ENRON SCAM

(Financial Accounting)

Group 2:

Smarak Panda - F-351

Bipin Bansal Agarwal – F-316

Anil Kacholiya – F-308

Ishita Kaur Kandra – F-323

Ajay Parasuraman – F-304

Mukul Azad Meena – F331

Gururaja Subhash Bhutale – F-320

ENRON (2001)

The Enron scandal is one of the largest in the US history. It was revealed in October 2001.

Aftermath of the Enron scam

1. It eventually led to the bankruptcy of the Enron Corporation, which was an American energy

company. Enron’s $63.4 billion in assets made it the largest corporation bankruptcy in US history

at that time.

2. As a consequence, the shareholder lost nearly $11 billion when Enron’s stock price, which hit a

high of US$90 per share in mid 2000, dived to less than $1 by the end of November 2001.

3. Many executives of Enron including its chairman Mr. Kenneth lay, President Mr. Jeffery Skilling

and chief financial officer Mr. Andrew Fastow were indicted of variety of charges and were later

sentence to prison.

4. Enron’s auditors. Arthur Anderson was found guilty and ultimately the audit firm was closed

down.

5. Employees and shareholder received limited returns in lawsuits, despite losing billions in

pensions and stock prices.

6. In the aftermath of the scandal, new regulation and legislation (such as Sarbanes- Oxley act) were

enacted in the US to increase the accuracy of financial reporting for public companies and to

expand the accountability of auditing firms to remain unbiased and independent of their clients.

Rise of the Enron

Kenneth Lay formed Enron in 1985 after merging the natural gas pipeline companies of Houston Natural

Gas and Inter North. In the early 1990s deregulation of sale of natural gas in the US made it possible for

Enron to sell energy at higher prices, thereby significantly increasing its revenue. Enron rose to become

the largest natural gas seller in North America by 1992. 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 for the array of

the product and services it was involved in.

By December 31, 2000, Enron stock was priced at $83.13 and its market capitalization exceed $60 billion

-70 times of the earnings and six times of the book value. Not surprisingly, Enron was rated the most

innovative large company in America in Fortune’s most admired companies survey.

Causes of Downfall

In retrospect, a combination of issues ranging from complex business model followed by Enron to

unethical practices of misrepresenting earnings and modify the balance sheet, poor financial reporting and

non transparent financial statement, creation of special purpose entities to hide debts from failed project

laid to sudden bankruptcy of the corporate giant.

1. Faulty revenue recognition model. Enron adopted the “merchant model” of revenue reporting in

respect of providing services in wholesale trading and risk management. In this model the entire

sale value was reported as revenue and product cost as a cost of goods sold. This merchant model

approach was considered as much more aggressive in the accounting interpretation than “agent

model” where only trading and brokerage fee are recognized as revenue not the full value of the

transaction.

2. Mark to market accounting. The company adopted mark to market accounting to account for its

complex long term contract. Mark to market accounting requires that once a long term contract

was signed, income was estimated as a present value of future cash flow. Often, the viability of

these contracts and their related cost were difficult to judge. Due to large discrepancies of

attempting to match profit and cash, investor were typically given false or misleading report.

However in further years profit could not be included, so new and additional income were

included from more projects to develop additional growth to appease investors. Enron later

expanded its use to other areas in the company to help it meet the stock market projections.

3. Special purpose Entities. Enron created special purpose entities-limited partnerships or

companies to fulfill a temporary or specific purpose of providing fund or managing risks

associated with specific assets. Much of the problem of Enron related to complex and non-

transparent dealings between Enron and SPEs (such as LJM 1, LJM 2, JEDI 1, JEDI 2, Chewco).

The company disclosed minimal details on its use of special purpose entities. These firms were

created by the company, but funded by independent equity investors and debt financing. The

special purpose entities were used for more than just circumventing accounting conventions.

Enron disclosed to its shareholders that it had hedged downside risk in its own illiquid

investments using special purpose entities. The investors were oblivious to the fact that the

special purpose entities were actually using the companies own stock and financial guarantees to

finance these hedges. This allowed large losses to the concealed and create false impression that

company’s investment were hedged. The motive clearly was financial window dressing rather

than transfer of risk. By 2001, Enron had used hundreds of special purpose entities to hide its

losses and debt.

