Enron Scandal

Enron Scandal Letter of Transmittal 9th April, 2017 Mohammad Amzad Hossain Assistant Professor School of Business United International University Subject: For the Acceptance of the Term Paper Dear Sir, It is a great pleasure for us to submit this Term Paper, prepared in accordance to the guidelines provided by you, as a requirement of the course “Accounting Information System”. We have tried our best to fulfill the requirements of this paper. By preparing it, we have gained a great deal of knowledge. Therefore, pray and hope that you would be kind enough to accept this term paper and oblige thereby. Sincerely by, Mohammad Aslam …………… Acknowledgement It is a great pleasure for us to express our deep sense of gratitude to our honorable course instructor Mohammad Amzad Hossain. He has given us an opportunity to study, evaluate and prepare the report on “Enron”. This term paper helped us a lot in understanding of how Accounting can have huge impact on a Corporation like Enron. Our honorable course teacher helped us from time to time on different issues regarding the term paper & preparation of it. During the preparation of the term paper we had some problem that had been erased out with his propound lecture and assistance. Without his cooperation and guideline this term paper would have been an incomplete one. We acknowledge his kind cooperation. We also appreciate the unity, spontaneous workability and successful team spirit of our fellow group members/friends. Without cooperation and support from each other, it would not be possible to prepare a resourceful report. We enjoyed preparing the term paper. Objective of the study: To get an idea about the Enron case To increase our analytical ability. Limitations: The first limitation is the lack of intellectual thought and analytical ability to make it the most perfect one. We had to complete the analysis within a time limitation, which restricted our analysis. Method: Different data and information are required to achieve the requirement of this term paper. Those data and information were collected from various sources, such as published articles and online websites etc Table of Contents Contents Items Page No Introduction And Company Profile Discussion 1-4 Findings Shaky structure collapses 5 Enron’s Collapse : The Auditors 7 The Accounting scandal Of Enron 11 Rise of Enron 12 Causes of Downfall 13 Mark to Market Accounting 13 Special Purpose Entities 14 Corporate Governance 14 Executive Compensation 15 Risk Management 15 Financial Audit 15 Ethical And Political Analyses 16 Other Accounting Issues 16 Investors’ Confidence declines 16 Restructuring Losses And SEC Investigation 17 Credit Rating Downgrade 17 Proposed Rating by Dynegy 18-19 Bankruptcy 19 Consequences 20-22 Conclusion And Recommendation 23 References 23 Introduction The term paper is based on the collapse of Enron which is one the largest company whose bankruptcy has raised various questions in United States of America. Before filing for bankruptcy in 2001, Enron Corporation was one of the largest integrated natural gas and electricity companies in the world. It marketed natural gas liquids worldwide and operated one of the largest natural gas transmission systems in the world, totaling more than 36,000 miles. It was also one of the largest independent developers and producers of electricity in the world, serving both industrial and emerging markets. Enron was also a major supplier of solar and wind renewable energy worldwide, managed the largest portfolio of natural gas-related risk management contracts in the world, and was one of the world’s biggest independent oil and gas exploration companies. In North America, Enron was the largest wholesale marketer of natural gas and electricity. Enron pioneered innovative trading products, such as gas futures and weather futures, significantly modernizing the utilities industry. After a surge of growth in the early 1990s, the company ran into difficulties. The magnitude of Enron’s losses was hidden from stockholders. The company folded after a failed merger deal with Dynegy Inc. in 2001 brought to light massive financial finagling. The company had ranked number seven on the Fortune 500, and its failure was the biggest bankruptcy in American history. Company Profile Enron began as Northern Natural Gas Company, organized in Omaha, Nebraska, in 1930 by three other companies. North American Light & Power Company and United Light & Railways Company each held a 35 percent stake in the new enterprise, while Lone Star Gas Corporation owned the remaining 30 percent. The company’s founding came just a few months after the stock market crash of 1929, an inauspicious time to launch a new venture. Several aspects of the Great Depression actually worked in Northern’s favor, however. Consumers initially were not enthusiastic about natural gas as a heating fuel, but its low cost led to its acceptance during tough economic times. High unemployment brought the new company a ready supply of cheap labor to build its pipeline system. In addition, the 24-inch steel pipe, which could transport six times the amount of gas carried by 12-inch cast iron pipe, had just been developed. Northern grew rapidly in the 1930s, doubling its system capacity within two years of its incorporation and bringing the first natural gas supply to the state of Minnesota. Discussion Public Offering in the 1940s The 1940s brought changes in Northern’s regulation and ownership. The Federal Power Commission, created as a result of the Natural Gas Act of 1938, regulated the natural gas industry’s rates and expansion. In 1941, United Light & Railways sold its share of Northern to the public, and in 1942 Lone Star Gas distributed its holdings to its stockholders. North American Light & Power would hold on to its stake until 1947, when it sold its shares to underwriters who then offered the stock to the public. Northern was listed on the New York Stock Exchange that year. In 1944, Northern acquired the gas-gathering and transmission lines of Argus Natural Gas Company. The following year, the Argus properties were consolidated into Peoples Natural Gas Company, a subsidiary of Northern. In 1952, Peoples was dissolved as a subsidiary, its operations henceforth becoming a division of the parent company. Also in 1952, the company set up another subsidiary, Northern Natural Gas Producing Company, to operate its gas leases and wells. Another subsidiary, Northern Plains Natural Gas Company, was established in 1954 and eventually would bring Canadian gas reserves to the continental United States. Through its Peoples division, the parent company acquired a natural gas system in Dubuque, Iowa, from North Central Public Service Company in 1957. In 1964, Council Bluffs Gas Company of Iowa was acquired and merged into the Peoples division. Northern created two more subsidiaries in 1960: Northern Gas Products Company (later Enron Gas Processing Company), for the purpose of building and operating a natural gas extraction plant in Bushton, Kansas; and Northern Propane Gas Company, for retail sales of propane. Northern Natural Gas Producing Company was sold