Events leading to the collapse of Enron

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Enron was an American Energy giant corporation headquarters based in Texas which started on 1985 and prospered fast. Enron was not only limited to energy but expanded its business water companies, electrical energy plants an dmany mother business like fibre optic, broadband cable and newsprint etc. making a profit of upto $101 Billion in the year which increased its share price and fame in the business. However in the year 2001 Enron fell into bankruptcy in spite of it being valued $60 billion. The reason being was Enron venturing into unprofitable business enterprises and forged accounting practices to veil the true financial position of the corporation. It was revealed that the reported financial statements of Enron was a consciously planned and well structured accounting scam which is well known as Enron Scandal.

The consequence of this scandal was immense. It had a remarkable impact in the accounting, commercial; economic and federal regulatory which became a political scandal as well. Arthur Anderson, the accounting firm for Enron was held for carrying out the accounting fraud which resulted in the loss of thousands for investors and workers of Enron and the demise of the corporate giant Enron and the accounting firm Arthur Anderson as well.

Conduct your own research on the events leading to the collapse of Enron and list the series of questionable business deals by Enron, in particular, between Enron and Raptor, and between Enron and Condor. How those deals were accounted for in the financial statements?

Answer:

Organization is charged with the responsibility to function in an ethical fashion. In the early 2000's the largest or most well known business failure occurred. Enron was exposed for their immoral practices and not only was the organization held responsible, but the individuals involved were also.

Enron grew to be the middleman for energy companies that allowed them to exchange energy contracts. The growth was very impressive and the business expanded into other facets including Internet services. During the time period 1993-2001 Enron formed more than 3000 Special Purpose Entities abbreviated as SPA. SPA's are the entities that are formed to serve a specific purpose as in Enron's case the purpose of such SPA's were to hide the liabilities from the balance sheet of Enron and falsely improving the leverage and equity return and asset return ratios.

With the growth in business Enron needed to borrow more and more money and to hide the liabilities from Enron's record they began to create spin out organizations that were used to hide the loss of $600 Million created by Enron. By hiding their debt, Enron looked like a very successful company until the Securities and Exchange Commission of United States gave notice to start investigation on Enron in 2001.

The first reason for Enron's collapse was because it was leveraged through debt. The second was the fall of the stock price. This caused issues with their debts and resulted in credit downgrades. The third stage was the increased cost of borrowing due to the credit down grades that caused liquidity issues for Enron.

In August 2001, Jeff Skilling placed his resignation from CEO. Then, in October 2001, Enron came out with losses over $600 million. Ironically, that is the same amount that was being sheltered under Chewco Investments.

Arthur Anderson (AA) can also be included in the fall of Enron. As their auditor, AA was an extension of the Enron organization. In October 2001, AA destroyed almost all of Enron's books. Arthur Anderson had helped Enron to form the spin out organizations and hide their losses. All of these behaviours between Enron and Arthur Anderson were reasons for the fall of Enron.

Enron was exposed for their immoral practices and not only was the organization held responsible, but the individuals involved were too. There are specific organizational behaviour theories that could have predicted Enron's failure such as the debt that was hidden under other businesses or the changes in upper management with no clear reason being provided. In addition to the organizational behaviour the leadership, organization, and managerial structures added to the collapse of one of the largest companies in the world.

Their accounting firm, Arthur Anderson, was not innocent in the scandal whatsoever. In the end, leaders and managers from both organizations paid the price for the mess that they had created. Not only were the organizations held responsible, but several individuals reaped the repercussions as well. This situation shows the immense impact that leaders and managers have on an organization. They can control whether an organization acts ethically or if the organization becomes greedy and does whatever necessary to be profitable and viewed positively in the public eye.

Enron involved in partnership business deal with its various SPEs. The deals with CALPERS, ZEDI, RAPTER, CONDERS were those deals and the accounting treatment of those transactions, were responsible for inevitable demise of the Enron Company.

Deals with Raptors

Enron had created a partnership aiming to buy and sell stocks of other companies. Enron lent the partnership of $ 500 million in Enron stock to operate Raptor and also guaranteed the load by promising to give more stock if Raptor was unable to repay the loan. Raptor issued a note to Enron that Enron considered assets. Raptor then bought stock in companies like Avici.

Enron treated the loan to Raptor as an assets and claimed profit on the rising value of Raptor's holdings. The transaction worked until the stocks of the companies owned by Raptors fell down. Raptors could not pay the loan. Enron was obliged to cover the Raptor's loan as it guaranteed for that, it had to issue more and more shares although its own stocks were declining.

Deals with Condor

Condor is other SPEs. The executives of Enron created another partnership called condor to sale and buy the assets in the best possible price. Condor was established to buy assets from Enron. Enron had lent the partnership shares to Condor of Enron's stock.

