A Forensic Review of Enron’s Financial Statement Fraud


This paper addresses the Enron financial statement fraud case and specifically with the advantage of hindsight, answers the question:  “As a fraud investigator, how would you go about finding the existence of these liabilities and partnerships?” (Albrecht et al., 2012, p. 481)  The paper concludes with analysis of the final Enron Annual Report of 2000 highlighting areas in the report most indicative of financial irregularities.

In a post-bankruptcy financial audit with the SEC and auditors from other stakeholders involved, the approach for a fraud investigator would be quite different than most audits of an ongoing concern.  Standard practice in a fraud investigation involves discretely planning an approach from general to specific, gathering all available data, creating a hypothesis, testing the hypothesis and refining the hypothesis as predications are discovered (ACFE 2015).  In the post-analysis of Enron bankruptcy, predication is both widespread and enormously complex.  The rapid fall of one of the largest businesses in the world makes this evident where in the last year of operation the stock collapsed from $80 to 26 cents per share by November 30th all while burning through an estimated five billion in cash in only 50 days (Thomas, 2002).  In short, in a post-bankruptcy case almost all the existing liabilities and partnerships that have been harmed by the fall of Enron would actively seek out the lead investigator or agency for remedy and to register proof of claim.  The challenge would be using these claims to sort out legitimate liabilities and partnerships based on Enron files and the data submitted by the claimants.

A fraud investigator on the Enron case would likely defer to the lead of federal auditors and the SEC who would have immediately seized all available books, files, databases and other material evidence for criminal and civil litigation.  With such an enormous company and so much available financial information post-bankruptcy, one of the first steps is to develop detailed entity and personnel organization charts to understand the general relationship of every subsidiary, partnership, joint venture and the management personnel responsible for each.  From there an examiner would identify knowledgeable managers and whistle-blowers willing to cooperate in explaining the complex financial activities of each of the entities.  The investigation would move in a more detailed process toward fraudulent activities central to future litigation.  Good witnesses provide contextual narratives into which detailed financial data can be structured to validate and document more accurately what transactions occurred.  With so much financial mismanagement across so many entities and divisions, prioritizing task forces based on the size of the area of perceived financial loss would be necessary.  Then follow the investigative work from the most damaging schemes to lesser ones.

The nature of the Enron fraud involved many financial accounting schemes as well as a layering process deliberately adding complexity and obscurity to the methods engineered by management.  Two major areas where an investigator would focus are the use of “special purpose entities” (SPEs) and “stealth guarantees” that facilitated enormous off balance sheet activity:

  1. “Enron created thousands of off balance sheet SPEs and then interlaced these with a myriad of transactions that were so complex that they were difficult, if not impossible, for investors to understand. They were probably only barely understood by a few Enron insiders” (Hayes & Arial, 2013, p. 142).
  2. “Stealth guarantees” were a fraudulent financial structure using securitizations that recycled cash flows across SPEs to inflate asset values and remove liability from the balance sheet by categorizing them as Total Return Swaps (Lipson, 2010).

The formation of so many SPEs, many of which were non-qualifying entities according to GAAP’s three percent independent ownership standard, allowed for an intricate web of fraudulent securitization transactions too complex to properly value.  This mislabeling of the guarantees as swaps also allowed for the creation of “price risk management activities” valued at more than $12 billion in assets, an increase of 545% from the year prior (Enron 2000). The fraud schemes were pervasive and substantial in value throughout Enron:

“It was later determined that just a short list of these accounting devices included hiding debt and financial losses off balance sheet in non-qualifying SPEs, failing to disclose conflicts of interest between Enron executives and the ownership of certain SPEs, disguising significant contingent liabilities, misrepresenting debt as minority interest, reporting gains on asset sales that were simply transfers to other Enron controlled entities, and creating overstated gains by incredibly inflating the future value of projects in mark-to-market calculations” (Hayes & Arial, 2013, p.137).

             As a fraud investigator following the independent approach detailed above helps to develop a more accurate and fresh financial framework from which to begin a comparison against the Enron Annual Report 2000 and other filings known to be inaccurate and fraudulent.  Of particular interest for fraud detection are accounts that increased dramatically year over year and purportedly represented large financial amounts.  Conducting horizontal and vertical analysis as well as financial analytics on all the reported financial information would help to try to isolate anomalies and develop an understanding how the schemes were conducted.  Examples of effective financial statement analytics are demonstrated on Enron financials at the conclusion of this paper.

On Enron’s consolidated income statement examining the Revenues shows enormous increases in Total Revenues of over $60 billion year over year as well as their Costs and Expenses that should be validated based on the sheer magnitude of their extraordinary increases in one year alone.  hfs-enron1Unusual in this report is the lack of commensurate increases in the 2000 Operating expenses, Depreciation, and Taxes (other than income taxes).  Relative to prior years’ ratios these accounts appear flat and proportionally understated by more than $6 billion below amounts expected from the Revenue and Cost accounts’ enormous increases at end of year 2000.  This anomaly then carries through the rest of the income statement more comparably to prior years.

