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Enron Corporation was considered as one of the most innovative companies during the 1990s. According to Michael Frontain in Handbook of Texas Online, Enron was on Fortune's "Most Innovative" in the United States listing for several years and reached number seven on the Fortune 500 list in 2000. Enron was created by a merger between Houston Natural Gas and another natural gas company called InterNorth in 1985. Kenneth Lay, who was the former chief executive officer of Houston Natural Gas, became the CEO of Enron and in the next year, he won the post of chairman. Enron's headquarter was located in Houston, Texas and it "operated one of the largest natural gas transmission networks in America, totaling over 36000 miles, in addition to being the largest marketer of natural gas and electricity in the United States." (Frontain)
Enron, from the beginning, focused on traditional sales and natural gas transportation. However, during the 1980s, because of the deregulation of energy markets, Enron no longer had the exclusive rights to its pipeline and the company had a huge debt as a result of the merger. In order to keep the company on its feet, Kenneth Lay had to find some ways to generate profits. In 1990, Lay decided to bring his former consultant Jeffery Skilling to work for Enron as an accountant. Skilling directed the company into new ways of doing business. He developed a concept called the Gas Bank in order to market natural gas to consumers. Basically, Enron bought gas from a network of suppliers and then sell it to consumers at a fixed price with contracts. Enron also advanced into deregulated electricity markets in California in 1998, offering discounts for customers to sign up with the company. This brought them 4 billion dollars a year from electricity sales. Enron did not just focus on the US market but it also expanded overseas. In the beginning of 1991, the company built its first power plant in England, which became the largest gas-fired cogeneration plant in the world. Enron continued to build power plants in other industrial and developing nations, such as Italy, Argentina, China, India, Brazil, Philippines, Colombia, and others. The revenues generated from these projects accounted for approximately 25 percent of the total revenues of the company.
Besides energy contracts, Enron also launched an Internet-based commodities trading service called Enron Online in 1999. Most of Enron's income came from trades over Enron Online. Moreover, Enron also traded industrial commodities such as steel and wood fiber, financial derivatives and innovative items such as broadcast time for advertisers, weather futures, and Internet bandwidth capacity. (NPR)
Enron's growth rate was incredible. Its annual revenues increased from 9 billion dollars in 1995 to approximately 100 billion dollars in 2000. Enron's stocks rose 55 percent in 1999 and 87 percent in 2000. However, by the fall of 2000, Enron's stock price started to decrease significantly and it was revealed that Enron involved with an accounting fraud. On December 2, 2001, Enron declared bankruptcy. According to Cathy Booth Thomas in Time Magazine, the drop of Enron's stock price from 90 dollars per share in 2000 to less than 1 dollar per share in 2001 caused investors to lose more than 60 billion dollars within a few days.
This is considered as one of the largest bankruptcy in American history at that time. The scandal has caused approximately 45 thousand employees to lose their jobs and it has become a symbol of corruption for the whole Western economic system. This bankruptcy did not only affect the economy in the United States but also many other companies all over the world. This paper will analyze the causes to the scandal, who is responsible, and what we can learn after this accounting fraud.
2/ The Causes of Enron's bankruptcy
There were different reasons for the company's bankruptcy. In this essay, we will focus on some of the main causes that led to the company's bankruptcy.
2.1. Mark-to-market accounting
In accounting, assets and liabilities are usually shown at their historical costs and they remain the same value since the day of acquisition. The numbers that are recorded on a company's book do not indicate the market values. According to generally accepted accounting principles (GAAP), the company needs to record the value of assets at their costs. However, everything changed in the 1980s. Companies started to adopt this method in accounting. Basically, with this method, companies record their assets at the current market data, not the price they purchased in the past. In trading liquid financial instruments, such as stocks, bonds, and all forms of commodities that are traded on the exchange market, this method will work really well because it allows companies to determine the value of their assets at that point in time. However, applying this method to other businesses, it can be dangerous due to the fact that it creates the opportunities for companies to manipulate the value of their assets.
