The Enron Scandal
The Enron Scandal
The Enron Scandal
From the 1990's until the fall of 2001, Enron was famous throughout the business world
and
was known as an innovator, technology powerhouse, and a corporation with no fear. The
sudden fall of Enron in the end of 2001 shattered not just the business world but also the
lives
of their employees and the people who believed that their soar to greatness was
genuine. Their
collapse was followed by a series of revelations on how they manipulated their success.
Introduction
Enron shocked the world from being Americas most innovative company to America's
biggest corporate bankruptcy at its time. At its peak, Enron was America's seventh
largest
corporation. Enron gave the illusion that it was a steady company with good revenue but
that
was not the case, a large part of Enrons profits were made of paper. This was made
possible
by masterfully designed accounting and morally questionable acts by traders and
executives.
Deep debt and surfacing information about hiding losses gave the company big problems
and
in the late 2001 Enron declared bankruptcy under Chapter 11 of the United States
Bankruptcy
Code.
Many factors affected Enron's surge to the top and its sudden fall. In this report we will
discuss and present what we think were the main reasons of their rise and fall.
best universities across America, which gave the company more competence and a big
urge to
strive forward. The strive forward was the same as the aim to increase the stock price.
Enron
employees were partly paid in stocks so increasing the stock price became a main
interest.
Mark-to-market Accounting
In 1990, Jeffery Skilling joined Enron Corporation and in 1997, he was appointed as the
company's Chief Executive Officer. Skilling demanded to change Enron's accounting
system
from a straightforward kind of accounting were Enron had listed actual revenue and costs
of
supplying and selling gas to the mark-to-market accounting system. The mark-to-market
method requires estimations of future incomes when a long-term contract is signed.
These
estimations were based on the future net value of the cash flow, costs related to the
contract
were often hard to predict. This means that the estimated income from projects were
include
in Enron's accounting even though the money was not yet received and if there were any
changes such as additional income or loss it would show up in subsequent periods.
Investors
were given misleading information because of the deviation in the estimations.
Enron was the first non-financial company to use the mark-to-market method. The U.S.
Securities and Exchange Commission gave Enron their approval to use the method on
January
30,1992. (The smartest guy in the room, 2004)
Special Purpose Entity
Special purpose entities are legal entities that are created only to carry out a specific or
temporary task. The purposes are to handle assets either by funding or by risk
management.
A sponsor creates the entities but the funding comes from investors. The financial
reporting
has many rules about if the entity is separated from the sponsor. In Enron's case the
special
purpose entities were not only used to dodge the traditional accounting conventions but
also
so they could hide debts. The entities made it possible for Enron to underestimate, hide,
its
debts and overestimate its equity.
A new strategy
Enron was by 1992 the largest seller of natural gas in North America, their earnings
before
interest and taxes was $122 million. To grow further, Enron followed a differentiation
strategy that were based on that the company owned and operated a variety of assets,
pipelines, broadband services, paper plants, water plants and electricity plants. Enron
did not
only make money on its assets, it also traded actively with contracts of the products and
services it provided, making further revenue. This made Enron a favorite among
investors and
between 1990 and end of 1998 Enron's stock price increased 311%. The increase didn't
stop
there, 1999 it increased 56% and 2000 it increased an additional 87%. The index for the
market the same two years was +20% and -10%. Enron's stock price was 83.13 dollars
and its
market value was just above 60 billion dollars the 31 December of 2000. (The fall of
Enron,
2003)
The Commodity Futures Modernization Act of 2000, which ensured the deregulation of
overthe-counter derivatives, helped Enron with their derivatives business. One example was
during the California electricity crisis (2000-2001) where they manipulated the California
energy market and sent electricity prices surging by at least a factor of eight. During that
time,
the price of natural gas was trading as much as $60 per thousand cubic feet in California
(which was previously selling for about $3 per thousand cubic feet). This kind of
manipulation increased Enron's stock price and revenues. But this not so clever
manipulation
of Enron made itself a political target and accelerated the ruins of their finances.
Enrons collapse
Mark-to-market Accounting
The use of mark-to-market accounting later backfired. The company's aggressive
accounting
had corrupted Enron's books and had allowed the company to be far too optimistic in it's
assumptions about the future profits. Cash is a necessity for any company to run and
Enron
mostly had paper revenue, so by the middle of 2001, they came to the conclusion that
the cash
crisis had struck them.
that
sent the company to bankruptcy.
Andrew Fastow was the Chief Financial Officer of Enron who was the mastermind of the
Special Purpose Entities like LJM1, LJM2, etc. in Enron. He made the complicated financial
structures so that Enron could hide their losses and debts.
Rebecca Mark was the head of the failed businesses of Enron, which were Enron
International
and Azurix. Some of here projects were the $3 billion power plant in Dabhol, India and
the
expensive acquisition of Wessex Water. She also used the Enron Jet with her trips around
the
world. One executive even mentioned that whenever Mark attends a meeting, it costs
the
company at least $60,000 (that would cover just her transportation).
Ofcourse, who could forget the contribution of the Chairman and CEO of Enron, Kenneth
Lay, regarding Enron's bankruptcy. Aside from straying away from the business because
he
was too busy socializing, he and his family misused the company assets. At one point,
they
were all using the company jets for personal travels. He was also involved in conspiracy
and
fraud in the company in order to hide its downfall.
Morally questionable acts were made from both executives and traders. One thing that is
unavoidable is the fact that employees at Enron were partially paid in stocks which
motivated
the workers to take actions that were unethical in order to raise the stock price and
equivalently their own money. As seen in the California case traders manipulated the
market
in favor of the company.
Enron culture was heavily influenced by competition and since the employees were
motivated
by fat bonuses and scared of getting laid off if they did not perform well, and in effect
resulted to an unhealthy competition between the co-workers. The colleagues would
rathe
stab each other in the back than help one another to close a deal. Employees getting
paid in
stock did not help, neither the working environment nor the competition among
colleagues.
The working environment at Enron became unbearable and from an outsider 's point of
view,
you can see that it is not impossible that illegal and immoral things were done.
Incentives
such as money are always strong, we think that there is a higher probability that the
greed will
take over and people would do anything if the price is right.
Mark-to-market accounting mixed with the use of SPEs made Enron look financially
healthy
when it actually was bleeding, bleeding severely. Misleading information was given to the
investors due to the accounting system, which eventually lead to decreasing stock price
when
the information about this started to surface. We think this was just a matter of time
rather
than a question about if they would get away with it. Sooner or later more and more of
the bad
investments had to be questioned because of its great sizes and also because at some
time it
hade to show that there were short of real cash in the company.
We think the downfall of Enron was caused by several factors. Among many are the
topics
we have chosen to present in this paper, the mark-to-market method, the competitive
working
environment and the use of special purpose entities. Not to forget is the importance of
the
people behind this, Lay, Skilling, Fastow and Mark. The Enron scandal is not only a story
about complex accounting it is also a story about the people who made it possible.
People that
made decisions affecting not only themselves or the 21.000 employees at Enron but also
America as a whole.
Recommendations
Incentives must be paid after a project is done or at least when the company is really
profiting from that certain project.
Operational risk should be minimized and there should be some sort of
check up.
Careful selection of accounting approach and financial structures to use.
Minimized payment in stocks.