Examining the balance sheet reveals more areas for concern consistent with the fraud described previously surrounding the use of SPEs and securitization schemes characterized as “risk management” or Total Return Swaps: hfs-enron2            The 415% increase to over $30 billion in total current assets, defined in the notes to the financial statements by Enron as liquid assets convertible within three months, was erroneous given the immediate subsequent bankruptcy and the severe lack of liquidity Enron faced as obligations came due (Enron, 2000).  As documented, Enron inflated assets, recycled cash-flows, included worthless or inflated receivables and mischaracterized guarantees as liquid assets trying to portray a much stronger balance sheet than what actually existed.  Related to this, the Investment and Other Assets show extremely large amounts and significant increases in typical non-monetary accounts known well for GAAP challenges with proper asset valuations and frequent occurrences of fraud:hfs-enron3

The 300% increase to nearly $9 billion in price risk management activities is as equally vague and significant as the account by the same name under Current Assets.  Taken at face value this risk management activity attributed to Total Return Swaps was valued at more than $21 billion or 32% of all of Enron’s assets in 2000 and with completely inadequate disclosures in the report raises concern for further investigation.

As expected the inflated and mischaracterized assets would need to be offset by equally sizeable liabilities and shareholder equity: hfs-enron4

The large and unusual increases in Accounts Payable by 454%, Price Risk Management Activities by 572% and Customers’ Deposits by 9,720% seem much more meaningful in retrospect of known fraud.  These dramatic increases in assets and liabilities support the established behavior of roundtrip transactions through thousands of SPEs that were improperly accounted for according to GAAP (Albrecht et al., 2012; Lipson, 2012).  A basic curiosity of the sudden increase from almost nothing to more than $4 billion in Customers’ Deposits would have raised questions of a business practice where so much money was tendered as refundable deposits in contracts beginning only in 2000.

Most meaningfully in the consolidated statement of cash flows are the unusual 77% decrease of nearly $2 billion from financing activities and a corresponding 389% increase in operating activities by more than $3.5 billion:hfs-enron5            The real basis of these changes was the improper accounting of sales and purchases between SPEs creating recycled cash flows that inflated current assets as well as overstated the incorrect source as operating activities.  Much of the SPE transactions and risk management activity was kept off the accounting books and could appear in the financial statements in whatever forms management desired to concoct and cover their schemes.  To expose such complex fraudulent financial structuring additional investigative techniques are needed.  Further investigations into the highlighted areas of Enron’s Annual Report for 2000 could be conducted with interviews of affiliated financial entities, subsidiary managers, customers, and other informed sources. Financial analytics could also leverage financial data using ratio analysis and other financial detection algorithms to detect sources and methods of financial statement fraud.

One such fraud detection model is the M-Score developed by Messod Beneish using a predictive formula that signals high probabilities of earnings manipulation (Zack, 2013).  Applying the five-factor formula of the Beneish model with Enron’s reported financials of 2000 yields the following outcome:

DSRI (Days’ sales in receivables index of prior year and current year) = (10,396/100,789) / (3,030/40,112) = (0.103) / (.076) = 1.35

GMI (Gross margin index of prior year and current year) =

[(40,112 – 39,310)/(40,112)] / [(100,789 – 98,836) / (100,789)] = 0.020 / 0.019 = 1.05

AQI (Asset quality index of current year and prior year) =

[(65,503 – 30,381 – 15,459) / 65,503] / [(33,381 – 7,255 – 13,912) / 33,381] = 0.3 / 0.366 = 0.82

SGI (Sales growth index of prior and current year) = 100,789 / 40,112 = 2.51

TATA (Total accruals to total assets) = (1,769 – 1,086 – 330 – 3,716) / 65,503 = -0.05

M-Score formula = -6.065 +0.823DSRI +0.906GMI +0.593AQI +0.717SGI +0.107*TATA

M-Score for Enron 2000 Annual Report = -6.065 + 1.11 + 0.95 + 0.48 + 1.8 – 0.005 = -1.73

The analysis by Beneish and subsequent research by Maria Roxas found that an M-Score greater than a -2.76 benchmark is a statistically reliable predictor of revenue recognition earnings manipulation (Zack, 2013).  The Enron M-Score of -1.73 is also significantly greater than the benchmark score needed for a reliable signal of earnings manipulation, validating in general what is known about fraudulent earnings reporting by Enron in 2000.  Whether tracing liabilities, locating subsidiaries, or understanding fraudulent accounting schemes, these are a few of the methods a fraud examiner would use to detect fraud, isolate anomalies, and test hypotheses in the forensic pursuit of a wide range of fraudulent financial activity in an organization.


Association of Certified Fraud Examiners. (2015). CFE Exam Review Guidebook: Fraud             Prevention and Deterrence.  Austin, TX: ACFE.

Albrecht, W. S., Albrecht, C. O., Albrecht, C. C., & Zimbelman, M. F. (2012). Fraud        Examination (4th ed.). Mason, OH: South-Western, Cengage Learning.

Enron (2001).  Enron Annual Report 2000.  Houston, Texas.

Hayes, J. B. & Ariail, D. L. (2013). Enron should not have been a surprise and the next major fraud should not be either.  Journal of Accounting and Finance, 13(3), 134-145.

Lipson, J. C. (2012). Defining securitization.  Southern California Law Review, July 2012,           85(1229).

Thomas, C. W. (2002).  The rise and fall of Enron.  The Journal of Accountancy, April 2002,     41-48.

Zack, G. M. (2013). Financial Statement Fraud: Strategies for Detection and Investigation.            Hoboken, NJ: John Wiley & Sons.