The Nature of the Enron Scandal: Revenue Recognition
The Enron scandal cannot be attributed to just one type of financial scheme or even just one person. Rather, it was an amalgam of complex events that contributed to the company’s eventual collapse. So complex, in fact, that some schemes took years for law enforcement and regulators to fully parse out. In hindsight, however, it has become clear that here were predominantly three such causes of destruction:
1) Revenue Recognition, which inflated earnings;
2) Mark-to-Market Accounting, and;
3) Special Purpose Entities that were established to hide Enron’s debt.
In addition to building and maintaining electric power plants and natural gas pipelines, a major part of Enron’s business was based in energy trading contracts. In essence, these are simply commodities contracts for products such as oil, gas, and electricity. Under normal circumstances, an agent or a broker would appropriately record the fees generated from trading, known as the “net” revenue. At the ever-innovative Enron, however, a much different approach was adopted. Starting in the mid-1990s, Enron began reporting the revenue from its trading activities as “gross” instead of “net”. While this tactic significantly inflated Enron’s top-line figures, it did little to improve its bottom line. Using the “gross” method, Enron was able to recognize the entire face value of the contract as revenue. That is, if the total size of the contract was $1,000,000 on its face, then that figure would be reported as both revenue and expense – with no impact on profit. Between 1996-2000 Enron’s revenues skyrocketed by more than 750% (65% per year), in an industry where 2-3% growth was the norm. This anomalous growth, like many other apparently inexplicable financial windfalls at Enron, went unquestioned for a number of years.