% consistently is good number.  A company’s accounting department can easily manipulate it.

8) Market Capitalization
Mid is good basically.

9) Volume -

 Volume is the number of stocks bought and sold in a single day of trading.  Make sure the average volume of the stock is over 50,000 or so.  If the volume is low, then liquidity is low.  This means it is hard to buy and sell because there aren’t many buyers and sellers and the stock moves in a very choppy fashion.  This creates a lot of unnecessary volatility, which most traders generally avoid. Average volume should be around 50,000. Stocks going down in relatively high volumes is good for buying and vice versa.