to Mobil Corporation in 1964, but the parent company continued expanding on other fronts. In 1966, it formed Hydrocarbon Transportation Inc. (later Enron Liquids Pipeline Company) to own and operate a pipeline system carrying liquid fuels. Eventually, this system would bring natural gas liquids from plants in the Midwest and Rocky Mountains to upper-Midwest markets, with connections for eastern markets as well. Growth through Acquisitions Northern made several acquisitions in 1967: Protane Corporation, a distributor of propane gas in the eastern United States and the Caribbean; Mineral Industries Inc., a marketer of automobile antifreeze; National Poly Products Inc.; and Viking Plastics of Minnesota. Also in 1967, Northern created Northern Petrochemical Company to manufacture and market industrial and consumer chemical products. The petrochemical company acquired Monsanto Corporation’s polyethylene marketing business in 1969. Northern continued expanding during the 1970s. In February 1970 it acquired Plateau Natural Gas Company, which became part of the Peoples division. In 1971, it bought Olin Corporation’s antifreeze production and marketing business. It set up UPG Inc. in 1973 to transport and market the fuels produced by Northern Gas Products. UPG eventually would handle oil and liquid gas products for other companies as well. In 1976, Northern formed Northern Arctic Gas Company, a partner in the proposed Alaskan arctic gas pipeline, and Northern Liquid Fuels International Ltd., a supply and marketing company. Northern Border Pipeline Company, a partnership of four energy companies with Northern Plains Natural Gas as managing partner, began construction of the eastern segment of the Alaskan pipeline in 1980. This segment, stretching from Ventura, Iowa, to Monchy, Saskatchewan, was completed in 1982. About that time, it became apparent that transporting Alaskan gas to the lower 48 states would be prohibitively expensive. Nevertheless, the pipeline provided an important link between Canadian gas reserves and the continental United States. Northern changed its name to Inter North, Inc. in 1980. That same year, while attempting to grow through acquisitions, Inter North became involved in a takeover battle with Cooper Industries Inc. to acquire Crouse-Hinds Company, a manufacturer of electrical products. Cooper rescued Crouse-Hinds from Inter North’s hostile bid and bought Crouse-Hinds in January 1981. The takeover fight brought a flurry of lawsuits between Inter North and Cooper. The suits were dropped after the acquisition was finalized. While Inter North grew through acquisitions, it also expanded from within. In 1980, it set up Northern Over thrust Pipeline Company and Northern Trailblazer Pipeline Company to participate in the Trailblazer pipeline, which ran from southeastern Nebraska to western Wyoming. Also that year, it created two exploration and production companies, Nortex Gas & Oil Company and Consoled Gas and Oil Limited. The latter company was a Canadian operation. In 1981, Inter North set up Northern Engineering International Company to provide professional engineering services. In 1982, it formed Northern Intrastate Pipeline Company and Northern Coal Pipeline Company as well as Inter North International Inc. (later Enron International) to oversee non-U.S. operations. Inter North significantly expanded its oil and gas exploration and production activity in 1983 with the purchase of Belco Petroleum Corporation for about $770 million. Belco quadrupled Inter North’s gas reserves and added greatly to its crude oil reserves. Exploration efforts focused on the United States, Canada, and Peru. New Markets in the Early 1990s In the early 1990s, Enron appeared to be reaping the benefits of the Inter North-Houston Natural Gas merger. Its revenues, at $16.3 billion in 1985, fell to less than $10 billion in each of the next four years but recovered to $13.1 billion in 1990. Low natural gas prices had been a major cause of the decline. Enron, however, had been able to increase its market share, from 14 percent in 1985 to 18 percent in 1990, with help from efficiencies that resulted from the integration of the two predecessor companies’ operations. Enron also showed significant growth in its liquid fuels business as well as in oil and gas exploration. Beginning with the 1990s, Enron’s stated philosophy was to “get in early, push to open markets, position ourselves to compete, compete hard when the opening comes.” This philosophy was translated into two major sectors: international markets and the newly deregulated gas and electricity markets in the United States. Beginning in 1991, Enron built its first overseas power plant in Teesside, England, which became the largest gas-fired cogeneration plant in the world with 1,875 megawatts. Subsequently, Enron built power plants in industrial and developing nations all over the world: Italy, Turkey, Argentina, China, India, Brazil, Guatemala, Bolivia, Colombia, the Dominican Republic, the Philippines, and others. By 1996, earnings from these projects accounted for 25 percent of total company earnings before interest and taxes. In the United States, states were given the power to deregulate gas and electric utilities in 1994, which meant that residential customers could choose utilities in the same way that they chose their phone carriers. This looked like an enormous opportunity for Enron. CEO Lay was fervently in favor of deregulation, believing it would solve problems for consumers and utilities alike. The company moved into the residential electricity market in 1996, when Enron agreed to acquire Portland General, an Oregon utility whose transmission lines would give the company access to California’s $20-billion market, as well as access to 650,000 customers in Oregon Literature review of Enron Enron is a Houston based energy firm which is founded by Kenneth Lay. In its 16 years lifespan, it becomes the world’s largest energy trading company with approximately 37000 miles of pipeline. It was credited to create market trading in energy. It experienced a meteoric rise and has 22th rank in the fortune’s 100 best companies list in America in 2000. It was the first foreign company to begin construction of a power plant in UK. It had offices around the world including Australia, Japan, South America, and Europe. Enron has three main business units: Wholesale Services: It was allowed customers to sell or buy commodities on their own terms by marketing a number of wholesale commodity products. Energy Services: It was the largest Energy services provider with a total value of $2.1 billion in 2000. It was used to develop and execute energy strategies of various companies. Global Services: It included North American pipeline businesses of Enron transportation services with an international level engineering business. Enron online was the world’s largest e-commerce siting which handle real-time transaction for global commodity. Employees increases from 15076 in 1985 to 18000+ in 2000. Operating countries number increases from 4 to 30+ in 2000. Its assets value increased from $12.1 billion to $33 billion in 2000. It