Why Did Enron Go Bankrupt?

Enron was an American energy company that employed over twenty thousand individuals. It was one of the leading companies in the energy and electricity industry and was even named “America’s Most Innovative Company” for six consecutive years. However, in 2001, the company went bankrupt due to a variety of reasons. It was called the “Enron scandal.”

In December of 2001, Enron filed for Chapter Eleven bankruptcy, and shocked both investors and the world. One of the major reasons behind its bankruptcy was improper accounting.

The company was using corrupt accounting measures to make their profits appear more favorable, and thus increase their amount of investors. For example, the company used accounting limitations to manage earnings and alter their balance sheet. This then depicted a more positive economic performance for the company than was actually accurate.

The financial statements from Enron to their stockholders and the stock analysts were often vague, and didn’t specify their operation costs, their operations, and their finances.

Revenue Recognition

Enron practiced revenue recognition prior to its downfall. The company provided wholesale trading and risk management to different energy plants. However, Enron wasn’t reporting this properly, and instead of reporting its revenue using only the trading or brokerage fee, it reported its revenue for the entire value of each of its trades.

It exaggerated the amount of money that Enron was actually making through this process, thus making its financial performance appear even more appealing to potential stock buyers.

Mark-to-Market Accounting

Another reason behind Enron’s downfall was their use of mark-to-market accounting. While financial companies would frequently use this approach, non-financial companies would not. In fact, Enron was the first non-financial company to switch to this type of accounting.

Under mark-to-market accounting, income was estimated as the present value of net future cash flows when a long term contract was signed. The problem with this approach is that it is difficult to accurately predict future costs which may lower the actual income, or even the strength and durability of the contract.

Enron would greatly overestimate these figures to its investors and the stock analysts. Further, even when deals might result in a loss, Enron would continue to record the contracts as making money. Enron would not adjust their future predictions to even match the present reality.

For example, Enron reported that a contract with Blockbuster was going to bring over one hundred million dollars of profit to the company. Even though Blockbuster pulled out of the deal and thus the contract was dissolved, Enron continued to “recognize” its profits in the company’s statements.

Special Purpose Entities

There were other reasons why Enron went bankrupt. Enron used special purpose entities in its risk management practices. Special purpose entities are limited partnerships or the creation of a temporary company that has a limited and specific purpose.

Frequently, investors were not informed of these temporary companies even though the companies were funded by independent equity investors and debt financing. Enron was using these companies to get around its growing debt. By the time of its collapse, hundreds of these companies had been used to hide Enron’s debt.

Whitewing Associates

Another example of Enron’s irresponsible accounting and reporting is its connection with the Whitewing Associates, LP. In December of 1997, Enron and another company helped fund the creation of the company, Whitewing Associates L.P. In fact, Enron invested over five hundred million dollars in the deal.

However, after two years, Enron stopped counting the company on its balance sheet. Enron was able to do this by altering the arrangement of Whitewing Associates. However, Whitewing Associates was used to buy assets that were used by Enron using the Enron stock as collateral. These actions were reported as sales, and instead should have been reported as loans. Thus, investors were unaware that Enron had essentially loaned almost two billion dollars to Whitewing Associates, LP.