Conspiracy of Fools: Materiality and Financial Statements

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Enron had banking and finance relationships with some of the largest international firms: Credit Suisse First Boston, Merrill Lynch, and Greenwich NatWest to name a few. All of the firms were interested in continuing their business relationships with Enron, as the company brought significant fees with it.

As Enron was scrambling to meet analysts’ estimates for the fourth quarter of 1999, they were looking for “creative” ways to add profits to their bottom line.

Enron approached Merrill Lynch with a deal that would add $12 million to its bottom line through a shuffle of some Nigerian barges. Merrill Lynch executives were concerned with Enron’s accounting methods, and didn’t believe that it was appropriate to recognize the $12 million that quarter.

But as would happen often during Enron’s rise, the executives reasoned that $12 million wasn’t material to Enron’s financial statements, so it didn’t really matter if they booked the profits or not. Despite their reservations, Merrill Lynch went forward with the (sham?) deal in order to preserve their business relationship.

Again we are back to the accounting concept of [tag]materiality[/tag]: $12 million in comparison to the Enron [tag]financial statements[/tag] as a whole is just a drop in the bucket. Therefore, the auditors would “pass” and not correct the accounting because the difference to the company as a whole is minute.

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