According to charges made by the SEC, Enron Corporation engaged in a number of “prepay transactions” with Citigroup and J. P. Morgan Chase41 between 1997 and 2001, totaling billions of dollars. In these cases, Enron sold certain commodities to a company owned by one of these banks, and received cash at the date of sale. Enron also agreed to buy back these commodities at a later time, for more money. The price Enron would pay in the future did not depend on any changes in the values of these commodities. The only risk the banks took was that Enron might not repay it, and in that case, the banks could sell the commodities at the market price.

A. How is a normal sale of commodities accounted for, in terms of the accounting equation? What are the effects on:

a. Cash

b. Inventories

c. Sales

d. Loans payable

e. Cost of goods sold

f. Operating cash flows g. Financing cash flows?

B. How is a borrowing normally accounted for? (Note that no entry is needed when a company “pledges” that its inventory will be collateral for a loan. The company still owns the inventory. However, it would disclose that the inventory is pledged.) What are the effects on:

a. Cash

b. Inventories

c. Sales

d. Liabilities

e. Cost of goods sold

f. Operating cash flows g. Financing cash flows?
C. The SEC claimed that these arrangements were disguised loans, and should not have been accounted for as true sales. In fact, the SEC cited one internal Chase email that said

a. “WE ARE MAKING DISGUISED LOANS, USUALLY BURIED IN COMMODITIES OR EQUITIES DERIVATIVES (AND I’M SURE IN OTHER AREAS). WITH AFEW [sic]
EXCEPTIONS, THEY ARE UNDERSTOOD TO BE DISGUISED LOANS AND APPROVED AS SUCH.”

b. Why should these transactions be accounted for as loans?
Explain your answer.
D. What benefits, in terms of their financial statements, do you think that Enron was trying to achieve with these arrangements?