Question

Enron made a deal in 1992 to supply Sithe Energies, a New York utility, with 195 million cubic feet of gas per day for 20 years for its new plant in upstate New York. The estimated value of the contract was $3.5 to $4 billion. Therefore, in 1992, Enron recorded about $3.5 billion in revenue and profits on its income statement based on the proceeds from a 20-year contract. In other words, Enron recognized revenue all at once on this kind of long-term sales contracts. Enron went bankrupt nine years later. Thus, over half of the revenue booked in 1992 from the Sithe Energies sales contract was never earned.

Required:

1) Discuss why the above-mentioned Enron’s revenue recognition practice violated the accounting standards. You should form your discussion based on the revenue recognition criteria— which criteria are violated and why do you think they are violated.

2) Discuss the incentives of Enron’s management team to record revenue this way. You should form your discussion based on what we have learned about earnings management—what’s the impact of this accounting practice on Enron’s financial statement and why do you think Enron’s management would do it.

Answer 1

Answer 1) ASC 606 - Revenue from contracts with Customers has laid down step model for revenue Hecognitione Steps : Identify the contract with a cutemer Step2 Identify the performance obligation in the controut. Step3 Determine the transcutiess price Step 4 : Allocate the transcution price to peformance obligation Steps : Recognise revenue when entity satisfies - betarp pes.lformance obligation 1. 2u 3. 4 니 m order for revenue recognition to be achueued , following cutería are met Persuasive edundance of an arrangement enirke, Delivery has occurred or services have been . rendered The А seller's prive to the buyer fined on determinable, and collectibility is reasonably assured In the given case, Enson recognized revenue all at 20 year long term sales contraut. As we can learnt from Criteria No. 2 above that revenue shall be recognised only when delivery has occurred or seruicy have been rendered. in the quien scenerio it is clearly evident that services are spread ouer 20 years and this Enxon cannot rewgnise revenue in first year itself. the

Enxon's revenue recognition practice vidlated the Menuce accounting Standard because Enxon did not apply the revenue rewgnition a cuteria while recording the revenue mstead of recognising revenue over the service period ie 20 years, Enson recognized revenue in 1992 itself.. which u a clear violation of accounting standarde which says at Enron has violated biteria Revenue shall be recognised when services have been rendered" This is violated because Enson necognised revenue in 1992 itself. The correct approach would be spreading the revenue over the service period ie 20 years • Answer 2) Enron's management reagnised revenue of $3.5 billion . in 1992 itself. Ine contrad period was for 20 . years, The incentive that management desired is to enaggerate profits in 1992 . As Onxun recognized meenue in 1992, folosite her 1992 were shy rocheted. gnis might benefit Enxon is attracting inuestras to invest in Enron. Moreover the high profile might enable Enson in getting financial assistance from financial institutions .' maddition to above if the Enxon is lited public liited public company than these high profits might push share prue to upwards. of Enron