Accounting treatment of the Enron's deals with Raptor and Condor

Enron should have combined the financial reports of Raptor and Condor on its own as they were not autonomous entity and were the division of Enron but Enron recorded all the gain or losses including all the hedge transactions of its SPEs entities and did not consolidate it into its financial statements. The executives of Enron planned the deals in a way that income would show up and not the losses and that too showed up as decrease in shareholder equity and had no effect on income statement.

Enron recognised $800 million in cash flow from condor. In fact Enron should instead have been accounted for as an issuance of stock, But Enron counted it as cash flow.

Question 2:

"I am incredibly nervous that we will implode in a wave of accounting scandals." What accounting scandals was Watkins referring to here? List the questionable and/or fraudulent accounting practices Enron was engaged in. What were the effects of such practices on the reported results of Enron?

Answer:

Sherron Watkins born August 28, 1959) was Vice President of Corporate Development at the Enron Corporation. She is considered by many to be the whistleblower who helped to uncover the Enron scandal in 2001.

It has been remarked that her actions cannot be considered whistle blowing in a strict sense, because she only wrote a concerned internal email message to Enron CEO Lay warning him of potential whistleblowers in the company and pointing out that there were misstatements in the financial reports. Her memo did not reach the public until five months after it was written.

Watkins according to me was the hero; he was the person who found out all the fraud done in the financial statement she was recently appointed as CEO of the company before she was working as COO in the same company. Watkins questioned how can ENRON maintain a consistent stock market price for such a long time? She looked at the financial statement and found that the actual share price which should be $30 has the value of $90 in the market and this was all because every thing was created virtually there were no expense in the company all the expenses were used as capitalisation due to which there share price increases any breakage of deal was never indicated instead it remained as an asset for the company.

On October 16, 2001, Enron, the seventh largest corporation in the U.S., announced a $638 million loss in third-quarter earnings. On November 8, 2001, the company publicly admitted to having overstated earnings for four years by $586 million and to having created limited partnerships to hide $3 billion in debt. As investors lost confidence in the company, Enron stock, which had been worth as much as $90 per share in 2000, plummeted to less than $1 per share. Thousands of Enron employees lost their jobs and retirement savings, which had been invested in corporate stock through a 401(k) retirement plan. Banks and lenders lost millions of dollars in loans made to Enron based on the fraudulent earnings reports.

The innovative business practices of overstating profits and concealing debt increased the company's stock value, thus allowing the company to borrow more money and to expand. It also led to some top executives selling their stock and making over one billion dollars. Those former executives were later indicted for Fraud, Money Laundering, and conspiracy, and they also face dozens of civil lawsuits filed by Pension funds and former employees. The company's accounting firm, Arthur Andersen, admitted to having shredded Enron documents after it had learned that the Securities and Exchange Commission (SEC) was conducting an investigation of the corporation. The accounting firm was convicted of Obstruction of Justice, lost hundreds of clients and employees, and went out of business.

After the Enron scandal became public knowledge, many wondered how such an overstatement could have escaped notice.

The collapse of Enron Corporation in 2001 led to massive investigations involving allegations of a range of criminal activities perpetrated by some of the company's top executives. In January 2002, the US justice department announced that it had formed an Enron Task Force consisting of a team of federal prosecutors and under the supervision of the department, agents of the Federal Bureau of Investigation, and agents of the criminal division of the Internal Revenue Service. The scandal developed into a case study of corporate fraud, poor management decisions, and faulty accounting practices.

Enron had built itself into the seventh largest company in the United States, with annual revenues of $100 billion. In December 2000, the company's stock sold for as much as $84.87 per share. However, stock prices fell throughout much of 2001. In October, the company announced that it had overstated its revenues, claiming losses of $638 million during the third quarter of 2001 alone. Stock prices then plunged, hurting investors and employees with retirement plans that were tied into company stock. By the beginning of December, Enron's stock prices had fallen to below $1 per share. Enron filed for Chapter 11 Bankruptcy protection on December 2, 2001. To date, the event constituted the largest bankruptcy in U.S. history.

Much of the early investigation into the Enron fiasco focused on the company's financial reporting practices. Though the company followed generally accepted accounting principles (GAAP), these practices gave the false impression that the company was more profitable and more secure than it really was. The company reported revenues that were actually funds flowing through transitional transactions with related companies. Moreover, the company hid its losses and debts in partnerships that did not appear on Enron's financial statements.

 

Question 3:

"The overriding basic principle of accounting is that if you explain the 'accounting treatment' to a man in the street, would you influence his investing decisions? Would he sell or buy the stock based on a thorough understanding of the facts? If so, you best present it correctly and/or change the accounting. My concern is that the footnotes don't adequately explain the transactions" What is the context of this comment by Watkins? Why footnotes do not adequately explain transactions?

