Table of contents
2. The Enron scandal
2.1 Business and accounting practices
2.2 Corporate governance
2.3 Involved parties
2.4 The downfall of Enron
3. Arthur Andersen as auditor
4. Prevention of the scandal
5.1 Enron and Andersen
5.2 Sarbanes-Oxley Act
In 1985, Enron Corporation came into existence by way of a merger of InterNorth and Houston Natural Gas. Having started as a natural gas pipeline company, Enron rapidly grew and entered into new business sectors. Around the 90s, Enron was primarily realizing its profits by trading gas contracts as well as later on - during the rise of the internet, by means of an online trading platform.
In the beginning of 2001, Enron was the seventh largest publicly listed company in the United States of America and its stock was priced around $100. Few month later, the same stock was worth only a few pennies leaving investors, shareholders, employees and the public confused and shocked (Beasley et al, 2009, pp. 75-77).
This term paper discusses the scandal of Enron Corporation. In the first part, main reasons having led to its sudden and scandalous downfall will be explained; in particular accounting and business practices as well as corporate governance will be outlined.
Subsequently, in the second part, important parties having been involved will be shown; notably the role of the auditing company Arthur Andersen and their conduct will be analyzed.
In a final step, aftermaths for Enron, Arthur Andersen and further involved actors will be outlined. A special focus will be on consequences for the accounting world and how regulations have been changed in order to prevent future accounting violations.
2. The Enron scandal
The scandal of Enron Corporation is often referred to as the ‘Enron scandal’. Until 2001 it was the largest bankruptcy in the United States. Causes for its sudden downfall will be outlined in the following section by explaining questionable practices conducted by Enron as well as failed corporate governance.
2.1 Business and accounting practices
On the one hand, Enron established ‘special purpose entities’ (SPE) serving different kinds of needs. The main idea behind those entities was to dispose less productive assets and debt of Enron’s balance sheet; thereby, record less liabilities, higher profits and create cash flows as well as to increase the stock’s value (Johnstone, Grämling & Rittenberg, 2014, pp. 42-43).
Even though a whole network of SPEs was established - and evidently also controlled, by Enron, they did not have to appear on its balance sheet due to the simple fact that there was no accounting standard requiring consolidation in 2001. A company was said to be an independent entity if at least three percent of the capital was provided by external investors. Enron created a group named ‘Friends of Enron’ consisting of several investors, chiefly close related to Enron’s executive employees. For example, a friend of CFO Fastow’s family was one Friend of Enron. When a new entity was to be established one of the Friends provided the necessary three percent outside capital. Later on, Fastow even created a private equity fund for similar purposes (McLean & Elkind, 2003, pp. 166; 197).
By using special pulpose entities, such as Chewco, Whitewing or LJM2, naming the most prominent ones, Enron took advantage of accounting rules (Beasley et al., 2009, 79-82). Two examples of how Enron availed itself of the SPEs will be explained in the following.
Firstly, Enron used the method of securitization to a great extent. Securitization is a way to receive future cash flows immediately. If, for example, Enron owns an asset which is supposed to generate cash flows each month or each year, they would sell these future cash flows (at a discount) to special pulpose entities or other investors. In return, Enron receives money it would have gotten in the future today (Conerly, 2008). The advantage of securitization is that the company will get a lot of cash on a short-term basis; the disadvantage is that debt has not disappeared and is still to be repaid. Securitization itself is not illegal but Enron estimated its assets at sanguine values and used this method to the point of having nearly every asset securitized. An Enron employee once said: “Enron borrowed from the future until there was nothing left to borrow” (McLean & Elkind, 2003, p. 158).
Secondly, Enron established a Global Finance department with the single task to create cash flows. Global Finance came up with the idea of prepays. Prepays worked in a way that Enron signed a contract with one of their SPEs setting forth a certain amount of gas or electricity Enron is supposed to deliver to that entity in the future. This entity would pay Enron up front with money it received from its lender. The lender himself had a contract with Enron as well: he should also deliver gas to Enron, and Enron would pay for it. Without the lender’s delivery the whole transaction will rather classify as a loan. For these transactions, Enron never recognized any loan but instead a trading liability. In contrast to securitization, it was not a legal transaction; that is the reason why Enron tried to keep them a secret (McLean & Elkind, 2003, pp. 158-160).
On the other hand, Enron also adopted an uncommon accounting method called mark-to-market accounting. The mark-to-market method is a legal way allowing to recognize future returns from an asset at current market prices. If there is no active market stating a price companies are allowed to develop their own models helping to estimate the fair value. Companies are allowed to recognize the whole future profit at time of signing the contract and need to adjust this value regularly for profits or losses. Enron used this method for its long-term deals in order to recognize future profits immediately (Norris & Eichenwald, 2002).
For example, Enron did recognize revenue from a long-term project with Blockbuster under mark- to-market accounting. The estimated future profit was recognized immediately and even when the contract with Blockbuster was terminated a few month later Enron did not recognized a loss (McLean & Elkind, 2003, pp. 296-98). To keep the mark-to-market accounting method going, new projects had to be concluded to keep the same (or even higher) amounts of revenues - a vicious circle. Once started it is difficult to drop out.