had 14 power projects under construction in 11 countries and 51 power projects in operation in 15 countries in 2000. Findings A Shaky Structure Collapses In 1995, Enron CEO Kenneth Lay promised investors that Enron’s profits would rise by 15 percent a year over the next five years. Yet the pace of growth was not uniformly smooth for Enron. By 1997, only seven states were moving ahead with deregulation of their electricity markets. Enron’s profit from a national deregulated electricity market was potentially huge, and the company spent millions on advertising and lobbying for the cause. It also hired hundreds of top business school graduates to help the company define new markets. The company seemed a potential gold mine if it could successfully open up the electricity market. Meanwhile, some of its earlier projects were going badly. Its huge deal to build a power plant in India, worth $2.8 billion, was held up by embittered local politicians. Other overseas projects also faltered. Earnings had grown annually in the early 1990s by between 16 and 20 percent. The figure shrank to 11 percent for 1995, then to only 1 percent in 1996. In the second quarter of 1997, the company took a $550 million charge, representing losses on the Indian project and others. The company continued to spend heavily to advertise and lobby for deregulation. Enron advanced into the newly deregulated California electricity market in 1998, offering consumers discounts for signing up with the company. Enron’s president, Jeffrey Skilling, predicted a revolution in electricity marketing once deregulation took hold, while admitting that California residents initially would not save much money by switching to Enron. The company was bringing in $4 billion a year from electricity sales in 1998, while predicting it would have ten percent of the $300 billion domestic gas and electric retail market within ten years. Yet in 1999 the company halted its efforts to expand into California and admitted it had been losing $100 million a year in its retail push. But Enron had many other ideas for turning a profit. In 1999, it launched an Internet-based commodities trading service, EnronOnline. Enron traded gas and electricity as well as more exotic futures such as weather. This gave companies whose business was affected by weather, such as home heating companies or golf courses, a hedge against the risk of unfavorable weather. Enron also launched Enron Broadband Services, a unit that traded capacity in telecommunications bandwidth. The company invested some $1.3 billion to build a fiber optic network so that more players would be able to buy and sell bandwidth capacity. The company investigated other e-commerce markets as well, such as trading in airport landing rights. The company had made natural gas into a tradeable commodity in the 1980s, and it was looking to pull off the same trick again in these various other commodities. Wall Street began to take notice, and Enron’s stock, which had languished, began to climb again. It rose 55 percent in 1999, and leapt another 87 percent over 2000. What apparently drew investors to Enron was its aura of getting in on the ground floor of various related industries. It seemed to be a new kind of company, not a blundering old regulation-bound utility but a savvy energy trader. Though new ventures such as broadband trading were not expected to be immediately profitable, Enron supposedly had a sound core business as a gas and electricity wholesaler. In fact, Enron’s core business was floundering. Newsweek (January 21, 2002) estimated that in the late 1990s Enron had lost “about $2 billion on Telecom capacity, $2 billion in water investments, $2 billion in a Brazilian utility, and $1 billion on a controversial electricity plant in India.” An unnamed Enron insider quoted in Business Week (December 17, 2001) put it this way: “You make enough billion-dollar mistakes, and they add up.” Yet investors were not aware of Enron’s troubles. Losses were disguised in elaborate partnerships and joint ventures, keeping them off Enron’s books. Enron’s duplicitous bookkeeping kept the stock price high, even as Enron’s top executives began selling off their own holdings. Enron’s president Jeffrey Skilling abruptly resigned in August 2001, citing only personal reasons. The slowdown in technology and Internet stocks brought Enron’s stock down too, and it had fallen almost by half by the third quarter of 2001. At that point the company announced a loss of $618 million. Shortly thereafter, the company announced that actually it had been misstating its earnings since 1997. While the Securities and Exchange Commission began investigating irregularities at the company, Enron tried to sell out to another Houston energy company, Dynegy. That deal collapsed when the extent of Enron’s losses became clear. In December 2001, Enron filed for bankruptcy, the largest ever by an American company. Enron’s collapse stirred tremendous fallout. Its executives had made millions selling off their Enron shares, while many of its employees lost their retirement savings as the stock hit rock bottom. The accounting firm Arthur Andersen, which had certified Enron’s bookkeeping, was disgraced, especially as revelations surfaced that it had destroyed potentially incriminating documents. The scandal reached into the upper echelons of government as well, as Enron had given liberally to many politicians, including President George W. Bush and Attorney General John Ashcroft. CEO Kenneth Lay resigned in January 2002, while the company faced multiple congressional, criminal, and SEC investigations. The company faced liquidation, with its only valuable asset the network of natural gas pipelines it had started out with in the mid-1980s. Principal Subsidiaries: Enron Engineering and Construction; Enron International Inc.; Enron Renewable Energy Corp.; Enron Ventures Corp.; EOG Resources Inc.; EOTT Energy Partners LP; Florida Gas Transmission Co.; Houston Pipeline Co.; Transwestern Pipeline Co.; Enron Wind Corp.; Louisiana Resources Co.; Northern Border Pipeline Co.; Northern Plains Natural Gas Co.; Northern Transportation & Storage; Linc Corp.; Azurix Corp.; Enron Capital & Trade Resource; Enron Corp. ENRON’S COLLAPSE: THE AUDITORS (Who’s keeping the Accountants Accountable?) After decades in which accountants managed to convince the public of their ability to bless the books of corporate America with virtually no regulatory oversight, there is growing skepticism about whether accountants can continue to police themselves. In a way that no previous accounting scandal has – and there have been plenty of late – the collapse of Enron and the role of its auditor, Arthur Andersen & Company, have galvanized a discussion in the profession, among regulators and within Congress over the future of the industry. Investors, including thousands of Enron’s own employees, poured billions of dollars into Enron as it reported strong profits, only to see their stock dwindle to nearly nothing amid doubts about the reliability of the company’s financial statements. Andersen is now the subject of a Justice Department investigation, numerous