NAME:-GHAN SHYAM CHOUDHARY

ROLL NO:-21035

THE RISE AND FALL OF ENRON: A CASE STUDY

1.1 Background of the Case

Enron based in Houston, Texas emerged as the largest seller of the natural gas and other energy
resources in America in 1990s. It was a multinational corporation providing energy,
communication services and heavy goods employing approximately twenty thousand staff.
Kenneth Lay founded the company in the year 1985 after Houston Natural Gas and Inter North
merged together. The company’s earnings increased when it followed a diversification strategy
when it decided to expand its product base from natural gas to other products like coal, steel,
paper and pulp, broadband communications etc. The rise of the company was evident from its
revenue earnings which amounted to $ 112 billion during the year 2000 and it was rated as the
most innovative company by the Fortune magazine during that year (Miceli da Silveris, 2013).
The real misfortune of the company began at the end of 2001 when the financial state of affairs
of the company was uphold by a deliberate accounting fraud which was renowned as Enron
Scandal. The scandal consequently questioned the accounting and auditing practices of the
company and the role of accounting professionals in providing such misleading financial
statements for the company. Enron broke the trust of their investors, share holders and their
employees as the top executives of the company were lured by the positive publicity and
worldwide media attention undertook aggressive methods of hiding company’s weak finances.

1.2 Corporate Governance of Enron

The board of directors of the company included Jeffrey Skilling, President and CEO; Mark
Frevert, Vice Chairman; Greg Whalley, Chief Operating Officer and Andrew Fastow, Chief
Financial Officer. Andersen was responsible for handling the auditing and accounting business
of the company. Enron’s rise and fall was due to the activities of the corporate governance
which was of elaborated structure. Initially, the company thrived over the market of energy
sector as it redefined their business model to energy broker from energy delivery. Deregulation
in the energy sector helped Enron to become the first company to be more innovative as
limitations often results in creating newer techniques and systems with the help of accelerated
experimentation(Weaver, 2004). The company now recognised for its corruption practices was
once looked as an ideal model for corporate responsibility and business customs.

1.3 Major Issues and Challenges Revolving the Case

The corporate governance of the company cultivated ethical and cultural views of pushing the
limits of their strengths which made their employers more creative as well as aggressive. In
addition to the company’s competitive cultural and ethical background, the positive scrutiny
from the press and popular financial analysts in the late 1990s added fuel to the exploitative
escalation of the company. In order to maintain the reputation the company earned from
worldwide business forums it started undertaking unfair means of the preserving their financial
status. The executives of Enron knew that negative earnings would lead to fall in their
investments and that would result in subsequent decline in their credit ratings of the company’s
stocks. Not only this, the ruin of the country’s financial outlook can affect its trading relations
also. The loss in the faith of the trading partners in the company would result in fall in cash flows
and quality earnings of the company. In the view of maintaining its investment status and
avoiding such state of affairs the company adopted accounting methods which were against the
norms of accounting practices. The complex financial reports were unclear to its shareholders
and moreover, the company used restrictive accounting methods to manipulate their balance
sheet and income statement (McLean and Elkind, 2013).

