Enron Corp.
The Fall of a Wall Street Darling
Group 5
Brandon Hall
Joseph Gasparini
Andrew Beamon
Matthew Pugh
--- Internal Audit, Fay ----- February 20 2013 ---
Group 5, Enron Corp.
Enron is a unique case in regards to fraud. The accounting complexities that were
created are still being investigated today. Many individuals were involved and lives
were completely ruined.
Key Individuals Involved
Kenneth Lay founded Enron in 1985 with the merger of Houston Natural Gas and
InterNorth. Mr. Lay retired the February before Enron entered its free-fall which left the
company Bankrupt. Mr. Lay was convicted of six counts of security fraud which could
have led to 45 years in prison, however he died in 2006 before his sentencing.
Jeffrey Skilling stepped into the CEO position after Mr. Lay retired. Mr. Skilling stepped
down later that year due to “personal reasons.” He was convicted of 19 counts of
securities fraud and sentenced to 24 years in prison. His trials are still occurring today.
Andrew Fastow is considered the mastermind of the fraud. He was the CFO of Enron
and was responsible for creating a network of special purpose entities (SPE). He was
convicted of 98 counts of fraud, money laundering, and conspiracy and he was
sentenced to ten years in prison with no parole. He is currently working for the law firm
that defended him as a “documents revision clerk” and he travels the country giving
speeches to college students about business ethics.
Accounting Practices
Skilling advocated the use of market-to-market accounting. He had devised a way to
hide any financial losses or Enron’s operations or businesses. Market-to-market
accounting is generally used for securities, but not for business assets. The accounting
method allows you to determine what the actual value of the security is at the given
moment. Enron would purchase an asset, and then immediately claim the projected
profits on its books when the asset hadn’t yet earned even a penny. This allowed Enron
to inflate revenue and seem extremely profitable. If the revenue of the asset turned out
to be less than the projected amount, they would write the asset off to a SPE. Basically
Enron would write off any loss without it affecting the bottom line. Enron essentially
made the company appear much more profitable than it really was.
Concealing the Fraud
Enron’s fraud was concealed through a sophisticated system of SPE’s. SPE’s are
business entities created to fulfill a specific purpose, in the case of Enron they were
formed for the construction of gas pipelines or handling a group of accounts receivable.
Enron used these SPE’s to shield itself from losses from its aggressive accounting
practices. The accounting practice they used was called mark-to-market or fair value
accounting. Enron manipulated this accounting practice by transferring the losses from
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Group 5, Enron Corp.
investments to its SPE’s to prevent Enron from a loss on the fair value. These SPE’s were
used to manage the risk and because they’re a pass through entity they have lower taxes,
lower financing costs and they have off-balance sheet financing which can outweigh the
cost of establishing the SPE. Lastly Enron took advantage of the confusing language in
GAAP to find loopholes and prepare financial statements which even the most
sophisticated investor could not understand.
Detecting the Fraud
The fraud at Enron was detected in early 2001 when a Fortune 500 writer took a look at
the 10-K for Enron and saw that they had a stock price that was way higher than
earnings and was a bit odd. After further investigation into the report it cited strange
transactions and a huge amount of debt that was concealed into its subsidiaries and an
irregular cash flow. After these findings the writer called Enron to discuss, and was told
that she did not know the company and that they didn’t want others to know exactly
where they were making the money at.
This prompted a financial statement restructuring and it caused assets and liabilities to
be adjusted and showed massive amounts of debt and assets that were not worth nearly
as much as stated. The final straw that showed that there was massive accounting fraud
was when the company was for sale and the sales price was cut in half which then lead to
Enron filing bankruptcy. It was also discovered that Arthur Andersen had been
committing massive accounting cover-ups for Enron and it was the end of their
company as well.
Fraud Prevention Possibilities
Enron could have been prevented or avoided in many ways. First off, the former
accounting firm, Arthur Andersen should not have been allowed to be their auditor and
their immediate right hand consultant because we know today that in external auditing,
that is a conflict of interest most of the time. Second, Enron had too many Board of
Directors of which were involved within the company and so there was lack of attention
to anything that was going on or there was an overlook to detail within the financials.
The lack of truthfulness through their management and overall financial health of the
company was just horrible and so that’s why there needed to be professional skepticism
examined from both the internal and external auditors. The Board of Directors was also
not paying attention to the nature and actual income or cash that these off-the-book
entities were supposed to have. This caused Enron’s books to look amazing when
overall, they were in a bad financial position and nobody even cared or looked close
enough to see it. There needed to be more pressure on the Board of Directors and the
CEO who was on that board in being responsible for signing off on different statements
and actually knowing what they are signing off on so that this crisis could have been
avoided. The problem was that all of these members and upper management was seeing
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Group 5, Enron Corp.
the stock price raise up and up and shareholders getting richer, so they in fact were
getting bonuses and compensation packages and no one cared to look into anything.
Enron could have been prevented if there were more disclosure requirements as well
explaining exactly what some of the accounts entailed and how they were calculated.
This would give both the SEC and the shareholders a better understanding and so there
would be less of a chance for this to occur again and would be harder to cheat the system
and fake your financials. In all, if Sarbanes Oxley Act was in place during Enron scandal,
there would have been a much less impact and significantly less chance that these
fictitious financial statements would have succeeded so long.
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