Congressional inquiries and lawsuits from shareholders over its stamp of approval on Enron’s books. The firm’s admission last week that it had destroyed documents involving Enron has only intensified speculation about whether Andersen acted improperly in some way ‘This is potentially a seminal breach of C.P.A. standards and ethics,’’ said Representative Jim Leach, Republican of Iowa, a former chairman of the House Banking Committee, referring to certified public accountants. The result is likely to be a careful analysis of both the profession’s standards and the means for enforcing those standards, he said. In recent years, concerns have mounted about whether auditors are truly independent of their clients. Accounting firms have come to rely more on consulting work rather than on traditional audits for their revenues, raising questions about their ability to stand up to clients if improper bookkeeping is suspected. In Enron’s case, consulting work accounted for slightly more than half of the $52 million that Andersen received in fees in 2000. Even more important, though, was the potential income from consulting, according to John C. Coffee Jr., a law professor at Columbia. ‘’Enron was a potential market for $50 million or $100 million in consulting fees,’’ he said. Accountants have always been paid by their clients for their role in reviewing their books, and critics have also argued that auditors are increasingly reluctant to alienate a big client that may contribute a significant portion of its revenue. Andersen has acknowledged that Enron was one of its biggest and most desirable clients, something that would give pause to any auditor thinking about challenging the energy concern. ‘’There’s no way that you could have a client which is that huge and important to you and not be tempted to turn your head away from problems,’’ said Dan L. Goldwasser, a lawyer who often advises accountants. ‘’If the audit partner who’s on the Enron account lost that account, they were history.’’ Many companies also hire former auditors, making the relationships between the accountants and the companies particularly cozy. Enron routinely hired accountants away from Andersen – as well as from other Big Five firms – including the company’s chief accounting officer and its chief financial officer. But critics also say that accountants are far less liable today for mistakes in signing off on a company’s books than they were a decade ago. Suing accountants in both state and federal courts has become increasingly difficult because of new laws governing securities class-action lawsuits, and a Supreme Court decision has made it harder for shareholders and others to sue a company’s auditors, according to Mr. Coffee. ‘’Over the last 10 years, the legal threat that kept auditors honest has been greatly diminished,’’ he said. The industry has managed to beat back most attempts at greater oversight, including a rule proposed by Arthur Levitt while he was chairman of the Securities and Exchange Commission that would have significantly reduced the amount of consulting work a firm could perform for a client it audits. Among the compromises reached was one to require greater disclosure of fees for audit and consulting work. Many industry observers cynically note that however big the scandal, accountants have emerged largely unscathed. Accountants have regulated themselves, largely though an entity called the Public Oversight Board. The board was created in 1977, after Senate hearings debating whether the government should have a more active role in regulation. ‘’There may be questions about the adequacy of the Public Oversight Board, which is an entity that most Americans have never heard of,’’ said Richard C. Breeden, a former S.E.C. chairman. ‘’There certainly have been concerns expressed in the past that it was not adequately funded and did not have the realistic ability to oversee the conduct of audits.’’ To ensure the quality of audits, accountants generally rely on peer reviews conducted by one firm of another. Andersen was recently given a clean bill of health by Deloitte &Touche. ‘’I don’t think we should conclude that peer review doesn’t have any benefits,’’ Mr. Breeden said. ‘’It’s a useful tool, but the question is, is it enough?’’ The S.E.C. is already in discussions with the Big Five and the industry association about how to improve the way accountants regulate themselves, according to a commission spokeswoman. Some members of Congress, including Senator Joseph I. Lieberman, Democrat of Connecticut, are discussing the possibility of greater oversight, in light of disclosures by Andersen. ‘’Should there be more law with regard to Arthur Andersen?’’ Mr. Lieberman asked rhetorically. ‘’Should there be more law and less self-regulation by the industry?’’ Senator Paul Sarbanes, Democrat of Maryland and chairman of the Senate Banking Committee, has scheduled hearings next month on some proposed industry changes. Critics of the accounting industry have long complained of potential conflicts of interest that prevent auditors from being totally independent and calling for increased oversight. Mr. Levitt, for example, has described the current environment as ‘’an opportunity to rethink the way the industry is overseen and the way standards are set.’’ Though the industry has discussed changes to financial reporting, the Enron collapse may point to a lack of compliance with existing rules, according to Lynn Turner, a former chief accountant with the S.E.C. who is now director of the center for quality financial reporting at Colorado State University. The industry may need a new independent body, akin to the regulatory body of the National Association of Securities Dealers or the National Transportation Safety Board, to address problems like Enron. ‘’We’ve got nothing like that in the accounting profession,’’ Mr. Turner said. Many of the big accounting firms declined to comment for this article. The American Institute of Certified Public Accountants, the industry association, has unveiled no specific plans to address concerns about the adequacy of its self-regulation. ‘’We are obviously as concerned as anybody about the fallout from Enron,’’ said a spokesman, noting that the facts surrounding the company’s collapse are not yet known. ‘’We are prepared to make changes where necessary as soon as we could,’’ he said. But many within the industry acknowledge that the problem may be a lack of enforcement of the existing rules. If the rules ‘’are not being enforced sufficiently, the first thing we need to do is figure out what it would take to get them enforced,’’ said Louis Grumet, executive director of the New York State Society of Certified Public Accountants. It is not clear exactly how aggressive the S.E.C. will be in pursuit of change – nor is it clear that any such effort would have more success than past efforts to rein in the powerful industry. Harvey Pitt, the new chairman of the S.E.C., has been criticized for close ties to the accounting industry because he was active in defending the large firms when he was a lawyer in private practice. The two people nominated by the Bush administration to serve as commissioners are also former accounting professionals. The chairman and commissioners are traditionally from the business arena and are governed by rules that prevent any possible conflicts of interest, according to an agency spokeswoman. Just yesterday, the S.E.C. censured KPMG, another of the Big Five accounting firms, for improper professional conduct. The S.E.C. said KPMG had violated the auditor independence rules by having a substantial investment in an AIM mutual fund that it had audited. KPMG consented to the order without admitting or denying the commission’s findings. In addition to Andersen, Deloitte and KMPG the Big Five include PricewaterhouseCoopers and Ernst & Young. Any form of outside regulation would be a challenge to the long-standing practice of accounting firms’ policing themselves. That tradition may not survive the Enron debacle, said Arthur Bowman, the editor of Bowman’s Accounting Report, an industry newsletter. ‘’The profession could lose control of this part of its destiny.’’ The Accounting Scandal of Enron: The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the de facto dissolution of Arthur Andersen, which was one of the five largestaudit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron was cited as the biggest audit failure.Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he developed a staff of executives that, by the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions of dollars in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives not only misled Enron’s board of directors and audit committee on high-risk accounting practices, but also pressured Andersen to ignore the issues. Enron shareholders filed a $40 billion lawsuit after the company’s stock price, which achieved a high of US$90.75 per share in mid-2000, plummeted to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and rival Houston competitor Dynegy offered to purchase the company at a very low price. The deal failed, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron’s $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom’s bankruptcy the next year. Many executives at Enron were indicted for a variety of charges and some were later sentenced to prison. Enron’s auditor, Arthur Andersen, was found guilty in a United States District Court of illegally destroying documents relevant to the SEC investigation which voided its license to audit public companies, effectively closing the business. By the time the ruling was overturned at the U.S. Supreme Court, the company had lost the majority of its customers and had ceased operating. Employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices. As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies.[4] One piece of legislation, the Sarbanes-Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients Rise of Enron: In 1985, Kenneth Lay merged the natural gas pipeline companies of Houston Natural Gas and InterNorth to form Enron. In the early 1990s, he helped to initiate the selling of electricity at market prices, and soon after, the United States Congress approved legislation deregulating the sale of natural gas. The resulting markets made it possible for traders such as Enron to sell energy at higher prices, thereby significantly increasing its revenue. After producers and local governments decried the resultant price volatility and asked for increased regulation, strong lobbying on the part of Enron and others prevented such regulation.As Enron became the largest seller of natural gas in North America by 1992, its trading of gas contracts earned $122 million (before interest and taxes), the second largest contributor to the company’s net income. The November 1999 creation of the Enron Online trading website allowed the company to better manage its contracts trading business. In an attempt to achieve further growth, Enron pursued a diversification strategy. The company owned and operated a variety of assets including gas pipelines, electricity plants, pulp and paper plants, water plants, and broadband services across the globe. The corporation also gained additional revenue by trading contracts for the same array of products and services with which it was involved. Enron’s stock increased from the start of the 1990s until year-end 1998 by 311%, only modestly higher than the average rate of growth in the Standard & Poor 500 index. However, the stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a 10% decrease for the index during the same years. By December 31, 2000, Enron’s stock was priced at $83.13 and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market’s high expectations about its future prospects. In addition, Enron was rated the most innovative large company in America in Fortune’s Most Admired Companies survey. Causes of Downfall Enron’s complex financial statements were confusing to shareholders and analysts. In addition, its complex business model and unethical practices required that the company use accounting limitations to misrepresent earnings and modify the balance sheet to indicate favorable performance. The combination of these issues later resulted in the bankruptcy of the company, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling, Andrew Fastow, and other executives. Lay served as the chairman of the company in its last few years, and approved of the actions of Skilling and Fastow although he did not always inquire about the details. Skilling constantly focused on meeting Wall Street expectations, advocated the use of mark-to-market accounting (accounting based on market value, which was then inflated) and pressured Enron executives to find new ways to hide its debt. Fastow and other executives “created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people could understand them.” Mark-to-market accounting In Enron’s natural gas business, the accounting had been fairly straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, citing that it would represent “true economic value.” Enron became the first non-financial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract was signed, income is estimated as the present value of net future cash flow. Often, the viability of these contracts and their related costs were difficult to estimate. Due to the large discrepancies of attempting to match profits and cash, investors were typically given false or misleading reports. While using the method, income from projects could be recorded, although they might not have ever received the money, and in turn increasing financial earnings on the books. However, in future years, the profits could not be included, so new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor stated, “If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income.” Despite potential pitfalls, the U.S. Securities and Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992. However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections. After several pilot projects, Enron recognized estimated profits of more than $110 million from the deal, even though analysts questioned the technical viability and market demand of the service. When the network failed to work, Blockbuster withdrew from the contract. Enron continued to recognize future profits, even though the deal resulted in a loss. Special purpose entities Enron used special purpose entities—limited partnerships or companies created to fulfill a temporary or specific purpose to fund or manage risks associated with specific assets. The company elected to disclose minimal details on its use of “special purpose entities”. These shell companies were created by a sponsor, but funded by independent equity investors and debt financing. For financial reporting purposes, a series of rules dictate whether a special purpose entity is a separate entity from the sponsor. