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Enron was believed to be one of the leading, innovative corporations of the world. The company that received the “America’s Most Innovative Company” award for six years in a row by Fortune magazine saw a sudden fall in 2001 and shocked the entire industry. The fall of the giant corporation did not only affect the industry but also shattered the dreams of the employees and stockholders of the company who had been bedazzled by the great profits.
The factors behind the fall of this huge corporations were never identified before the fall, the abrupt fall disclosed the hidden secrets, bad management and the failed audit that led the company from the top to pieces.
The audit scandal of Enron was uncovered and publicized by the end 2001 resulting in the bankruptcy of the corporation. Along with that, one of the five largest audit firms in the world, Arthur Andersen was also dissolved, as the case of Enron was the biggest proven failure of audit and accountancy. The following image shows the summary of the fall and the aftermaths of the scandal to the main players and most importantly to the investors and employees:
Figure 1: Summary Of Scandal,
Enron was established in 1985 as a successful merger of Houston Natural Gas and InterNorth by Kenneth Lay the founding member. The corporation saw the dramatic fall as they published false numbers for profits and covered the loopholes falsely, the millions of debts were kept hidden from the top management and shareholders until it all came down to ashes. The case of Enron is a case study for accountancy frauds as it shows how a huge and successful company fail due to the lack of accuracy in their financial records.
The accountancy frauds are classified as the following infographic shows:
Figure 3 Accounting Frauds,
The accounting system frauds have definite red flags and the audit firm especially internal auditors can mostly catch the discrepancies and gaps according to these basic classifications very easily. However in case of Enron several red flags were ignored and bypassed by a much- acclaimed audit firm, Arthur Anderson.
The following paper will discuss a brief history, management practices, bad audit and accounting practices involved and the events leading to the bankruptcy.
History of Enron
Enron was established in 1985 from a natural gas pipeline company that was formed in 1930 and until 1960 was engaged in domestic operations for natural gas pipeline only. By late nineties, the company started to explore other verticals of the industry and started its global operations during 1990s. The expansion of the company not only focused on the fixed energy assets but also expanded into communication, risk management and financial services verticals.
Enron was recognized as one of the leading innovative companies of that era as the management expanded its operations in high opportunity verticals. The company transformed from a domestic energy company into a global services’ and commodities’ corporation while tapping high yield lesser regulated or deregulated markets to make enormous profits. The strategies of the expansion seemed promising and timely as the market capitalization report for Enron rose from $2 billion in mid-80s to $70 billion in 2001.
The following chart shows the stock rates for the company showing a peak in 2001 and a sudden fall right after that as shown below:
Figure 2 Enron Share Prices,
Until 2000, the company was ranked 7th in the fortune 500 list and reported $101 billion as consolidated revenue for 2000, with 58,920 shareholders as of 2001. As the above chart shows, Enron’s stock prices rose exponentially in 2000 and reached a peak at US$ 90/share by mid-2000. The projections made the shareholders hopeful for even greater returns by the end of the year .However, the shareholders lost almost US$ 11 billion as the share price took a downward slope by mid-2001 and crashed below US$ 1.
The entire country was shocked, and this acted as a red flag for US SEC to begin investigations on the company. During that same time, Dynegy announced to purchase the company at a fire sale price. Though the deal didn’t go through and in December 2001 Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code, and showed corporate assets worth $63.4 billion at the time of bankruptcy.
The Enron Management
The founding member of Enron Kenneth Lay was known to have close connections in the government and especially with the Bush family. During 1990s when deregulation of sale of natural gas and energy were under discussion in congress, he was a key spokesman and an initiator of selling electricity to the free market. His strong ties and market foresight provided Enron the opportunity to trade energy in the free market on great returns. This was the start of the expansion of the company into various other trading verticals, and the company made several huge investments to earn huge profits.
