From Management to Fraud

How much can companies manipulate accounting figures before they cross the line and managed earnings become fraud? Where is the line?

Enron was certainly pushing the envelope at every chance. The firm used sophisticated and very complicated methods to generate earnings out of thin air. Paul Krugman of the New York Times describes one type of technique called the fictitious asset sale. For example, Enron could sell an asset, like a truck, to its own subsidiary (technically a special-purpose entity) for an outrageously high price. The book value of the truck is low, so Enron books a huge capital gain and profits go up. The subsidiary capitalizes the cost of the truck. This means that the subsidiary will have to report a little lower earnings in each of the future years as the truck cost is depreciated. In effect, Enron is taking a profit now that it will have to offset as expenses in the future over the sale of a truck that it still owns! This kind of accounting trickery is just the tip of the iceberg for Enron. While these types of maneuvers help to manage earnings, their effect is limited unless the company crosses the line and uses them fraudulently.

As another example, Enron would enter into a contract to sell energy to a customer for 30 years. Then they would deliberately underestimate the cost of providing that energy, thereby overestimating the annual profit of the contract. ^[6] Lastly, Enron would book all 30 years of inflated profits in the current year. This practice made Enron appear incredibly profitable over the short term, but it was detrimental to its longer- term financial health.

It appears that Enron went over the line and committed fraud. Indeed, the examples given here are only the simplest of the gimmicks that can be used. Enron created complex partnership arrangements and foreign subsidiaries to perpetrate the worst of its accounting offenses . These partnerships are mostly created and used with the help of investment banks, which we discuss in Chapter 7.