Enron Inter-Company Transactions


 

Introduction

The suddenness of Enron's downfall came about in part because stockholders, and perhaps some insiders, did not know about complex transactions with related smaller businesses. This description of the most damaging of these relationships presents an opportunity to evaluate the importance of financial statement classification and disclosure.

 

A Further Look

Enron's downfall was so sudden because a complex series of inter-company transactions was not made clear to stockholders, hiding Enron's enormous liabilities and overstating its earnings. Federal investigators are trying to determine what insiders knew about these transactions; one of the insiders is Robert A. Belfer, an outside director of Enron. (Note: An outside director is not affiliated with the company in any way other than as a director.)

The interlocking companies described in this article worked like this:

  • Belco Oil & Gas purchased a portion of an Enron-related business, JEDI. Belfer is Belco's CEO.
  • JEDI use some of the proceeds of this sale to assist Chewco Investments, LP.
  • Chewco's situation was highly complex, but arguments could be made that Enron controlled Chewco. Among other peculiarities, Chewco was managed by Enron executive Michael Kopper. Three percent of the funding in Chewco came through two small companies, Big River and Little River. At first those were controlled by Kopper; later, he turned his ownership and control over to Michael Dodson, said to be his domestic partner. Other funding came from one of Enron's banks.
    The problem was that JEDI had $700 million in debt that Enron did not want to show in its financial statements. But Enron could be said to control Chewco, and Chewco controlled JEDI. So, normally, the balance sheets would be consolidated, presenting the results as if they were all one company.


However, a special rule says that a company like Chewco or JEDI does not have to be consolidated if at least 3% is owned by independent investors, and they have the control, along with the risks of ownership. The two River companies invested $11.5 million, apparently satisfying the 3%, so Enron did not combine its financial statements with those of Chewco and JEDI. The $700 million became "off-balance sheet financing."


In November of 2000, Enron's former outsider auditors, Arthur Andersen, discovered that Big River and Little River apparently were not independent of Enron and the other companies. Belfer's involvement was a part of this, but Kopper's and Dodson's involvement may have been the deciding factors.
Because of this and other such discoveries, Enron revised and reissued financial statements for the previous several years. These restatements resulted in a sudden, tremendous decline of its stock prices and its eventual bankruptcy declaration.



Source

"Who Knew of Use of Funds from Belco?," The Wall Street Journal, by John Emshwiller, February 8, 2002, p. A5

Questions

Click here for Instructor Discussion Notes

1. To help you clarify just what happens when one entity purchases part of another, think about the bookkeeping for a transaction like the one in which Chewco purchased part of JEDI. Assume that Chewco paid cash. Think about: (a) What might be debited and credited in an entry to record the transaction on Chewco's books. (b) What might be debited and credited in an entry to record the transaction on JEDI's books. Alternatively: (a) What accounts on Chewco's books probably would be affected by the transaction, would they be increased or decreased, and what would be the financial statement impact? (b) What accounts on JEDI's books probably would be affected by the transaction, would they be increased or decreased, and what would be the financial statement impact?

2. During the years when JEDI and Chewco were operating, their financial statements were not combined with those of Enron. As a result, much less debt appeared on the Enron statements, since JEDI had a large amount of debt. Do you feel that Chewco and JEDI were so much a part of Enron that their statements should have been combined, or are separate statements for Enron sufficient? Explain your reasoning.

3. Who are the stakeholders in this - that is, the people who might have been hurt if Enron's financial statements were unfairly presented?

 



 

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