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt.The special purpose entities were used for more than just circumventing accounting conventions. As a result of one violation, Enron’s balance sheet understated its liabilities and overstated its equity, and its earnings were overstated. Enron disclosed to its shareholders that it had hedged downside risk in its own illiquid investments using special purpose entities. However, investors were oblivious to the fact that the special purpose entities were actually using the company’s own stock and financial guarantees to finance these hedges. This prevented Enron from being protected from the downside risk. Corporate governance On paper, Enron had a model board of directors comprising predominantly of outsiders with significant ownership stakes and a talented audit committee. In its 2000 review of best corporate boards, Chief Executive included Enron among its five best boards. Even with its complex corporate governance and network of intermediaries, Enron was still able to “attract large sums of capital to fund a questionable business model, conceal its true performance through a series of accounting and financing maneuvers, and hype its stock to unsustainable levels.” Executive compensation Although Enron’s compensation and performance management system was designed to retain and reward its most valuable employees, the system contributed to a dysfunctional corporate culture that became obsessed with short-term earnings to maximize bonuses. Employees constantly tried to start deals, often disregarding the quality of cash flow or profits, in order to get a better rating for their performance review. Additionally, accounting results were recorded as soon as possible to keep up with the company’s stock price. This practice helped ensure deal-makers and executives received large cash bonuses and stock options.The company was constantly emphasizing its stock price. Management was compensated extensively using stock options, similar to other U.S. companies. This policy of stock option awards caused management to create expectations of rapid growth in efforts to give the appearance of reported earnings to meet Wall Street’s expectations. Risk management Before its scandal, Enron was lauded for its sophisticated financial risk management tools. Risk management was crucial to Enron not only because of its regulatory environment, but also because of its business plan. Enron established long-term fixed commitments which needed to be hedged to prepare for the invariable fluctuation of future energy prices. Enron’s bankruptcy downfall was attributed to its reckless use of derivatives and special purpose entities. By hedging its risks with special purpose entities which it owned, Enron retained the risks associated with the transactions. This arrangement had Enron implementing hedges with itself. Enron’s aggressive accounting practices were not hidden from the board of directors, as later learned by a Senate subcommittee. The board was informed of the rationale for using the Whitewing, LJM, and Raptor transactions, and after approving them, received status updates on the entities’ operations.The Senate subcommittee argued that had there been a detailed understanding of how the derivatives were organized, the board would have prevented their use. Financial audit Enron’s auditor firm, Arthur Andersen, was accused of applying reckless standards in its audits because of a conflict of interest over the significant consulting fees generated by Enron. During 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees. Enron hired numerous Certified Public Accountants (CPAs) as well as accountants who had worked on developing accounting rules with the Financial Accounting Standards Board (FASB). The accountants searched for new ways to save the company money, including capitalizing on loopholes found in Generally Accepted Accounting Principles (GAAP), the accounting industry’s standards. 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.” Ethical and political analyses Commentators attributed the mismanagement behind Enron’s fall to a variety of ethical and political-economic causes. Ethical explanations centered on executive greed , a lack of corporate social responsibility, situation ethics, and get-it-done business pragmatism. Political-economic explanations cited post-1970s deregulation, and inadequate staff and funding for regulatory oversight. A more libertarian analysis maintained that Enron’s collapse resulted from the company’s reliance on political lobbying, rent-seeking, and the gaming of regulations. Other accounting issues Enron made a habit of booking costs of cancelled projects as assets, with the rationale that no official letter had stated that the project was cancelled. This method was known as “the snowball”, and although it was initially dictated that such practices be used only for projects worth less than $90 million, it was later increased to $200 million. In 1998, when analysts were given a tour of the Enron Energy Services office, they were impressed with how the employees were working so vigorously. In reality, Skilling had moved other employees to the office from other departments (instructing them to pretend to work hard) to create the appearance that the division was larger than it was. This ruse was used several times to fool analysts about the progress of different areas of Enron to help improve the stock price. Investors’ confidence declines Something is rotten with the state of Enron. —The New York Times, Sept 9, 2001. By the end of August 2001, his company’s stock value still falling, Lay named Greg Whalley, president and COO of Enron Wholesale Services and Mark Frevert, to positions in the chairman’s office. Some observers suggested that Enron’s investors were in significant need of reassurance, not only because the company’s business was difficult to understand (even “indecipherable”) but also because it was difficult to properly describe the company in financial statements. One analyst stated “it’s really hard for analysts to determine where [Enron] are making money in a given quarter and where they are losing money.” Lay accepted that Enron’s business was very complex, but asserted that analysts would “never get all the information they want” to satisfy their curiosity. He also explained that the complexity of the business was due largely to tax strategies and position-hedging. Lay’s efforts seemed to meet with limited