During this period when market and regulations looked promising Kenneth Lay consulted McKinsey & Co. for strategizing new business dimensions for the company. Jeffery Skilling was a consultant with McKinsey & Co., who was assigned to this project, had experience in asset and liability management. He gave innovative ideas to setup network of consumers and suppliers to trade the energy within the network, which is now recognized as the energy derivative and Enron earned not only great returns but also created new product and a new vertical. In 1990, Enron established a division Enron finance Corp and hired Jeffery Skilling to manage it. This division obtained great profits for the company and in a short period, dominated the prime vertical of natural gas operations for Enron with more customers and contracts for future.
The Transformed Enron Culture
As Skilling took over the culture of the company also transformed into a more competitive and aggressive environment, the new executives were offered high compensation with perks such as concierge services and a company gym. Skilling initiated employee assessment program through performance review committee (PRC) that only measured any employee’s performance based on the profits made and deals completed. Soon the only value employee and the management had was to make deals and add profit.
Jeffery Skilling hired Andrew Fastow, an expert on leveraged buyouts from Continental Illinois Bank in Chicago had the same vision as Skilling and made his way quickly to the position of CFO in 1998.
During their reign Enron’s stock prices rose by 311% that was significantly high as compared to any other growth rate index. As the price for the stock rose the market capitalization reached US$ 60 billion, revenue increased by 70 time and six times the book value corresponding to the aggressive plans of the company for launching new business verticals and the generally high expectations of the future. At this stage, Enron was rated as the most innovative company in a survey of the most admired American companies.
The Accounting System Of Enron
Jeffery Skilling, who joined the company in 1990 and was titled CEO in 1997 due to his strategies for the business. Skilling made tremendous changes to the accounting system of the company.
Enron had a simple accounting procedure of listing actual price, cost and earned revenue of selling gas to the market; the new CEO changed this procedure to the mark-to-the-market accounting system. The mark-to-the-market accounting practice involves future estimations of the income especially for long term contracts. These predictions were projected on the basis of estimated future net cash flow and estimated costs that were hard to estimate beforehand. This lack of accuracy in estimations created a false picture for the investors and shareholders as the estimated income were showing in the system before the payments were actually made. Additionally, any additional costs or profits were not realized timely and were shown in the following period. Thus, the accounting system view of the company had no accuracy on the profit and loss of the company in any given period.
These gaps became apparent to Jeffery Skilling quickly and he along with Andrew Fastow misused a special accountancy practice of “Special Entities” that is normally used for a small period of time to manage assets through temporary funding.
However, the management of Enron knowingly used special entities to fill in the gaps of the accounting system and to cover the huge debts and falsely estimated its equity on higher values. This might have worked if it was only temporary however the management made it a practice until it all went down.
Fastow took SPEs to high complexity and created multiple SPEs to hide losses and formulate the unrealistic profits. The SPEs created and recorded didn’t even satisfied the conditions required by SPEs and were not independent of Enron or belonged to any investor or other outside source, in fact these SPEs were controlled by the company employees.
As the business grew, accounting became complicated and the management made it a practice to use SPE cover failing or devaluing assets and facilities, unsuccessful operations. Keeping them under SPEs kept them out of the books and thus stayed hidden from the auditors and investors. Transferring these assets to SPEs meant their losses would be kept off Enron’s books.
When this practice was uncovered, the stock prices of the company started downgrading instantly.
The Role of Auditor
Arthur Anderson was one of the leading firms in the audit and accountancy profession. Arthur Anderson engaged with Enron for their internal and external auditing as well as for accounting consulting servicing since 1986 and were in contract till the end.
According to the publically available records there were complaints raised against the internal auditors at several instances but the cases were resolved and settled somehow. David Duncan was a key player from the audit firm worked as Andersen’s global engagement partner, responsible for the internal audits. His responsibilities included formation, supervision and analysis of audit procedures to assess and timely inform the management to take the right actions to fix the problem areas.
When the news of accountancy frauds was publicized the auditing firm also faced controversies and the initial partnership ended.