By the fall of 2000, Enron did not make any profits and the company was on the edge to collapse. Skilling requested permission to change accounting procedures and he "lobbied the Securities and Exchange Commission (SEC) to allow Enron to use mark-to-market accounting." (Reeher) Despite the potential collapse of Enron, the SEC still approved this accounting method in trading of gas future contracts on January 30, 1992 Malcom S. Salter, who was a professor at Harvard Business School, said that Enron is the first nonfinancial company that was allowed to use this method of accounting to account for its long-term contracts. In this case, when Enron builds, for example, a power plant, the company will immediately claim the projected profits in the financial statement although they have not made anything from that power plant. If the company could not make the amount of money that has been projected, instead of taking the loss, Enron would just "transfer those assets to an off-the-book corporation, where the loss would go unreported." ("Investopedia") Enron basically did not have any incentives to create profits for the company and they could just ignore any loss without hurting the company's net income when using this accounting method.
In July 2000, Enron signed a 20-year agreement with Blockbuster Video to introduce on-demand entertainment for people in different places in the United States. After several small scale projects, Enron estimated the profits to be more than 110 million dollars from this deal with Blockbuster. When this kind of entertainment did not work too well in the US market, Blockbuster decided to pull out the contract with Enron. However, after Blockbuster has pulled out the contract, Enron still continued to recognize the future profits despite the fact that the deal Enron had with Blockbuster resulted in a loss.
According to Investopedia, one of the reasons that Enron was able to cover up its shady business for a long time is that at that time, Skilling was competing with the top Wall Street firms to recruit the best business school graduates and that helped Enron to gain luxuries and corporate benefits.
2.2. Special Purpose Entities
Special Purpose Entities (SPE) are legal entities formed to accomplish narrow or temporary objectives. SPE are often referred as off-balance-sheet arrangements and it is often used in the 1970s when a number of companies involved with securitization. SPE is a powerful finance tools and if used properly, it can be beneficial to companies because it can help to separate them from financial risks. A company usually uses SPE to finance a large project by dividing it into different goals in order to conduct a well specified activity and not put all the financial risks on the company. In the other hand, in some cases, companies can use SPE illegitimately such as inflating profits or "embezzlement, money laundering, mischaracterizing revenues and loses, perpetrating fraud on unwitting fund investors, moving money offshore for tax invasion, channeling funds to terrorist operations, and disguising the source of money for illegal arm sales." (Tavakoli)
Enron is best known for its abuse of SPE in order to manipulate the accounting results. The company, at that time, tried to cover up most of the information about SPE that it used instead of disclosing that information to the public. According to GAAP for SPE, Enron would have full control of the SPE and as a result, all the activities were not conducted by Subsidiary Corporation or partnership and therefore, the entity would be recorded as a part of Enron's financial statements. Moreover, it is also stated in GAAP that outside investors put up at least 3% of the equity capital and if a GAAP net loss cause the equity to dip below 3%, the equity holders need not contribute more capital to maintain the 3% capital level but equity-holders may not withdraw their equity interests such that the equity level drops below 3% (Holtzman) In many of the Fastow deals, the investors did not put up 3% because the deals turned out to be irrational.
Enron devalued the liabilities on the balance sheet and overvalued its earnings. The company claimed that it had blocked the risk of an unexpected decline in security values by using SPE. However, stockholders were not aware that SPE was actually using Enron's stocks to finance for that at the time and it was difficult for stockholders to realize that security values were decreasing at a significant rate. Some of the SPEs that Enron employed were JEDI, Chewco, Whitewing, and LJM. ("Wikipedia")
2.3. Arthur Andersen and Audit Failures
The firm Arthur Andersen was founded in 1913. It used to be one of the "Big Five" accounting firms, which provided auditing services for big corporations. The firm had two major audit failures a few years before the Enron's collapse. In 1996, Andersen's auditing reports of Waste Management was false and it inflated the income by over 1 billion dollars, which led to the selling of Waste Management to another company. Another audit failure was in 1997 when Sunbeam used accounting tricks to create false profits and Andersen still signed off the financial statements even after a partner detected them. Arthur Andersen and Enron are the two names that will always go together due to the fiasco of December 2011, when Enron declared bankruptcy. These two big firms took advantage of not only the investors but also the government to gain profits for themselves.
