enron case study

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I have been reading Graham and Dodd for the first time. I thought it would be fun to read enron's financial statements in light of GD's advice and see what I could find. Here is a gem from Enron's year ending 2000 statement

"On August 16, 1999, Enron exchanged approximately 62.3 million
shares (approximately 75%) of the Enron Oil & Gas Company (EOG)
common stock it held for all of the stock of EOGI-India, Inc., a
subsidiary of EOG. Also in August 1999, Enron received net
proceeds of approximately $190 million for the sale of 8.5
million shares of EOG common stock in a public offering and
issued approximately $255 million of public debt that is
exchangeable in July 2002 into approximately 11.5 million shares
of EOG common stock. As a result of the share exchange and share
sale, Enron recorded a pre-tax gain of $454 million ($345 million
after tax, or $0.45 per diluted share) in 1999. As of August 16,
1999, EOG is no longer included in Enron's consolidated financial
statements. EOGI-India, Inc. is included in the consolidated
financial statements within the Wholesale Services segment
following the exchange and sale. Enron accounts for its oil and
gas exploration and production activities under the successful
efforts method of accounting."

I read this as saying that Enron sold debt and common stock and recorded the proceeds of this sale in their income account. Are there other interpretations? Does my interpretation suggest fraudulent activity, or is this sort of thing common practice in accounting?

Has anyone else done this exercise? If so, what have you found?

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Comments (8)

 
May 5, 2012 - 3:31pm

I believe that your interpretation is partly correct: Enron booked a profit on the appreciation in their EOG stock. It's not clear here, but I highly doubt that they booked any kind of gain from issuing the debt.

This is not fraud per se: they realized an increase in the value of something they owned, which is what "income" is. And of course they broke it out as non-recurring, since they can't promise to re-create EOG on an annual basis. But it is a good avenue for fraud, since:

  1. It lowers their stated P/E, making the stock look cheaper. Smart investors will of course back out one-time gains, but if you're doing a simple stock screen it makes their P/E appear more normal.
  2. Enron did often state or imply that they'd be able to repeat this kind of process. The energy industry is weird like that: lots of companies invest in various projects, and then sell their stakes when they need capital or get a good offer. Enron tended to pick the flowers and water the weeds: they'd keep bad projects on the book to avoid a write-down, and sell good projects to book profits.
  3. Again, not fraud per se, but if you run a complicated corporation, and complicate your life in such a way that you pay lots of fees to bankers, you may get some favors out of it.

I read Enron's 10-K the week they took their giant write-down (I believe this was the week after the markets opened post 9/11), and I realized at the end of it that I literally had no idea what they did to make money. If you look at writeups of how e.g. Chanos decided to short them, there isn't a smoking gun, just lots of suspicious people buying gun permits. The biggest red flag, aside from the opaque books, was that Enron was doing business with a fund run by its CFO. That, plus valuation, is why Chanos shorted.

In fact, you can make the argument that Enron could have survived if the market was kinder. They were a massively levered oil and gas hedge fund, and their counterparties realized that they were probably going to have to liquidate lots of positions, and thus started trading against them. You can look at the records of ex-Enron traders who left the company (I know at least one) to see that these guys did know their stuff. Enron Inc. went under; if they'd been Enron LP and operated out of Greenwich, they could plausibly still be in business.

 
May 5, 2012 - 4:10pm

They traded 75% of the stock of EOG for 100% of the stock of a subsidiary of EOG. There was some right pocket to left pocket stuff going on here that isn't illegal per se, but is misstating earnings in the long run. Real investors notice stuff like this, but to the public it looks like they're doing very well and continue to grow (I feel bad for the employees still)

I hate victims who respect their executioners
 
May 5, 2012 - 6:45pm

BlackHat:
They traded 75% of the stock of EOG for 100% of the stock of a subsidiary of EOG. There was some right pocket to left pocket stuff going on here that isn't illegal per se, but is misstating earnings in the long run. Real investors notice stuff like this, but to the public it looks like they're doing very well and continue to grow (I feel bad for the employees still)

...and the honest companies. Because of the Enron debacle, they suffered, not unlike the rest of us are suffering because of the blowout in 2007/8. The public can't hate them as much as us.

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