The Enron Scandal
GROUP 2 AA 3101 MW 7:30-9:00 PM
Group 5
Alvizo, Althea A.
Balagtas, Francis Ysabella S.
Geverola, Krystyll Corine R.
Gimenez, Zaira Andrealee M.
Lim, Jude Gabriel S.
Roman, Arielle H.
Sabayday, Den Marie O.
Sumalinog, John Francis F.
SUMMARY
Enron Corporation, located in Houston, Texas, was an American
energy company founded in 1985 when Houston Natural Gas and
InterNorth merged. Enron's business plan expanded over time in order
to maximize profits. The company was praised for its innovative
business approach, with Fortune magazine naming it "America's Most
Innovative Company" every year from 1996 to 2001. The
corporation's shareholders launched a $40 billion lawsuit when it was
revealed that Enron had been engaging in accounting fraud, disguising
billions of dollars in debt through various accounting loopholes. By the end of November 2001, Enron's
shares had fallen to less than $1 per share. Enron then declared bankruptcy on December 2, 2001.
In 1992, Jeff Skilling advised a new accounting technique which is the Market to Market
(MTM) Technique, by which it can adjust the value of an asset on the balance sheet from its historical
cost up to the fair value and capture the difference as a revenue. Surprisingly, the company was able to
get the approval of the Securities and Exchange Commision (SEC). The MTM accounting technique
adopted results to inflation of the estimated profits and misled numerous investors. Another deal made
by Enron was with Blockbuster in 2000. The deal was that Blockbuster will stream movies online while
Enron will provide the internet service, but Enron took the profits from the contracts that they expect to
make in the future and recorded it as a revenue in 2000 which resulted in inflating the revenue. By the
end of 2001, the investor confidence in Enron had started to decline and reported its first quarterly loss
on October 6. Shortly after, the SEC announced that they will be opening an investigation into Enron
and its SPV’s. Lastly, after Dynegy backed out from the merger with Enron, Enron filed for bankruptcy.
Many of the executives were eventually charged. Kenneth Lay, the former CEO of the company,
was convicted on six charges of fraud and conspiracy, as well as four counts of bank fraud, but died
before he could be sentenced. The fall of Enron caused President Bush to sign the Sarbanes-Oxley Act,
which is intended to safeguard investors from corporate malfeasance. Enron's bankruptcy was also the
largest in US financial history at the time.
When subjective data is provided at the end of an audit, it may provide false information to
investors, managers, and regulators of such organizations. As a result, there is a significant demand for
auditing information to show the present operation of the firm while avoiding being subjective in
character, as this information is depended upon. Due to the fact that this information is depended upon
by a large number of people, there is a huge need for auditing information to show the present
functioning of the firm while avoiding being subjective in character. Accountants are frequently hired
to conduct audits for businesses. These accountants may be skilled in their field, yet they might conduct
poor audits that tamper with a company's records. The main cause of their inefficiency and inaccuracy
in conducting audits is not corruption, but rather unconscious bias, which they frequently practice.
WHAT WENT WRONG?
Enron Corporation was a company that achieved great success and top status as an energy
provider, with multiple other business ventures that propelled its fame to even greater heights.
However, the tremendous fall of the company previously dubbed “Wall Street’s Darling” changed the
way the world perceived corporate governance and business administration forever.
It is believed that the beginning of the end of Enron was when the company transitioned from a
traditional historical cost accounting system to the MTM (Mark to Market) accounting method. It is a
method of accounting where assets and liabilities are measured using their fair value which can change
over time. This transition was approved by the SEC in 1992 as the primary aim of this method was to
provide a realistic view of a company’s financial situation. However, this system of accounting allowed
Enron to easily manipulate losses and gains as the fair value of an account is naturally more difficult to
determine. This practice of accounting allowed the company to devise schemes that led to the extreme
overstatement of profits and understatement of losses. In fact, when the company had finally restated
their earnings as far back as 1997, Enron had losses of $591 million dollars, and incurred debt of $690
million - all this was hidden from their creditors and investors prior to the fall out.