In the article "Enron Scandal" on Wikipedia, it says that Enron hired many Certified Public Accountants (CPA) as well as accountants who had worked on developing accounting rules with the Financial Accounting Standard Boards (FASB) Those people will try to look for ways to save the company as much money as they can by taking advantage of the loopholes which can be found in General Accepted Accounting Principles (GAAP).
David Duncan was the one who is responsible for the Enron audits. One of the internal memos at Andersen showed that "there were conflicts between the auditors and the audit committee at Enron." (Stinson) In the memos, there were also several emails expressing concerns about the accounting practices using at Enron. However, Duncan ignored those concerns. The reason that Duncan overturned those concerns is that Enron tried to make Andersen to meet Enron's earnings expectations by allowing another accounting firm Ernst & Young or PricewaterhouseCoopers to complete some of the accounting tasks. It is also proved that Duncan's team wrote false memos which stated that the accounting practices used by Enron to hide debts and inflating profits was approved by professional standard groups.
The firm was also found guilty in Enron case because of "shredding documents relating to the failed energy giant Enron." ("BBC News") Andersen has already lost much of its business since the last two audit failures and after this verdict, Arthur Andersen, an 89-year-old accounting firm, was on the verge of bankruptcy following by multimillion dollar lawsuits by Enron investors and stockholders.
3/ People who are responsible for Enron's collapse
One of the first people that we need to talk about is Kenneth Lay, who was the former and Chief Executive Officer at Enron. According to the U.S. Securities and Exchange Commission website, in July 8, 2004, the SEC "initiated civil charges Kenneth Lay for his role in a wide-ranging scheme to defraud by falsifying Enron's publicly reported financial results and making false and misleading public representations about Enron's business performance and financial condition." In the fall of 2000, when Enron's stock price reached to 90 dollars, Lay told investors to go out and buy more stocks because stock price would keep climbing to 130 dollars in the future. However, Lay himself knew that Enron was in trouble and stock price would go down so he started selling his stocks. Ken Lay, as a CEO of Enron, did not care about the profits of the company but all he cared about was to make more profits for him. He was the only one that knew about the financial problems at Enron but he was trying to cover that up and claimed misleading information about Enron's stock price to investors. His selfishness and unethical behavior has taken away many jobs away from people working at Enron and also a great amount of money from investors and they have led to Enron's bankruptcy. Lay was convicted on all six counts of conspiracy and fraud but he died before sentencing.
The second person who is responsible for Enron's collapse is the former president of Enron- Jeffrey Skilling. On May 25, 2006, the jury laid out 36 charges against Skilling of "conspiracy, insider trading, making false statements to auditors, securities fraud." ("Wikipedia") As a result, Skilling was sentenced 24 years in prison with a fine of 45 million dollars.
The third person who was also responsible for what happened at Enron is Andrew Fastow. He was the former Chief Financial Officer at Enron. Fastow was the one who designed the "off-balance-sheet" arrangements which helped Enron to hide the true financial situation of the company. Enron's stock price was 90 dollars a share before the collapse and when the truth finally came out, the price went down to only 40 cents a share. He was found guilty to two counts of conspiracy and he "forfeited nearly 24 million dollars, and spent more than five years in prison for securities fraud." (Meglio) Fastow, after serving his sentence in jail, is starting to go to universities to share his story to students. He is trying to teach ethics to students at business schools so that those students will not make the same mistakes as him in the future.
Besides three people mentioned above, there were also many other individuals and organizations who got involved with this scandal and all of them were punished.
4/ Lessons learned from Enron scandal
The first thing that we can learn from the Enron debacle is that integrity should always be the most important thing in doing business. Enron used "off-balance-sheet" financing in order to inflate the company's profits and reduce debts. Arthur Andersen somehow overlooked the fact that what Enron did was unethical. Enron, as mentioned above, tried to find loopholes in GAAP to take advantage of those things and save as much money as they can. This practice might be considered as legal but it was not necessarily considered ethical. Every transaction within a company must be recorded accurately and no people should try to take advantage of the rules to gain profits for themselves.
The second lesson that we took from this scandal is that people should have the courage to step up and express their concerns about potential issues within the company. In Enron case, some employees and even some senior executive managers, tried to warn Ken Lay about the accounting issues but they did not do anything to prevent the company's scandal. If in this case some people had taken some serious actions, not too many people would have been lost their jobs and investors losing all their money.