2.0 Analysis of the Case

2.1 Role of Accounting Professionals in the Downfall of Enron

The role of the accounting professionals in the downfall of Enron cannot be overlooked. The
transactions and accounting issues of Enron especially the SPEs (Special Purpose Entities which
Enron used to fund the risks generated from specific assets) became the core of investigations
after the case was disclosed. The accounting rules were manoeuvred to their benefits. There were
six main accounting issues that were manipulated by Enron’s accounting professional and they
are:
1. Policy of not combining SPEs to cover the losses and outstanding debts from the investors.
2. The accounting methods of sales of the merchant investments were kept unconsolidated
with SPEs.
3. The company’s fair value accounting system that resulted in the restatements of
investments.
4. Accounting of those stocks that were issued to the SPEs.
5. The income reorganization practices under which they recorded sales from the
forward contracts in the current period.
6. Enron’s minimum disclosure of their party transactions and their costs to the stakeholders
(Healy and Palepu, 2003).
In addition to these accounting issues, Enron allowed its 6 key players including Andre Fastow
(CFO of Enron) to enter into partnership with SPEs as a result of which these players got
profitable amounts when there were transactions between SPEs and Enron. The mark to market
accounting which meant that the present value of the future inflows of the long term contracts
signed at present will be recognised as current revenues and the present value of expected costs
to be regarded as current expenditures. The fact that some of the long term contracts of the
company had the term of 20 years, made the practice of mark to market accounting a difficult
challenge for the accountants. There were questions regarding the viability of the contract and
the cost associated with them. The company’s long time auditor Arthur Andersen was charged
with the lawsuits for its dereliction and fraud accounting practices to hide the financial risks of
the company. Thus, the accounting problems of the company were largely seen in the context of
the SPEs and in the viability of the company’s strategies in pursuing its trading activities to other
market. There was uncertainty regarding the opportunities resulting from deregulation which
persuaded the accountants to devise statements that would hide this reality. Based on the
evidences, Power Committee reported that Andersen not only failed to discharge its
responsibilities of auditing the financial statements of the company, but also did not fulfil its
obligations to the Audit and Compliance Committee (Forbes, 2013).

2.2 Failure of Internal and External Balance Checks

Both internal and external checks failed to identify the losses which were hidden by the
company’s creative accounting methods for a number of years. In order to give the picture of the
company’s rapid earnings and to hide the substantial losses, Enron desperately followed the
creative accounting process. It overstated the prices and the stocks under the future contracts by
arguing that the future worth of the assets will be even more than what was then actually
estimated. Enron’s internal corporate system including the planning, budgeting and reporting
were the main causes of their downfall. The senior executive branch of the company utilized the
tools of mark to marketing accounting and the SPEs to disguise their financial distress and create
fabricated profits (Fox, 2003). Enron’s board of directors, lawyers, executives, compliance
officers and the external auditing agencies Arthur Andersen either ignored or intentionally
concealed the deceitful accounting practices by the company. The external governance over a
company is important for the organisational credibility of a company (Forbes, 2013). The role of
external auditor, Andersen was supposed to be disclosing the false financial statements that the
company was providing, but it was exactly the opposite. As one of the Big Five audit firms, it 7
was expected that they will ensure a correct financial status of the company to protect the
interests of the stakeholders and investors (Makkawi and Schick, 2003). However, their long
term cordial relation prevented Andersen in revealing the undermining scenario of their greatest
client. They earned hugely from the consulting fees rather than the auditing fees from the
company. Along with the high consulting fees that Andersen received, the well developed long
term inter personal relationship between both the company’s employees and stakeholders
obligated Arthur to overlook the faulty practices of Enron. The shredding of Enron related
documents by Andersen proved to be fuel in the fire, as that confirmed their guilt in the scandal.
Thus, the external as well as internal checks and balance system was ineffective in securing the
accountability of the company to its stakeholders.

2.3 Breach of Accounting and Ethical Code of Conduct

The role of the accountant is to furnish all those entities that are financially related to the
company or have the legal rights to know about the fiscal affairs of the company. In the view of
such accounting principle, there was arousal of conflict of interests between the firm and its
accounting partner. When an accounting firm does the auditing of a company’s loss and profits
and provides the accurate information to its investors and shareholders, even though the figures
represent the declining performance of the company, is an example of conflicts of interests
(Healy and Palepu, 2003). The ethics and code of conduct of Enron were based on jealously,
greed and competition to thrive in the market. The stakeholders of a company primarily looked
upon the cultures and behaviours of the leaders in valuing it. There are few evidences that the
corporate leaders of Enron followed the code of ethics which stated the company’s commitment
to respect, excellence, integrity and communications. The violations of ethical conducts were
clear from the actions of the managers and they frequently breached the law and were more
inclined towards fulfilling their own interests rather than those of the company and its
employees. A case was reported in 2001 when Lay announced its termination of a partnership
created by their former CEO, which resulted in elimination of $1.2 billion in stakeholder equity.
This helped the company to actively purchase and sale its assets keeping the stock prices high
and showcased the self serving mentalities of the company leaders (Thomas, 2002). 8

