✍️✍️✍️ Enron Accounting Scandal
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The Enron Fraud Explained
She frequently writes for corporate clients representing Fortune brands on subjects that include marketing, business, and social media trends. Share It. Lay was convicted for his role in engineering the massive fraud but died of a heart attack before sentencing. He was arrested in and sentenced to 28 years in prison. In , a series of negotiations led to his term being reduced to 14 years.
Andrew Fastow: After cooperating with authorities and providing evidence, former CFO Fastow was found guilty and sentenced to five years in prison in He was released in Accessed Feb. Texas State Historical Association. Federal Reserve Bank of St. Committee on Governmental Affairs. Commodities Futures and Trading Commission. Federal Energy Regulatory Commission. Department of Justice. Securities and Exchange Commission. Skilling, Richard A. The gain was responsible for offsetting its stock portfolio losses and was attributed to nearly a third of Enron's earnings for before it was properly restated in On paper, Enron had a model board of directors comprising predominantly outsiders with significant ownership stakes and a talented audit committee.
In its review of best corporate boards, Chief Executive included Enron among its five best boards. 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, often disregarding the quality of cash flow or profits, in order to get a better rating for their performance review.
Additionally, accounting results were recorded as soon as possible to keep up with the company's stock price. This practice helped ensure deal-makers and executives received large cash bonuses and stock options. Enron was constantly emphasizing its stock price. Management was compensated extensively using stock options , similar to other U. This policy of stock option awards caused management to create expectations of rapid growth in efforts to give the appearance of reported earnings to meet Wall Street's expectations.
Enron's proxy statement stated that, within three years, these awards were expected to be exercised. Skilling believed that if Enron employees were constantly worried about cost, it would hinder original thinking. Employees had large expense accounts and many executives were paid sometimes twice as much as competitors. Before its demise, Enron was lauded for its sophisticated financial risk management tools.
Enron established long-term fixed commitments which needed to be hedged to prepare for the invariable fluctuation of future energy prices. By hedging its risks with special purpose entities which it owned, Enron retained the risks associated with the transactions. This arrangement had Enron implementing hedges with itself. Enron's aggressive accounting practices were not hidden from the board of directors, as later learned by a Senate subcommittee. The board was informed of the rationale for using the Whitewing, LJM, and Raptor transactions, and after approving them, received status updates on the entities' operations. Although not all of Enron's widespread improper accounting practices were revealed to the board, the practices were dependent on board decisions.
The Senate subcommittee argued that had there been a detailed understanding of how the derivatives were organized, the board would have prevented their use. Enron's accounting 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. The auditor's methods were questioned as either being completed solely to receive its annual fees or for its lack of expertise in properly reviewing Enron's revenue recognition, special entities, derivatives, and other accounting practices.
The accountants searched for new ways to save the company money, including capitalizing on loopholes found in Generally Accepted Accounting Principles GAAP , the accounting industry's standards. All the rules create all these opportunities. We got to where we did because we exploited that weakness. 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. Since the entities would never return a profit, accounting guidelines required that Enron should take a write-off , where the value of the entity was removed from the balance sheet at a loss. In one case, Andersen's Houston office, which performed the Enron audit, was able to overrule any critical reviews of Enron's accounting decisions by Andersen's Chicago partner.
In addition, after news of SEC investigations of Enron were made public, Andersen would later shred several tons of relevant documents and delete nearly 30, e-mails and computer files, leading to accusations of a cover-up. Revelations concerning Andersen's overall performance led to the break-up of the firm, and to the following assessment by the Powers Committee appointed by Enron's board to look into the firm's accounting in October : "The 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".
Corporate audit committees usually meet just a few times during the year, and their members typically have only modest experience with accounting and finance. Enron's audit committee had more expertise than many others. It included: . Enron's audit committee was later criticized for its brief meetings that would cover large amounts of material. In one meeting on February 12, , the committee met for an hour and a half. Enron's audit committee did not have the technical knowledge to question the auditors properly on accounting issues related to the company's special purpose entities.
The committee was also unable to question the company's management due to pressures on the committee. When Enron's scandal became public, the audit committee's conflicts of interest were regarded with suspicion. Commentators attributed the mismanagement behind Enron's fall to a variety of ethical and political-economic causes. Ethical explanations centered on executive greed and hubris, a lack of corporate social responsibility, situation ethics, and get-it-done business pragmatism.
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. In , 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.
But as pressure to outbid all others and win the deal grew more intense with the approaching IPO, the Azurix executives decided to up their bid. But when Enron executives arrived at the Argentine facilities, they found them in a shambles with all of the customer records destroyed. At the beginning of , the Enron Corporation, the world's dominant energy trader, appeared unstoppable. The company's decade-long effort to persuade lawmakers to deregulate electricity markets had succeeded from California to New York. Its ties to the Bush administration assured that its views would be heard in Washington. Its sales, profits and stock were soaring. Berenson and R. Oppel, Jr. The New York Times , Oct 28, On September 20, , a reporter at The Wall Street Journal bureau in Dallas wrote a story about how mark-to-market accounting had become prevalent in the energy industry.
