Enron became the seventh largest public company in the United States in 2001. As a big company like Enron, there must be some business risk in their operation. Enron need to treat the risks seriously otherwise they can increase the likelihood of the material misstatements in company’s financial statement. The first business risk Enron faced is the technology requirement and online huge cash inflow. In 1999, to survive in the century of internet boom, Enron launched a web based commodity trading site, Enron online. Enron become the first company provide online trading service among the world. The online trading system brings Enron a gross revenue of $101 billion however the cost to get this result must be very high.
Enron need to improve their technology to make sure the business can run smoothly and able to access with a high-speed internet bandwidth and hire a lot of experts in the area of actuarial science, mathematics, physics, meteorology, and economics to make sure that they can manage the business risk by running the new online economy. The high cost become a business risk faced by Enron since it need a huge amount of cash to support the running of the online system. In the other hand, Enron online is handling more than $1 billion of transactions daily. A huge amount of cash inflow coming and monitored by the online system daily is the risk faced by Enron. It will increase the likelihood of a material misstatement for the financial statement once the system is fail or one of the transactions being missed. Besides that, the next business risks Enron faced is lack of independent of external audit firm. Enron is one of the largest client of the accounting firm, Andersen.
Andersen provide the external financial statement audit work and also the consulting service which is on Enron’s internal audit function. Andersen has been paid with a total amount of $52 million for the external financial statement audit and the internal audit function. As an external auditor, Andersen should only provide Enron external audit service to make sure they are independent. However, Andersen also provide internal audit service at the same time.
Therefore, Andersen is not independent with Enron. It becomes a business risk that faced by Enron and the risk can increase the likelihood of material misstatement. It is possible that Andersen may miss some material misstatement such as sale overstated, cost understated and omission of some expenses that will cause Enron’s profit in financial statement up or down due to their own benefits come from Enron since they are not independent. For example, when Andersen was auditing for Enron’s 1997 results, they found that $51 million of the adjustment should be done in Enron’s book but Enron refused to make the adjustment since it will reduce their 50% annual income. Andersen decided that the adjustment is not material and just let it go uncorrected. If the $51 million adjustment is justified as a material misstatement, Enron’s 50% annual income will be cut down, from $105 million to $54 million, the profit will be cut down by $51 million too.
Last but not least, the third business risk that Enron faced is the high degree of borrowings. Enron set up the “Special Purpose Entities”, sell off their assets in a share terms at over $100 per share, receiving an outside investment loan in a sale of assets term and without recording the liabilities on the company’s balance sheet. In result, Enron get a huge fund with the heading of sale of assets and no recognize as a liability but it actually is a borrowing fund received from external investor by sell off assets to “Special Purpose Entities”. Enron rely on a large amount of borrowing funds but never record them as a liability. Enron’s financial statement looks highly profitable and growth well, the stock valuation is also increasing continuously. This is entirely due to the existence of “Special Purpose Entities”.
However, the “Special Purpose Entities” can cause a business risk for Enron since the borrowing fund will increase as long as the “Special Purpose Entities” running. The more investors to invest in the company, the more liabilities incurred without record on the balance sheet while the cash inflows are coming in. It will increase the likelihood of material misstatement in the Enron’s financial statement.In conclusion, the business risks that faced by Enron which may increase the likelihood of material misstatement in the company’s financial statement are the technology requirement and online huge cash inflow daily, lack of independent of the external audit firm and the high degree of borrowing fund without recorded.