success; by September 9, one prominent hedge fund manager noted that “[Enron] stock is trading under a cloud.” The sudden departure of Skilling combined with the opacity 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. A particularly troubling aspect of this technique was that several of the “related-party” entities had been or were being controlled by CFO Fastow. Restructuring losses and SEC investigation On October 16, 2001, Enron announced that restatements to its financial statements for years 1997 to 2000 were necessary to correct accounting violations. The restatements for the period reduced earnings by $613 million (or 23% of reported profits during the period), increased liabilities at the end of 2000 by $628 million (6% of reported liabilities and 5.5% of reported equity), and reduced equity at the end of 2000 by $1.2 billion (10% of reported equity). Additionally, in January Jeff Skilling had asserted that the broadband unit alone was worth $35 billion, a claim also mistrusted. An analyst at Standard & Poor’s said, “I don’t think anyone knows what the broadband operation is worth.” Enron’s management team claimed the losses were mostly due to investment losses, along with charges such as about $180 million in money spent restructuring the company’s troubled broadband trading unit. In a statement, Lay revealed, “After a thorough review of our businesses, we have decided to take these charges to clear away issues that have clouded the performance and earnings potential of our core energy businesses.” Some analysts were unnerved. David Fleischer at Goldman Sachs, an analyst termed previously ‘one of the company’s strongest supporters’ asserted that the Enron management “... lost credibility and have to reprove themselve. They need to convince investors these earnings are real, that the company is for real and that growth will be realized.” Credit rating downgrade The main short-term danger to Enron’s survival at the end of October 2001 seemed to be its credit rating. It was reported at the time that Moody’s and Fitch, two of the three biggest credit-rating agencies, had slated Enron for review for possible downgrade. Such a downgrade would force Enron to issue millions of shares of stock to cover loans it had guaranteed, which would decrease the value of existing stock further. On October 29, responding to growing concerns that Enron might have insufficient cash on hand, news spread that Enron was seeking a further $1–2 billion in financing from banks. The next day, as feared, Moody’s lowered Enron’s credit rating from Baa1 to Baa2, two levels above junk status. Standard & Poor’s also lowered Enron’s rating to BBB+, the equivalent of Moody’s rating. Moody’s also warned that it would downgrade Enron’s commercial paper rating, the consequence of which would likely prevent the company from finding the further financing it sought to keep solvent. Proposed buyout by Dynegy Sources claimed that Enron was planning to explain its business practices more fully within the coming days, as a confidence-building gesture. Enron’s stock was now trading at around $7, as investors worried that the company would not be able to find a buyer. After it received a wide spectrum of rejections, Enron management apparently found a buyer when the board of Dynegy, another energy trader based in Houston, voted late at night on November 7 to acquire Enron at a very low price of about $8 billion in stock. Chevron Texaco, which at the time owned about a quarter of Dynegy, agreed to provide Enron with $2.5 billion in cash, specifically $1 billion at first and the rest when the deal was completed. Dynegy would also be required to assume nearly $13 billion of debt, plus any other debt hitherto occluded by the Enron management’s secretive business practices, possibly as much as $10 billion in “hidden” debt. Dynegy and Enron confirmed their deal on November 8, 2001. Bankruptcy Enron’s stock price (former NYSE ticker symbol: ENE) from August 23, 2000 ($90) to January 11, 2002 ($0.12). As a result of the decrease of the stock price, shareholders lost nearly $11 billion. On November 28, 2001, Enron’s two worst-possible outcomes came true: Dynegy Inc. unilaterally disengaged from the proposed acquisition of the company, and Enron’s credit rating was reduced to junk status. Watson later said “At the end, you couldn’t give it [Enron] to me.” The Company had very little cash with which to operate let alone satisfy enormous debts. Its stock price fell to $0.61 at the end of the day’s trading. One editorial observer wrote that “Enron is now shorthand for the perfect financial storm.” Systemic consequences were felt, as Enron’s creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt Enron’s failure indicated the risks of the post-September 11 economy, and encouraged traders to lock in profits where they could. The question now became how to determine the total exposure of the markets and other traders to Enron’s failure. Early calculations estimated $18.7 billion. One adviser stated, “We don’t really know who is out there exposed to Enron’s credit. I'm telling my clients to prepare for the worst." Enron was estimated to have about $23 billion in liabilities from both debt outstanding and guaranteed loans. Citigroup and JP Morgan Chase in particular appeared to have significant amounts to lose with Enron's bankruptcy. Additionally, many of Enron's major assets were pledged to lenders in order to secure loans, causing doubt about what, if anything, unsecured creditors and eventually stockholders might receive in bankruptcy proceedings.[126] Enron's European operations filed for bankruptcy on November 30, 2001. It was the largest bankruptcy in U.S. history (before being surpassed by WorldCom's bankruptcy the next year), and resulted in 4,000 lost jobs. In its accounting work for Enron, Andersen had been sloppy and weak. But that's how Enron had always wanted it. In truth, even as they angrily pointed fingers, the two deserved each other. Bethany McLean and Peter Elkind in The Smartest Guys in the Room. On January 17, 2002 Enron dismissed Arthur Andersen as its auditor, citing its accounting advice and the destruction of documents. Andersen countered that it had already ended its relationship with the company when Enron became bankrupt. Consequences Penalty for the responsible party Andy Fastow, the chief financial officer and his wife Lea both pleaded guilty and so he was sentenced for 10 years. The CEO and chairman Kennneth Lay was convicted for securities and wire fraud and was entitled to 45 years in prison. Skilling was found guilty on nineteen counts out of twenty-eight. He was also convicted for securities and wire fraud. Impact on employees and related parties The collapse had an impact on at least 20000 employees. Shareholders lost at least $74 billion, approximately, four years before the bankruptcy was declared. Pensions worth of almost $2billion was lost in 2004. The day that Enron filed for bankruptcy, the employees were told to pack their belongings and were given 30 minutes to vacate the building.]Nearly 62% of 15,000 employees' savings plans relied on Enron stock that