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Enron:Unfolding the scandal

Updated on July 30, 2016

Enron Corporation was commodities, energy and service company based in Texas, America. Enron was one of the world’s major natural gas, electricity and pulp and paper company which earned revenue of almost $111 billion during 2000. Fortune named Enron “America’s most Innovative Company” for six consecutive years. But the great company which almost employed 20000 staffs at its peak filed for bankruptcy citing accounting fraud, one which would change the accounting forever. The fall of America’s wall street darling was due to systematic and creatively planned accounting fraud. Enron Fraud has been the topic of almost all of the accounting books today. The scandal also resulted in dissolution of Arthur Andersen- a mammoth accounting firm. Let’s analyze how Enron one of the biggest American Company became the victim of accounting fraud:

Special Purpose Entities

Many entities were created to mask significant liabilities from Enron’s Financial Statements. This made Enron to inflate the profit in its financial statements but in reality it was losing money all way around. This also created a repetitive cycle in which the corporate officials had to create more and more deceptive accounting fraudulent tactics to create the illusion that company is in great shape and is really earning billions.

Insider Trading

Major corporate officials soon realized that they can earn more money due to creation of many special purpose entities. They were the one who knew every offshore accounts which were hiding the losses. The investors were not able to get even a hint what was happening as the corporate officials used creatively planned techniques to hide those practices. Fastow, CFO of Enron was the man behind the related party transactions.

Corporate Governance

Chief Executive (a popular magazine) enlisted Enron among its five best boards. Enron always had a model board of directors on paper. Due to this fact, Enron was able to attract large investments to fund its average business model. Enron managed to conceal its real performance through accounting and finance tricks and hype its stock value.

Compensation

By concealing true performance and hyping its stock value, employees of Enron were highly compensated with executives being compensated twice than their competitors would. This slowly became a routine for Enron.

Financial Audit

Arthur Anderson (a mammoth accounting firm then) was entrusted the responsibility of financial audit of Enron. The auditor’s methods were highly questionable with subject of lack of expertise in reviewing special entities, derivatives and other specialized topics. Enron was also hiring various top accounting individuals to use the literature of legislation to its advantage.

One Enron accountant revealed “We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness.

Anderson’s auditors were also pressured by management of Enron to defer recognizing charges from special entities after the credit risks of Enron became known. To pressure Andersen to meet its expectations, Enron would occasionally hire Ernst and Young and PWC to complete accounting tasks to create illusion of hiring them to replace Andersen. Andersen was also guilty of accepting the pressure as it was getting huge payout annually from Enron. In addition, after investigations of Enron was made public, Andersen would shred tons of documents and deleted nearly 30000 e-mails and files to cover up its association in Enron or the scandal. Thus it was also clear Anderson was unable to fulfill its professional obligations.

Mark to market accounting

Initially Enron was using a simple but effective accounting system for its contracts. When Skilling joined the company, he adopted mark to market accounting insisting it would represent true economic value. This system requires that in long term contracts, income shall be recognized at present value of future inflows. This was difficult to estimate. So, in order to match profits and cash, often misleading reports became a routine where financial earnings were shown in the books although they were not received. This system is generally used in Financial Companies while Enron was not a financial institution. This was a proper mismatch.

Booking costs of cancelled Projects

Enron made a habit of repeatedly capitalizing the cost incurred on cancelled projects as assets. This was in fact more complicated by the fact that though projects were not cancelled on paper but its cost was treated as assets.

Unfolding the Darkness

On March 5, 2001, “Is Enron Overpriced” was published in Fortune magazine by Bethany Mclean. She argued that investors and analysts did not know how Enron was making the money. She found erratic transactions, huge cash flows and huge debts which was alarming as she claimed in her article. She called Skilling(CEO) to discuss about it but skilling told her article did not do enough research on the company.

In a conference call on April 17, 2001, Skilling verbally attacked growing analysis by wall street analyst and said” Well, thank you very much, we appreciate that asshole”. Such words were hugely criticized by press and the public. As times passed, there were too many serious confrontations on the company. Enron had recently faced several serious operational challenges, namely logistical difficulties in operating a new broadband communications trading unit, and the losses from constructing the power project in India. On August 14, Skilling resigned citing personal reasons. The next day, however, Skilling stated that major reason for his departure was Enron’s falling price in the stock market. On Aug 15, Sherron Watkins , vice president of Corporate Development sent an anonymous letter to Lay (Chairman and CEO), warning about company’s accounting policies.

Lay consulted with other executives, and although they wanted to dismiss Watkins (as Texas legislation did not protect whistleblowers), they decided against it to prevent a lawsuit. On October 15, Vinson & Elkins announced that Enron had done nothing wrong in its accounting practices as Andersen had approved each issue.

In a conference call on April 17, 2001, Skilling verbally attacked growing analysis by wall street analyst and said” Well, thank you very much, we appreciate that asshole”. Such words were hugely criticized by press and the public. As times passed, there were too many serious confrontations on the company. Enron had recently faced several serious operational challenges, namely logistical difficulties in operating a new broadband communications trading unit, and the losses from constructing the power project in India. On August 14, Skilling resigned citing personal reasons. The next day, however, Skilling stated that major reason for his departure was Enron’s falling price in the stock market. On Aug 15, Sherron Watkins , vice president of Corporate Development sent an anonymous letter to Lay (Chairman and CEO), warning about company’s accounting policies.

Lay consulted with other executives, and although they wanted to dismiss Watkins (as Texas legislation did not protect whistleblowers), they decided against it to prevent a lawsuit. On October 15, Vinson & Elkins announced that Enron had done nothing wrong in its accounting practices as Andersen had approved each issue.

Gradual Decline

A large majority of investors lost confidence in Enron. The stock value was falling by end of Aug, 2001. Lay admitted that Enron’s business was complex but never wanted to give away the information analysts needed. The sudden departure of Skilling combined with outbreak of news of Enron’s accounting books made proper assessment difficult for Wall Street. In addition, the company admitted to repeatedly using “related-party transactions,” which some feared could be too easily used to transfer losses that might otherwise appear on Enron’s own balance sheet. The company then started selling its below par assets.

The End

On October 16, 2001, Enron announced to restate the financial statements to resolve the accounting violations made by it. The game changed after restatement. The income was reduced, liabilities increased and value of assets decreased resulting in poor condition of Enron than imagined. The credit rating of the company dropped emphatically. The company was unable to find suitors for buying its business. At last, Dynergy Inc proposed a buyout which also failed due to complications involved in Enron which include $13 billion in debts and billions as hidden debts among its special purpose entities. On Nov 28, 2001, Enron’s rating was downgraded again to junk status.

After Effects of Enron Scandal

The company’s shareholders lost at around $74 billion. More than 20,000 employees filed for compensation arising out of lost pensions, which they really won. Amount of $2 billion was settled among them.

The Birth of SOX

The Sarbanes Oxley Act as we know it today as one of the strong laws to protect investors and developing standards for audit and accounting was made. The Act is a mirror image of result of Enron Scandal. The SOX is a game changer in reality for investor protection and accounting issues.


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