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?