NUST Business School

FIN-329 Behavioural Finance

Enron Assignment

Submitted to:
Dr. Nabeel Safdar

Submitted by:
Mustafa Khan

BSAF 2K16 A
Date: 7th April, 2019.
The devastation of shareholders of Enron can be due to one of two things; either
lack of transparency in reporting or because investors and analysts perceived the
stock very well. Transparency in disclosing earnings and reporting financial
information is very important if markets are to properly evaluate the true value and
future prospects of a company. While the former has been proved, the behaviour of
investors, analysts and auditors also came into play. The social and psychological
factors in play influenced the behaviour of the Board of Directors and financial
analysts.

Enron used special purpose entities (SPEs) to hide foreign income from taxation and
debt financing. A loophole in the law was used to avoid consolidation, and they took
out loans with the stock of Enron as the principal asset. So, when the stock price
went down Enron ended up accumulating a great deal of debt from the SPEs.
Another malpractice was the recognition of revenue at the time of signing a deal, this
is not permissible according to accounting standards and when deals fell apart Enron
had to reverse a lot of revenues like in a deal with Blockbuster.

Now we come towards the behavioural side of the story. The Board of Directors of
Enron were not as much of monitors as puppets. Due to the complex nature and
wide scale of work, the directors had limited knowledge of details of all operations.
Furthermore, the continual good performance of management led directors to simply
sign off anything the management brought forward. Due to this behaviour the
malpractices were not identified. The argument of external/independent directors
may be valid but the six degree of separation theory suggests that there may be no
such thing as in independent directors. The board was also large with generous
packages so there was a severe lack of involvement. The reluctance and
incompetence resulted in the directors getting penalised by the court of law.

The analysts were also a part of the bubble created in the shares of Enron. Analysts
did little to scrutinise the information provided by Enron’s management. In a fear of
being wrong, analysts provided information in line with the company which had a
good track record and supposedly good financials. This led to even more investors
being misled by analysts who provided reports with little research in fear of losing
credibility if they published anything apart from what Enron was hinting. A conflict of
interest had arisen here. The short termism of executives was a also a reason
behind a lot of misinformation in the market to create these bubbles. The analysts in
fear of being wrong jumped the bandwagon resulting in huge losses to investors.

The auditor of Enron also became prey of the flashy tactics of Enron. He failed to
comply by professional scepticism and due diligence. The huge fee was also a
disincentive to work properly. The management of Enron was considered arrogant
and proud, considering themselves superior to the rest of the industry. Even so,
everyone loved Enron due to the money it was making. Even when losses started
accumulating many analysts remained optimistic about Enron. They believed it
would make a comeback. The employees of the firm were loyal, thinking Enron was
invincible and would last forever. All stakeholders in Enron were missing a separate
identity other than the organisation. When a person fails to have a separate identity,
their objectivity is affected and as a result, like in the case of Enron, they are pulled
in by social factors and make the wrong decisions.