The company also employed the practice of off-the-books accounting, and used fake holdings to
ensure only a minimal loss was recorded on Enron’s books. A fake holding, otherwise known as a false
company, is a dummy company or corporation that is created as a cover for one or more other
companies. Fake holdings may appear and present themselves as a legitimate and real company with an
official logo, a website, and sometimes it may even employ actual personnel. However, it lacks the
capacity to function independently. Enron’s practice would be to build an asset (like a power plant, for
example) and immediately recognize the projected profit in its books as earned, when in fact, it has not
earned a single thing from the constructed asset. If the actual revenue the asset earned was less than the
company’s initial projection, instead of recognizing the appropriate loss, the company would actually
transfer the asset to an off-the-books corporation which absorbed the loss for Enron. This granted the
company the ability to write off any unprofitable activities without hurting its bottom line. These
off-the-books accounting practices included the creation of SPVs or Special Purpose Vehicles. Special
Purpose Vehicles are separate legal entities that have for their purpose a single specific task which can
also act as a bankruptcy-remote for the company which created it. Enron believed in the rising value of
its stocks and so these SPVs were entirely capitalized using Enron’s stock which , unknown to the
investing public, would affect the SPVs ability to hedge Enron’s listed assets not to mention the fact
that Enron and it’s SPVs had some conflicts of interest. Thus, when Enron’s stock price started to fall,
the value of it’s SPVs fell as well which revealed all the losses and debts they were hiding. In a
revelation of the company in November 2001, it revealed that this practice allowed them to inflate their
income levels by $586 million dollars. By the following month, the company had filed for bankruptcy
and shares that were once traded at $90.75 had plummeted to $0.26.
A major enabler in the happening of all these events is attributed to Enron’s accounting firm
which at the time was Arthur Andersen LLP and partner David B. Duncan. The firm knew of the
company’s poor and fraudulent practices and they allowed this to happen for years giving their
approval to these false reports. The firm had been working with the company for 16 years before its
downfall and it overlooked large sums of money that were missing which allowed the company to hide
their losses. The firm was considered one of the top five accounting firms in the United States at the
time so when controversies about Enron’s scandal had surfaced, these allegations extended to them. In
fact in June of 2002, the firm was convicted on the grounds of obstruction of justice for destroying
Enron’s financial documents to hide them from the SEC. They were accused and found guilty of
destroying not only physical documents but also emails and computer files. The firm was also shown to
have not been practicing the generally accepted accounting principles in their reports. With the
culmination of all these practices surfacing, Enron started to fall.
RED FLAGS
Enron’s Revenue Accounting
Enron's major performance driver and measure of success was revenues, not profits. The use of
distorted, inflated revenues was more crucial to it in generating the image of outstanding business
performance. To conceal its financial records, Enron utilized a range of deceptive and fraudulent
accounting methods and tactics. As Enron was a company that trades energy, it was reasonably
acceptable that the main focus of determining the value and profitability of their stocks would be the
unrealized, noncash gains. Frequently, these profits depend on assumptions and estimates about future
market factors, the details of which the companies do not provide, and which time may prove wrong.
This is a normal system when it comes to Enron’s type of business model. The soaring prices of their
stocks and the abnormal increase of their average growth per year was what successfully attracted
investors and caught the attention of the center of American capitalism, Wall Street. However, this was
a red flag in itself, considering how the hyper-inflated revenues were accompanied with a very low
gross profit margin. Such information has piqued the interest of some financial analysts even before the
declaration of bankruptcy and prompted them to ask for the company’s balance sheets. However, such a
request was strongly denied. Further investigation on the misuse of the merchant model and MTM
accounting method revealed that over 95% of the profits in 2000 were simulated through these
techniques.
Enron’s Company Culture
The influence of a powerful risk-taking culture on Enron's controls and the cultural context
around Enron's management control systems, indicated red flags in the company's downfall. Enron
served as a model for how a lack of attention to changes in leadership and culture may derail what
appears to be an excellent management control system on the surface.