4. Exclusive Executive Compensation. Enron’s compensation and performance management

system was focused only on short term earnings to maximize bonuses. Employees constantly

looked to start high volume deals, often disregarding the quality of cash flow or profits to get

higher rating for their performance review. In addition, accounting results were recorded as soon

as possible to keep up with the company’s stock price. This practice helped ensure deal makers

and the executives receiving large cash bonuses and stock options. Employees had large expense

account and many executives were paid sometimes twice as much as the competitors.

5. Risk mismanagement. Risk management was crucial to Enron because of its long term fixed

commitments, which needed to be hedged to prepare for the inevitable fluctuation of future

energy prices. Enron 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 instead of hedging it.

Flaws in Corporate Governance

1. Failure of Board of Directors. On paper, Enron had a model Board of Directors comprising pre

dominantly outsider with significant ownership stakes and talented audit committee. In its 2000

review of best corporate boards, chief executive included Enron among its top five boards.

Collapse of Enron may be constructed as failure of corporate governance in particular the board

of directors of Enron. The board failed miserably in its oversight responsibilities. The board had

no clue of what the executives were doing. The directors failed to understand the related party

transaction between Enron and SPEs. The board flawed in implementing proper system of control

and risk management. The company extensively relied on derivatives for its businesses, the

company’s finance committee and board did not have comprehensive background in derivatives

to grasp what they were being told.

2. Audit committee. Enron’s audit committee was criticized for its brief meetings that would cover

large amount of materials. In one meeting on February 12, 2001, the committee met for an hour

and half. Enron’s audit committee did not have the technical knowledge to properly question the

auditors on accounting issues related to the company’s special purpose entities. The audit

committee failed to review the related party transactions with SPEs.

3. Low ethical standards. Ethical standards of the company had come down to a very low level

with employees indulging in self-dealings. Senior executives were selling their holdings in the

company while others were buying more and more. Extravagances where rampant. Employees

were putting self interest ahead of corporate interest.

4. Stakeholders. Stakeholders of the company including creditor, credit rating agencies and

regulators remained silent spectator until the scam became too evident. They failed to question

the wrong accounting policies and faulty business model by Enron.

5. Whistle blower policy. The collapse of Enron could have been averted had the company had a

whistleblower policy in place. Sherron Watkins, one of the employees of the company had raised

concern about some of the accounting concerns in Enron in 1996 but no notice was taken of her

concerns and she was shifted to another department. Only in 2001,when she raised the matter of

extensive frauds at SPEs again more vociferously that the scandal came to the surface

Failure of the financial audit

Enron’s auditor firm, Arthur Anderson, applied reckless standards in their audits. The auditors’ methods

were questioned as either being solely to receive its annual fees or for their lack of expertise in properly

reviewing Enron’s revenue recognition, special entities, derivatives, and other accounting practices.

Anderson’s auditors were pressured by Enron’s management to deviate from the established auditing and

accounting standards. The auditors bowed to the pressure ostensibly because of conflict of interest arising

from the significant consulting fees generated by Enron.

Dwindling Investors’ confidence

As time passed, a number of serious concerns confronted the company. In late 90s Enron faced several

serious operational challenges, namely logistical difficulties in running a new broadband communications

trading unit, and the losses from constructing the Dabhol Power project, a large power plant in India.

There was also mounting criticism of the company for the role that its subsidiary Enron Energy Services

had played in the power crisis of California in 2000-2001. In early 2001, burst of internet and telecom

bubble in the US questioned company’s expansion into the telecom sector. With a slowing US economy

and bearish stock market, the share price of Enron started falling.

The sudden departure of Skilling in August 2001combined with the complexity of Enron’s accounting

books made proper assessment difficult for the stock market. 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 appears on Enron’s own balance sheet. A particularly troubling aspect of this

technique was that several of “related party” entities had been or were been controlled by CFO Fastow.

When that became too evident, Fastow was sacked in October 2001. As the month of October came to

close, serious were concerns were raised by some observers of Enron possible manipulation of accepted

accounting rules; however, analysis was claimed to be impossible based on the incomplete information

provided by Enron. While this was underway, one employee of the company Watkins alerted certain

board members about the widespread financial improper ties and frauds in the company.

With dwindling investors’ confidence the downfall of the Enron was accelerated. In November 2001,

bank started cancelling Enron’s credit facilities, and rating agencies downgraded company’s credit rating.

This constrained the financial position of the company further. It was clear by that time that Enron

couldn’t survive the shattered confidence. With failed deal of possible acquisition of Enron by a rival firm

Dynegy, Enron was left with no alternative but to file bankruptcy in early December 2001.