was purchased at $83 in early 2001 and was now practically worthless. Apart from the financial loss, many people lost their stable jobs and security to earn their living. And most importantly the loss of pensions had a bigger impact on people’s future. Enactment of Sarbanes Oxley Act Enactment of an act Sarbanes Oxley Act is a US federal law that was enacted after the Enron Scandal. This consists of a list of standards for the regulation of company boards, management and public accounting firms. The main rules were that the majority of compensation committee and audit committee must consist of independent and financially knowledgeable of the member In early 1980s with the deregulation of the energy sector, Energy Corporation lobbied Washington to deregulate the business. As a result, the US government began to control the energy distribution. Enron saw it as a chance to make money. It decided to act as middleman and guarantee stable price to its customer. Encouraged by deregulation, Enron turned to electricity and tried to buy into the water business and to hedge London weather. In 1990, Enron creating an energy commodities business by offering companies the chance to hedge against the risk of adverse price movements in a range of commodities. It started expanding internationally, moving into water in the UK and power generation in India. In 1989, Enron was trading futures in gas contracts between suppliers and consumers betting against the future price of gas generated energy. In early 2000, with the dot.com boom Enron plan to move into broadband internet networks and trade bandwidth capacity with its stable old-economy energy background. In early 2000, with the dot.com boom Enron plan to move into broadband internet networks and trade bandwidth capacity with its stable old-economy energy background. In early 2000, with the dot.com boom Enron plan to move into broadband internet networks and trade bandwidth capacity with its stable old-economy energy background. Enron had used some powerful accounting techniques so that the price of its share becomes high. These techniques are referred to as aggressive earnings management techniques. It set up independent partnerships. This results in investment money flowing into Enron from new partnerships ended up on the books as profits, even though it was linked to specific ventures that were not yet up and running. It used many manipulative accounting practices especially in transactions with Special Purpose Entities (SPE) to decrease losses, enlarge profits, and keep debt away from its financial statements in order to enhance its credit rating and protect its credibility in the market. It was tried to accomplish favorable financial statement results, not to achieve economic objectives or transfer risk. These practices were generally disclosed investors but this inadequacy may result in conflict of interest to ignoring the fact that its top management was enriching them, which simply represents fraud. Enron’s structured finance transactions were so complex that disclosure becomes useless. That is why investors had to rely on their business judgment of Enron’s management, but it is failed due to conflicts of interests. It clears when it was known that most of the senior executives of Enron served as the SPE’s principals, receiving massive amounts of compensation and returns, in order to skew their loyalty in favor of the SPEs. Enron’s scandal effected both inside and outside accounting profession domestically and globally. This can be explained as below: In Relation to The Exchange: Great care is undertaken in the listing of foreign companies on CASE. It does not allow a company until it conducts due diligence analysis of prospective issuers prior to their listing. Now some regulations enforced to ensure timely and full disclosure of information from issuers by imposing penalties on listed companies that are engaged in fraud or misguide its investors. In Relation to The Regulator: Regulations passed to ban practices to hide losses from investors and report unrealized profits. Capital market regulators (Central Bank as well as CMA) publish a list of auditing firms that are licensed to carry out auditing for listed companies on CASE and exert effort in the regulation on credit rating agencies, their competency and the credibility of the ratings they publish to the market. 3.In Relation to Board of Directors & Management: The Board understand the nature of and strategy behind major transactions, including complex business structures and is willing to challenge whether such transactions are beneficial to the company and make good business sense. It is fully aware of major risks inherent in the business, especially in complex financial instruments and structured financial transactions and monitors the integrity of the financials to ensure transparency and disclosure of the firm’s financial position. Conclusion Performance review committee used individual bonuses and incentives to reward employee performance and it created huge competition between the employees. As it made the employees uncooperative towards each other and made everyone to act self-interested instead of looking for each other. These employees were rated from 1 to 5. Number 1 rating meant that they could be sure of a bonus and a lowest 5 meant that they might get fired any time. Another problem was that these bonuses were based on the closed deals rather than the end results of those deals. Irrespective of the aftermaths of the deals these employees would get their bonuses. These meant that the deals were not successful most of the time. Moreover, since the incentives came in the form of stock options and cash, that encouraged these employees to behave unethically as they were also involved for manipulating the market. Mark to market together with the use of SPEs made Enron look a good in the financial market but most these were just paper money. And hence investors were manipulated as their investments ended up in the wrong company. However, the results of the bad investments compelled these share prices to drop when the news about these investments were leaked. There was no other way because the paper money could no longer finance Enron and it was only a matter of time that the company would actually be in a financial crisis. Recommendations Incentives should be provided only after the closed deals generated profit in the organization otherwise not. Bonuses in stocks should be avoided as these encouraged employees to behave unethically and manipulate the financial market. A proper accounting basis should be applied and the implementation of Sarbanes Oxley Act is vital to avoid such conflict of interest that may end to distorted financial statements. References https://en.wikipedia.org/wiki/Enron https://en.wikipedia.org/wiki/Enron_scandal http://www.nytimes.com/2002/01/15/business/enron-s-collapse-the-auditors-who-s-keeping-the-accountants-accountable.html?pagewanted=all http://www.referenceforbusiness.com/history2/57/Enron-Corporation.html https://www.coastal.edu/media/administration/honorsprogram/pdf/Reddington_Accounting%20&%20Finance.pdf 30 | Page