Enron’s Performance Review System
The Peer Review Committee (PRC) structure was a crucial link in Enron's management
controls. The PRC system was created with the goal of aligning employee actions with the company's
strategic objectives, as well as retaining and rewarding exceptional performers in a fair and consistent
manner. Every six months, each employee received a performance assessment based on feedback
categories. No matter how competent they were, the poorest 15% received a “5,” which meant they
were sent to “Siberia,” a separate region where they had two weeks to find another job at Enron. This
encouraged the formation of private networks of loyal personnel who sought protection from prominent
individuals. Despite the fact that the RAC Group employed very knowledgeable risk management
personnel, they became increasingly hesitant to reject projects that appeared to be problematic over
time. Rejecting them meant the risk of losing their incentives, prompting them to seek vengeance
during the PRC process. Furthermore, they were not likely to reject recommendations out of fear of
actual Skilling implications.
Skilling’s Leadership
Skilling’s leadership style molded Enron’s culture which had complete control over practically
every aspect of the company, particularly its accounting practices, which were designed to manipulate
reported earnings to satisfy investor expectations. The use of special purpose companies (SPEs),
accounting "reserves for contingencies," and mark-to-market accounting, which instantly recognized
gains from long-term deals, hence showing only short-term results. Skilling also employed a variety of
techniques to transform company culture in a way that rewarded attempts to exploit and bend the rules
by subverting management controls. Under Skilling's leadership, a high-performance culture developed
that both institutionalized and accepted distorted behavior.
Compensation Structure
Compensation plans were designed to enrich executives rather than boost profits or shareholder
value that emphasized the value of rewards and status. Enron added a condition to stock option
incentives that if earnings and stock prices grew sufficiently, vesting timelines might be accelerated
more quickly, allowing executives to get their stocks sooner. Skilling rewarded traders who fulfilled
their earnings targets with hefty compensation packages, bonuses, and stock options; in 1999, Enron
granted 93.5 million stock options, up from 25.4 million in 1996.
The competitiveness of the Skilling-designed Peer Review Committee (PRC) was enhanced by
Enron's compensation structure, which was a major mechanism for synchronizing individual and
corporate goals. Employees utilized many strategies to take advantage of the system. The praise for
"creative risk-taking" and "revolution" led to violating legal and ethical boundaries. Traders began to
force through overvalued agreements. As a result, the reality of Enron's business activities contradicted
its Code of Ethics. By mid-2006, sixteen Enron accounting and finance executives had pleaded guilty
to a variety of criminal charges, including deceptive accounting and falsifying quarterly profits reports.
KEY TAKEAWAYS
Always Ask why. This was the motto of the company Enron and before an individual must venture into
something they must first ask the question Why?. You should never invest in things that you do not
understand and learn from the mistakes of the past because the investors of Enron did not understand its
business model because Enron had a complicated business model. It is also very important for the
company to gain the trust of the public because when the revelations of frauds in Enron began, the firm
lost the public trust making it impossible to conduct business as a trader and a party to thousands of
contracts. Once doubts were set in the public, as brought partly by the mysterious hit to equity and
Enron's inability to give an answer to the public about what it meant, other suspicious Enron moves
began to emerge.The end result was that these disclosures caused a crisis at Enron, sending its stock
plunging and clients fleeing.
Good corporate governance. There should be integrity, healthy corporate culture, and ethical behavior
in the company. In Enron’s case, its corporate culture played an important role in its collapse. When
there were failures and losses in their company performance, what they did was cover up their losses in
order to protect their reputation instead of trying to do something to make it correct. Because of this,
many professionals argue that, in reality, most business organizations do not have good corporate
governance practices and executives would always act in their self-interests. This element of corporate
governance means that we should always act with the highest integrity. Regardless of the situation, we
should always seek to find the truth and do the right thing. It is also essential that we ensure full
disclosure and transparency to all stakeholders including the reporting of financial information.
In addition, Enron had various internal control weaknesses such as Andersen who served as
Enron’s external auditor and as its internal auditor. That is why Andersen’s work as a consultant raises
several questions. To be professional and effective, auditors must be independent of management
and assess the financial representations of management for all users of financial statements. In Enron’s
case, it appears that Andersen’s audit team, when they were faced with an accounting dilemma, chose
to ignore and consented in silence about these bad accounting schemes. Therefore, the board of
directors must pay attention to the behavior of the management, its people and the way of making
money.
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