Answer:

Enron also failed to follow the accounting rules (Generally Accepted Accounting Principles). A completed financial statement with notes should be able to explain to the layman what is happening financially with the company. Any deviations in GAAP need to be noted on the financial statements. The famous note on their financial report mysteriously reports a profit of $500 million - which was in actuality was profit reported in part by the value of Enron stock. This and other extremely risky investments were mentioned very vaguely in the footnotes. If stockholders knew this would they have changed there investments? If the answer is yes, then it must be noted clearly - but it wasn't. The accountants and auditors, who were being paid by Enron, failed to accurately state the position of the company and let these technicalities pass. Accountants also failed to consolidate SPE's into Enron's financial statements when the special purpose entity (Chewco) could no longer be recognized as a separate entity. This lead to a misleading report of the financial health of Enron in turn resulting in a restatement o f income in 2001, which increased Enron's reported debt by over $2.5 Billion and reporting as far back as 1976. As one report said, "You couldn't slip these things by anyone … They're simply too big, and too many people were involved for it to go unnoticed." The Private Securities Litigation Reform Act reduced the auditor's liability for incorrectly reporting income which although not illegal, did not provide any incentive to stop these actions. Morally both upper management of Enron and the accountants served to line their own pockets with money while misleading the investors, creditors, and fellow employees. Upper management even sold stock as they encouraged normal employees to buy it. In the Sherron Walkins whistle-blower letter, she says that without a doubt "executive management of the company must have a clear and precise knowledge of these transactions." They emphasized values in maximizing short term profits through increased stock prices, and placed little value on the creditors, employees, and investors.

Question 4:

Watkin's memo refers to Arthur Anderson & Co (AA) at several places. How was their role as auditors of the company? Critically explain.

Answer:

Watkins, the whistleblower, warned Kenneth L. Lay that the company might "implode in a wave of accounting scandals," in August of 2001. Watkins describes "a veil of secrecy" around partnerships that involves the energy-trader's former chief financial officer, Andrew Fastow.

It was the job of Andersen Consulting to ensure the accuracy and reliability of the financial statements of Enron so that creditors and investors could make good financial decisions. However, it is now Andersen that is under investigation for illegal and unethical accounting practices which places both companies, Andersen and Enron. Enron hired Andersen to conduct corporate financial audits. Enron was one of Andersen's largest accounts, and also a major business partner to Enron as they sold millions of dollars in consulting service. Due to these relationships it was just too easy for both Enron and the accounting firm to work together in covering up financial losses and debt.

Andersen was also responsible for some of Enron's internal bookkeeping, with some of Andersen's employees eventually leaving to work for Enron. At the Andersen reins of this accounting scandal is chief executive officer Joseph F. Berardino. Berardino fired the lead Enron auditor David Duncan after it was learned that he had ordered the shredding of Enron audit related documents that would have disclosed true financial representation. Arthur Andersen also by oversaw some of the key factors that triggered disproportionate earnings and growth. Enron's stock peaked at over $90 per share but quickly bottomed out at 9 cents per share. Stockholders, investors, and creditors wanted to know how one of the nation's top accounting firms could have missed such shifts and irregularities in Enron's accounting practices, which is one factor that led to investigation into the accounting practices of the firm. As a result, the US Department of Justice brought obstruction of justice charges against Andersen which ultimately ran Andersen out of business.

Conclusion:

Enron executives placed their own personal wealth above the welfare of the company and the stockholders. Personal gain, greed, lack of ethics, and a general feeling of being above the law were the factors that brought down Enron. Enron was able to conceal its losses and create imaginary profits by creating ghost companies such as raptor. These companies shuttled money from banks to Enron, who reported it as profit. Arthur Andersen firm overlooked this factor most likely because of their involvement in keeping Enron's books, and the size of Enron itself. After time had elapsed and earnings were restated, an investigation ensued, resulting in prison sentences for some, the collapse of 2 businesses (Enron and Andersen), and enormous fines in the hundreds of millions of dollars. These small repercussions do not come close to the financial backlash of the Enron collapse and the total damage of the ordeal estimated over 100 billion dollars.

Due to accounting frauds of organizations such as Enron, the SEC has begun to take great steps in preventing loopholes within the accounting and financial disclosure system. The Enron case illustrates a number of flaws in the reporting system, which needs to undergo thorough re-evaluation and criticism before making any immediate alterations. Essentially most of the problems faced by Enron derive from the immoral and unethical actions taken on by the board of directors in their attempt to achieve personal profits. In order to prevent these unethical acts from occurring, there needs to be an enormous emphasis on the truthfulness and integrity of executives. In order for companies to prevent an Enron-like scandal, there needs to be supervision over managers and executives as they exercise their own business judgments about what is in the best interest for an organization.

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