The investigation reports suggested that the irresponsible attitude of the auditing firm might be a case of conflict of interests as the firm Arthur Anderson had two roles with Enron as their consultant as well as auditor. The auditing firm not only bypassed the cooked books but was found involved in the fabrication of the complicated financial structures and transactions to cover the bad debts and losses and lead to the deception of accounts. The auditing firm had given accredited certifications for the financial statements of the company guaranteeing that these statements had been in accordance to the GAAP principles however that was not the case and an experience firm like Arthur Anderson could not have missed that.
However, as the investigations later showed Duncan lacked the required skepticism and irresponsibly hid the fact that the management of Enron recklessly rejected the recommendations from audit committee on several cases. Moreover, the investigations later also proved that the financial statements were not in compliance with GAAS and clearly lacked the true financial standing of the company.
Duncan was alleged of ignoring important loop holes in the financial statements and releasing unqualified opinions on the 1998-2000 audits violating section 10(b) and even further, Rule 10b- 5 of the Exchange Act.
During the trials, the firm was charged with shrouding important financial documents regarding the audits that showed the cooked books of Enron and could have been important evidence for the investigations.
Even though only a few people from the audit firm were involved in the Enron scandal who were fired and even lost their CPA license, the firm lost more than just the reputation. Majority of the top clients as well as the most talented employees left the company. The huge firm ended up closing down some offices and settling as a small LLC even though the charges were dropped against them.
The Fall Of Enron
In 2001 as Lay retired Skilling was titled the new CEO of Enron. The future prospects of the company looked promising, as several new ventures and deals were in process in various verticals, Skilling proudly announced his predictions that the stock value will rise from US$ 80 to US$ 126 in near future.
However, the risky deals and investments Enron had made, especially in the Dotcom industry turned out to be bogus and the result was a steep decline in the stock prices and gradual but persistent exit of several members of senior management who had earned well in the company. Just six months after being titled CEO, Skilling resigned from the title.
The actual whistle blower for the scandal was, Sherron Watkins the VP of Enron who wrote an internal memo to Lay and discussed her suspicions about the SPEs managed by Fastow and the lack of information about it that could lead to accounting fraud. Lay notified the attorneys and audit firm. This led to the investigations against the accounting and audit issues of Enron.
The result of these initial investigation led to the restatement of financial records by the company and the company announced a loss publically. The following table shows the actual and cooked figures:
Several experts believe that even though the fall of Enron is a result of irresponsible and unethical leadership from the management. The company expanded into diversified verticals very quickly and without proper research and the management tried to hide their failing operations through accounting frauds. However, the year 2001-2002 were the worst years for the financial industry throughout the US. Several industries got hit badly due to the crashing economy and banking system, Dotcom being the hot favorite then was among them. Enron like many other bankrupt companies of that era invested heavily in the Dotcom bubble, believing that the returns will be great. However, the bubble busted and Enron could not survive the blow as it had been affected by the failed ventures in other industries too.
On one hand the case of Enron highlights the need of thorough research and prospecting while expanding into newer markets and industries, it also emphasizes the need of transparent and accurate financial reporting.
Enron’s management portrayed unethical leadership by only concentrating on the revenues and disregarding morality, the same was expected from the employees to generate the profits on the cost of moral values. The employees were more loyal to their earnings as compared to the success of the company.
The misleading financial position reporting affected the trustees and the investors especially the shareholders as the fall of prices came abrupt and kept declining. This fall of share prices also works as a lesson to the investors for future precautions while selecting and investing into a venture to thoroughly research about a company and industry to fully understand the possible outcomes. If it appears to be too good to be true, there often is something misleading. The financial and dotcom market were bloated at that time and several investors lost millions due to lack on insight into the situation.
For any corporation that is expanding into various domains, the management needs to be more vigilant and skeptic even at the highest level to gain true insight into the financial health of the company. Though the economic crisis affected several companies, however if the financial records were kept accurate and the operations were in control Enron too could have survived the hit. The top and middle management were more interested in earning profits than to build a long term rewarding strategy for a stable company, disregarding the loss employees, shareholders and investors had to face due to the sinking of this ship.
Bibliography
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