He noted that outsiders had no real way of knowing the assumptions on which companies that used mark-to-market based their earnings. While the story only appeared in the Texas Journal, the Texas regional edition of the Journal, short-seller Jim Chanos happened to read it and decided to check Enron's K report for himself. Chanos did not think it made sense that Enron's broadband unit appeared to far outpace a then-troubled broadband industry.
He also noticed that Enron was spending much of its invested capital, and was alarmed by the large amounts of stock being sold by insiders. In November , he decided to short Enron's stock. In February , Chief Accounting Officer Rick Causey told budget managers: "From an accounting standpoint, this will be our easiest year ever. We've got in the bag. McLean telephoned Skilling to discuss her findings prior to publishing the article, but he called her "unethical" for not properly researching his company. We don't want to tell anyone where we're making money. When Grubman complained that Enron was the only company that could not release a balance sheet along with its earnings statements, Skilling stammered, "Well uh Thank you very much, we appreciate it As time passed, a number of serious concerns confronted the company.
Enron had recently faced several serious operational challenges, namely logistical difficulties in operating a new broadband communications trading unit, and the losses from constructing the Dabhol Power project , a large gas powered power plant in India that had been mired in controversy since the beginning in relation to its high pricing and bribery at the highest level. There are no accounting issues, no trading issues, no reserve issues, no previously unknown problem issues. I think I can honestly say that the company is probably in the strongest and best shape that it has probably ever been in. On August 14, Skilling announced he was resigning his position as CEO after only six months citing personal reasons. On August 15, Sherron Watkins , vice president for corporate development, sent an anonymous letter to Lay warning him about the company's accounting practices.
One statement in the letter said: "I am incredibly nervous that we will implode in a wave of accounting scandals. On August 22, Watkins met individually with Lay and gave him a six-page letter further explaining Enron's accounting issues. He also named Mark Frevert as vice chairman, and appointed Whalley and Frevert to positions in the chairman's office. Some observers suggested that Enron's investors were in significant need of reassurance, not only because the company's business was difficult to understand even "indecipherable"  but also because it was difficult to properly describe the company in financial statements.
He also explained that the complexity of the business was due largely to tax strategies and position-hedging. 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 appear on Enron's own balance sheet. A particularly troubling aspect of this technique was that several of the "related-party" entities had been or were being controlled by CFO Fastow.
After the September 11 attacks media attention shifted away from the company and its troubles; a little less than a month later Enron announced its intention to begin the process of selling its lower-margin assets in favor of its core businesses of gas and electricity trading. On October 16, , Enron announced that restatements to its financial statements for years to were necessary to correct accounting violations.
In a statement, Lay said, "After a thorough review of our businesses, we have decided to take these charges to clear away issues that have clouded the performance and earnings potential of our core energy businesses. David Fleischer at Goldman Sachs , an analyst termed previously 'one of the company's strongest supporters' asserted that the Enron management " They need to convince investors these earnings are real, that the company is for real and that growth will be realized. Two days later, on October 25, Fastow was removed as CFO, despite Lay's assurances as early as the previous day that he and the board had confidence in him. In announcing Fastow's ouster, Lay said, "In my continued discussions with the financial community, it became clear to me that restoring investor confidence would require us to replace Andy as CFO.
His first task was to deal with a cash crisis. A day earlier, Enron discovered that it was unable to roll its commercial paper , effectively losing access to several billion dollars in financing. The company had actually experienced difficulty selling its commercial paper for a week, but was now unable to sell even overnight paper. Enron financed the re-purchase by depleting its lines of credit at several banks. While the company's debt rating was still considered investment-grade , its bonds were trading at levels slightly less, making future sales problematic.
McMahon and a "financial SWAT team" put together to find a way out of the cash crisis discovered that Fastow never developed procedures for tracking cash or debt maturities. For all intents and purposes, Enron was illiquid. As the month came to a close, serious concerns were being raised by some observers regarding Enron's possible manipulation of accepted accounting rules; however, analysis was claimed to be impossible based on the incomplete information provided by Enron.
Enron's tremendous presence worried some about the consequences of the company's possible bankruptcy. The main short-term danger to Enron's survival at the end of October seemed to be its credit rating. It was reported at the time that Moody's and Fitch , two of the three biggest credit-rating agencies, had slated Enron for review for possible downgrade.
