1. Enron was valued at $2.3 billion when it was formed in July 1985. On August 23, 2000, its stock was at $90 per share and it had a market capitalization of $65.9 billion. Explain the major business practices that created such dynamic growth in the price of the stock.
Enron used many different tactics to inflate their stock prices. The one that sticks out to me is when they signed a 20-year contract with Blockbuster. Early in the contract Blockbuster and Enron parted ways with a null and void contract. However, Enron still kept the contract on the books as future earnings when they knew that money was never going to come in. They did this so their stocks prices would stay inflated.
Another practice is that they switched from an agent model to a merchant model when recognizing revenue. Doing this gave them a 65% increase when typical industry standards only gain between 2-3%. Once they switched to this accounting method other companies started to follow their lead in order to stay competitive with Enron.
In addition, Enron understated its liability and overstated its equity. They would do this by creating special purpose entities. These entities were created to show investors the downside of risk.
I believe the main reason the stock increased so much is due to corruption of Arthur Andersen, an independent audit firm. On Wikipedia’s website there was a statement from Enron’s Power Committee and it appears they were placing blame on the Andersen firm. They were quoted as saying, “… evidence available to us suggests that Andersen did not fulfill its professional responsibilities in connection with its audits of Enron’s financial statements, or its obligation to bring to the attention of Enron’s Board (or the Audit and Compliance Committee) concerns about Enron’s internal contracts over the related-party transactions” (“Enron Scandal”). After reading about the scandal it seems as if Arthur Andersen was being pressured by Enron’s executive management to ignore all their flawed accounting principles.
Overall there were several business practices that caused Enron’s stock prices to increase and most of it was due to a flawed and failed accounting system. 2. Why did Enron go bankrupt? Enron went bankrupt because they were artificially inflating their stock price. They had an audit company that did not report a fair opinion of their findings. The public started to back away and chose not to invest due to their lack of confidence in the company. In 2001, the SEC started investigating the organization and they had to restructure their losses. Another loss took place when Enron’s credit rating was downgraded by Moody’s and Fitch. I believe they ultimately went bankrupt due to their lack of integrity and honesty, especially when it came to their accounting methods. a. What role did corporate governance (broad of directors’ and top management’s leadership and responsibilities) have in Enron’s demise?
Top management played an enormous roll in the fall of Enron. Management was always looking for loop holes to hide debt and keep their stock prices high. They also influenced their audit firm, Arthur Andersen, by paying them high consulting fees. By doing this they were essentially paying Andersen to look the other way. b. What was the responsibility of the “independent” outside auditors, Arthur Andersen & Co.?
Andersen should have come in and reported their findings in a fair and ethical way. Since Andersen went along with Enron in hiding debt it ultimately dissolved the Andersen business.
c. What was the responsibility of stock broker analysts, rating agencies, and the SEC?
The responsibility of the stock broker analysts was to evaluate the financial statements of Enron. They were also required to give the general public a recommendation in regards to stock options. Rating agencies were acting as a credit bureau. They determined if Enron had good credit or not. They also were required to let the public know if the company was paying its debt, as well as other financial obligations. According to the U.S. Securities and Exchange Commission (SEC) website, their responsibility was to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” (“The Investors Advocate”). They came under scrutiny because of their failure to prevent Enron’s collapse and ignoring “red flags” in Enron dealing by failing to review annual reports.
“Enron Scandal.” Wikipedia: The Free Encyclopedia. Wikimedia Foundation, Inc. (n.d.). Web. 03 Feb. 2014. http://en.wikipedia.org/wiki/Enron_scandal#Special_purpose_entities
“The Investors Advocate.” U.S. Securities and Exchange Commission. (n.d.) Web. 03 Feb. 2014. http://www.sec.gov/about/whatwedo.shtm l