A brief on Enron’s history
Enron was formed in 1985 by Kenneth Lay after merging
Houston Natural Gas and InterNorth.
In the early 1990s, he helped to initiate the selling of electricity at market prices, The resulting markets made it possible for traders such as Enron to sell energy at higher prices, thereby significantly increasing its revenue.
As Enron became the largest seller of natural gas in North America by 1992, Enron pursued a diversification strategy owning and operating a variety of assets including gas pipelines, electricity plants, pulp and paper plants, water plants, and broadband services across the globe. (cont.) brief
Enron’s stock increased from the start of the 1990s until year-end 1998 by 311% percent, 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%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 by using accounting limitations to misrepresent earnings and modify the balance sheet to indicate favorable performance, According to McLean and Elkind in their book The Smartest Guys in the Room, “The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiraled out of control.” the combination of these issues later resulted in the bankruptcy of the company.
• the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling, Andrew Fastow, and other executives, Skilling constantly focused on meeting Wall Street expectations, advocated the use of mark-to-market accounting and pressured Enron executives to find new ways to hide its debt. (Cont.) causes of downfall
• when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, citing that it would represent “… true economic value”.
• This method 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, 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. (Cont.) causes of downfall
• For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on-demand entertainment to various U.S. cities by year-end. 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 .
• Between 1996 and 2000, Enron’s revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.8 billion in 2000. This extensive expansion of 65% per year was unprecedented in any industry, including the energy industry which typically considered growth of 2–3% per year to be respectable. For just the first nine months of 2001, Enron reported $138.7 billion in revenues, which placed the company at the sixth position on the Fortune Global 500. (Cont.) causes of downfall
Special purpose entities:
• Enron used special purpose entities—limited partnerships or companies created to fulfill a temporary or specific purpose .
• These “shell firms” were created by a sponsor, but funded by independent equity investors and debt financing.
• 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. Enron’s balance sheet understated its liabilities and overstated its equity, and its earnings were overstated (cont.) causes of downfall
• 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, disregarding the quality of cash flow or profits, in order to get a better rating for their performance review. (cont.) causes of downfall
• The company was constantly emphasizing its stock price. Management was compensated extensively using stock
• Skilling would develop target earnings by asking “What earnings do you need to keep our stock price up?” and that number would be used, even if it was not feasible.
• Employees had large expense accounts and many executives were paid sometimes twice as much as competitors.
• In 1998, the top 200 highest-paid employees received $193 million from salaries, bonuses, and stock. Two years later, the figure jumped to $1.4 billion. (cont.) causes of downfall 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.
• Andersen’s auditors were pressured by Enron’s management to defer recognizing the charges from the special purpose entities as its credit risks became known.
• To pressure Andersen into meeting Enron’s earnings expectations, Enron would occasionally allow accounting companies Ernst & Young or PricewaterhouseCoopers to complete accounting tasks to create the illusion of hiring a new company to replace Andersen.
• In addition, after news of U.S. Securities and Exchange Commission (SEC) investigations of Enron were made public, Andersen would later shred several tons of relevant documents and delete nearly 30,000 e-mails and computer files, causing accusations of a cover-up. (cont.) causes of downfall
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. Bankruptcy
• On November 28, 2001, 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. • 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.
• Enron’s European operations filed for bankruptcy on November 30, 2001, and it sought Chapter 11 protection two days later on December 2. 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. Sarbanes-Oxley Act
• The bill was enacted as a reaction to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom. These scandals, which cost investors billions of dollars when the share prices of affected companies collapsed, shook public confidence in the nation’s securities markets.
• The main provisions of the Sarbanes-Oxley Act included the establishment
of the Public Company Accounting Oversight Board to develop standards for the preparation of audit reports; the restriction of public accounting companies from providing any non-auditing services when auditing; provisions for the independence of audit committee members, executives being required to sign off on financial reports.
1.Public Company Accounting Oversight Board (PCAOB):
Title I consists of nine sections and establishes the Public Company Accounting Oversight Board, to provide independent oversight of public accounting firms providing audit services (“auditors”). It also creates a central oversight board tasked with registering auditors, defining the specific processes and procedures for compliance audits
2. Auditor Independence:
Title II consists of nine sections and establishes standards for external auditor independence, to limit conflicts of interest. It also addresses new auditor approval requirements, audit partner rotation, and auditor reporting requirements. It restricts auditing companies from providing non-audit services (e.g., consulting) for the same clients. (Cont.)SOX
3. Corporate Responsibility:
Title III consists of eight sections and mandates that senior executives take individual responsibility for the accuracy and completeness of corporate financial reports. It defines the interaction of external auditors and corporate audit committees, and specifies the responsibility of corporate officers for the accuracy and validity of corporate financial reports.
It enumerates specific limits on the behaviors of corporate officers and describes specific forfeitures of benefits and civil penalties for non-compliance. For example, Section 302 requires that the company’s “principal officers” (typically the Chief Executive Officer and Chief Financial Officer) certify and approve the integrity of their company financial reports quarterly. (Cont.)SOX
4. Enhanced Financial Disclosures:
Title IV consists of nine sections. It describes enhanced reporting requirements for financial transactions, including off-balance-sheet transactions, pro-forma figures and stock transactions of corporate officers. 5. Analyst Conflicts of Interest :
Title V consists of only one section, which includes measures designed to help restore investor confidence in the reporting of securities analysts. It defines the codes of conduct for securities analysts and requires disclosure of knowable conflicts of interest. 6. Commission Resources and Authority:
Title VI consists of four sections and defines practices to restore investor confidence in securities analysts. It also defines the SEC’s authority to censure or bar securities professionals from practice and defines conditions under which a person can be barred from practicing as a broker, advisor, or dealer. (Cont.)SOX
7.Studies and Reports:
Title VII consists of five sections and requires the Comptroller General and the SEC to perform various studies and report their findings. Studies and reports include the effects of consolidation of public accounting firms, the role of credit rating agencies in the operation of securities markets, securities violations and enforcement actions, and whether investment banks assisted Enron, Global Crossing and others to manipulate earnings and obfuscate true financial conditions. (Cont.)SOX
8. Corporate and Criminal Fraud Accountability:
It describes specific criminal penalties for manipulation, destruction or alteration of financial records or other interference with investigations,
while providing certain protections for whistle-blowers.
9. White Collar Crime Penalty Enhancement:
This section increases the criminal penalties associated with white-collar crimes and conspiracies. It recommends stronger sentencing guidelines and specifically adds failure to certify corporate financial reports as a criminal offense. (Cont.)SOX
10. Corporate Tax Returns :
Title X consists of one section. Section 1001 states that the Chief Executive Officer should sign the company tax return.
11. Corporate Fraud Accountability :
It identifies corporate fraud and records tampering as criminal offenses and joins those offenses to specific penalties. It also revises sentencing guidelines and strengthens their penalties. This enables the SEC to resort to temporarily freezing transactions or payments that have been deemed “large” or “unusual”.