Additionally, all manner of companies began reviewing their existing contracts with Enron, especially in the long term, in the event that Enron's rating were lowered below investment grade, a possible hindrance for future transactions. Analysts and observers continued their complaints regarding the difficulty or impossibility of properly assessing a company whose financial statements were so cryptic. Some feared that no one at Enron apart from Skilling and Fastow could completely explain years of mysterious transactions.
Moody's also warned that it would downgrade Enron's commercial paper rating, the consequence of which would likely prevent the company from finding the further financing it sought to keep solvent. November began with the disclosure that the SEC was now pursuing a formal investigation, prompted by questions related to Enron's dealings with "related parties". Enron's board also announced that it would commission a special committee to investigate the transactions, directed by William C. Powers , the dean of the University of Texas law school. Sources claimed that Enron was planning to explain its business practices more fully within the coming days, as a confidence-building gesture.
However, investors worried that the company would not be able to find a buyer. With Enron in a state of near collapse, the deal was largely on Dynegy's terms. Dynegy would be the surviving company, and Dynegy CEO Charles Watson and his management team would head the merged company. Enron shareholders would get a 40 percent stake in the enlarged Dynegy, and Enron would get three seats on the merged company's board. Lay would not have any management role, though it was presumed he would get one of Enron's seats on the board.
Of Enron's senior executives, only Whalley would join the merged company's C-suite, as an executive vice president. As a measure of how dire Enron's financial picture had become, the company initially balked at paying its bills for November until the credit agencies gave the merger their blessing and allowed Enron to keep its credit at investment grade. By this time, the Dynegy deal was virtually the only thing keeping the company alive, and Enron officials wanted to keep as much cash in the company's coffers in the event of bankruptcy. Commentators remarked on the different corporate cultures between Dynegy and Enron, and on Watson's "straight-talking" personality. The corrections resulted in the virtual elimination of profit for fiscal year , with significant reductions for the other years.
Despite this disclosure, Dynegy declared it still intended to purchase Enron. In addition, concerns were raised regarding antitrust regulatory restrictions resulting in possible divestiture , along with what to some observers were the radically different corporate cultures of Enron and Dynegy. Both companies promoted the deal aggressively, and some observers were hopeful; Watson was praised for attempting to create the largest company on the energy market. Credit issues were becoming more critical, however. Watson again attempted to re-assure, attesting at a presentation to investors that there was "nothing wrong with Enron's business". It pretty much wiped out every employee's savings plan.
Watson assured investors that the true nature of Enron's business had been made apparent to him: "We have comfort there is not another shoe to drop. If there is no shoe, this is a phenomenally good transaction. Such debts were "vastly in excess" of its available cash. In a statement, Enron revealed "An adverse outcome with respect to any of these matters would likely have a material adverse impact on Enron's ability to continue as a going concern. Two days later, on November 21, Wall Street expressed serious doubts that Dynegy would proceed with its deal at all, or would seek to radically renegotiate.
Analysts were unnerved at the revelation, especially since Dynegy was reported to have also been unaware of Enron's rate of cash use. It subsequently emerged that Enron's traders had grabbed much of the money from Dynegy's cash infusion and used it to guarantee payment to their trading partners when it came time to settle up. The SEC announced it had filed civil fraud complaints against Andersen. Observers were reporting difficulties in ascertaining which of Enron's operations, if any, were profitable. Reports described an en masse shift of business to Enron's competitors for the sake of risk exposure reduction.
On November 28, , Enron's two worst possible outcomes came true. Credit rating agencies all reduced Enron's credit rating to junk status, and Dynegy's board tore up the merger agreement on Watson's advice. Watson later said, "At the end, you couldn't give it [Enron] to me. One editorial observer wrote that "Enron is now shorthand for the perfect financial storm. Systemic consequences were felt, as Enron's creditors and other energy trading companies suffered the loss of several percentage points. Some analysts felt Enron's failure indicated the risks of the post-September 11 economy, and encouraged traders to lock in profits where they could. One adviser stated, "We don't really know who is out there exposed to Enron's credit.
In May , the jury found Skilling and Lay guilty. Lay died in July from a heart attack some suspected he faked his death. Here's what you'll find in our full The Smartest Guys in the Room summary :. Carrie has been reading and writing for as long as she can remember, and has always been open to reading anything put in front of her. She wrote her first short story at the age of six, about a lost dog who meets animal friends on his journey home. Surprisingly, it was never picked up by any major publishers, but did spark her passion for books.
She especially loves literary fiction, historical fiction, and social, cultural, and historical nonfiction that gets into the weeds of daily life. Your email address will not be published. Save my name, email, and website in this browser for the next time I comment. Skip to content. Posted by Carrie Cabral Aug 24, Here's what you'll find in our full The Smartest Guys in the Room summary : How Enron rose to become one of the world's most promising companies How Enron management's greed led it to start cutting corners The critical failures that crashed Enron's house of cards to the ground Get the world's best book summaries now.
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