2.2 Corporate governance
The task of the board of directors is to oversee the company’s activities and thereby maximize its value. Further, it has to fulfill three specific functions: have expertized members, ensure the company does not breach any law and that information given to external are accurate as well as to evolve a business plan. However, not complying with these requirements has led to Enron’s corporate failure. The involvement of the board and its wrong-doing will be explained in the following.
On the one hand, Enron’s board at least partially achieved these requirements. It consisted of several well expertized and experienced individuals from business, legal and political areas. However, financial structures of Enron were greatly complex and difficult to understand for external. Even if they had tried to understand the structures they would have probably gotten confused.
Further reasons why the board did not discover any inconsistencies in the firm’s statements will be outlined at this point.
Firstly, the board was heavily deceived by management, in particular by Skilling and Lay. They did not have full access to information and those information they received were falsified or incomplete.
Secondly, members of Enron’s board were not independent since a lot of the directors found themselves in a conflict of interest as they also provided capital for special pulpose entities or peculiar donations have been made to chiefly related companies. For example, one of the director was also chairman at a cancer center and Enron started to pay for this particular center since then (Gopinath, 2002).
Thirdly, corporate governance mies in 2001 existed but their outcome did not correspond to the intention of their creators. By using the example of Enron’s audit committee which was a subcommittee of the board the problem of the existing mies becomes obvious: Members of the committee had also been paid with stock. This conduct might have encouraged them to help cover up discrepancies in financial statements since an increasing stock value was also profitable for them (bavelle, 2002; Byrne, 2002).
On the other hand, Enron had a tough and aggressive corporate culture. Each decision was based on how to raise the stock’s price; norms and ethical values were neglected.
For instance, a remuneration and evaluation system was established which allowed to assess employees’ perfomiance. Their overall performance and commitment for Enron was scaled into a ranking from 1 to 5. With 1 being the lowest category the respective employee risked being fired if performance does not improve in the close future. Moreover, good performance was compensated with stock and employees were also heavily encouraged to invest cash-based compensation in stock.
In addition, corporate culture was based on mistrust. Management purposely kept division separate and independent from each other in order to increase competition and achieve better results. Further, nobody was able to get a big picture of Enron and understand its complex structures (Comford, 2004).
2.3 Involved parties
Apparently, the responsibility and the execution of these accounting and business practices can be traced back to several people. Involved parties and their functions will be listed in the following.
Firstly, Kenneth Lay as Enron’s chairman and Jeff Skilling as CEO. Both were focused primarily on increasing the stock’s value as well as fulfilling Wall Street’s expectations. Neither of them cared about lying to investors, shareholders, employees or other stakeholder. Both Lay and Skilling were heavily involved in the scandal and one might even accuse them of having been the ones pulling the strings.
Secondly, the accountants and Global Finance team at Enron committing the actual accounting practices and fraud. Most important persons to name are Andy Fastow and Michael Kopper. Fastow was Enron’s chief financial officer since 1998 coordinating the Global Finance department. He is often referred to as the head behind the accounting. He did also come up with the idea of special pulpose entities, helped to establish them, provided his own capital for foundation and some of the SPE - such as LJM1 and 2, were also managed by him. Fastow took out a lot of money from this partnerships for personal gain. Kopper was employed for Enron since 1994 as Fastow’s deputy. He also invested in several partnerships as well as managed some SPEs. However, some even considered him to be more intelligent than Fastow and coming up with the actual ideas. Thus, Kopper and Fastow were able to persuade the other accountants to consider their methods as appropriate and to apply them (McLean & Elkin, 2003, 152-154; 161).
Thirdly, another big party contributing to the scandal were lawyers signing off Enron’s (partially illegal) contracts. Enron’s law firm was in particular Vinson & Elkins. It was an advantageous relation since V&E was in a conflict of interest: Enron was its largest client and if they had resisted to sign off some contracts they would have probably lost their biggest and most profitable client (The New York Times, 2002; McLean & Elkin, 2003, pp. 357-358).
Moreover, credit rating agencies - like Moody’s Analytics or Standard & Poors, knew a lot about Enron’s practices - particularly about their off-balance sheet debt, the fact that the final obligation of SPEs belonged to Enron and that it was actually their debt. The rating agencies had access to more documents than e.g. investors but they failed to see the big picture of Enron. In addition, the agencies got dazzled by the common sense perception of Enron being a great company (McLean &Elkind, 2003, 235-239).
Besides, the role of investors should not be underestimated. McLean and Elkind (2003) refer to a clear example of how investors knew about Enron’s accounting practices but did not care in order to keep making money with them: As we have seen before, Enron needed external investors for prepays.
The most prominent ones were two banks, Citigroup and Chase Manhattan. They kept providing capital as lenders to special purpose entities. Surely, they have known about the accounting practices of Enron since they signed exclusive contracts with insurance companies providing security in case Enron would not be able to pay (McLean & Elkind, 2003, pp. 159-160).
- Quote paper
- Milena Luke (Author), 2016, The Enron Scandal. Main Reasons for the Downfall of the Company, Munich, GRIN Verlag, https://www.grin.com/document/445639