2.4 Corporate Culture and Disregard for Code of Ethics by Top Managers
The behaviour of the leaders in an organisation is important in incorporating the organisational
culture and employees follow their leaders to develop the right corporate culture in them.
Enron’s shortcoming lies in their leaders’ entrepreneurial role in their organisation. The
company’s leaders pursued their own interests and denied the serious crisis prevailing in their
business economy. When the stock prices began to fall significantly, the company started
shifting their investments, while the employees could not sell of their shares. The leaders
portrayed a vivid picture of the company’s financial conditions and stated that the problems are
not so deep rooted that they cannot be solved, but they knew actually that the problems were
serious. Enron’s reward system was based on the principle of win at all cost that led them to
retain only those employees who produced consistently irrespective of the methods utilized by
them. The leaders’ decision of recruiting or dismissing the employees provides good signals of
the corporate values of the company. Ken Lay focused on immediate hiring by selecting the
brightest students from the top business institutions to strive in the competitive framework of
innovations and productivity. The executive or the top managers in charge of the business
inculcated the rules of winning at all costs to their employees as they focussed mainly on the
short term achievements. This was also the reason that they fired employees frequently on the
basis of the Performance Review Committee who sorted employees in one of the six common
performance categories in each job profiles. The categories were superior performance, excellent
performance, strong performance, satisfactory, needs improvement and issues. The ones who
were in the bottom line of these categories were fired immediately which showed the aggressive
hire and fire policies of Enron. Although this kind of hiring policies enabled the company to be
more productive in short run, it actually erode the cultural and ethical values of the company
(Healy and Palepu, 2002).

2.5 Lessons learnt from the Case

The key lessons learnt from Enron accounting fraud and violation of professional ethics is
discussed in brief in this section:
1. The healthy corporate culture is a significant factor in determining the fate of a company. The
executives on top management of Enron believed that whatever they do is the right thing as long
as that is generating more money. There optimistic behaviour of the shareholders of the board 9
was also a cause of their indulgences in fault practices. They tried to cover the losses and failures
to sustain their world class reputation instead of taking effective steps in resolving those crises.
2. A more elaborative system of supervising the executives and operations of the company were
needed to ensure that the company did not use any illegitimate ways of making money. Thus, the
board of directors should keep an eye over the management operations and the executives before
they start applying impractical methods for yielding higher revenues.
3. Mark to market accounting rules was used by Andrew and Jeffrey to substantially raise their
stock price and drive more investments. It was impossible to achieve long term sustainability
through this immoral practice and a more valid accounting system that would provide
transparency in the income and balance sheet statements were essential for a company with such
a large scale operations. The ignorance of the shortcomings of the mar to market accounting
rule by SEC (Securities and Exchange Commission) was also responsible for the final scandal.
4. The important aspect of business ethics that is to remain loyal to the employer was violated
in Enron’s case. The accountants should have been responsible for unveiling the true profits and
losses in the financial statements of the company based on which important decisions were
undertaken. Anderson’s relation with Enron’s executives beyond professionalism led to their
equal involvement in the scandal and they fail to remember that as an accounting agent they are
liable to the company for their activities.

3.0 Conclusion
Although Enron boasted about their corporate governance strategies were to look for the long
term success and viability of the company’s projects, but things were different internally. Most
of the leaders and directors of Enron and the risk management department had little role in
obstructing the projects that were perceived as risky. It is because of this reason, that most of the
directors and leaders held bonds to Enron, because of their personal relationship with the
company. Moreover, the hype over the Enron’s success in media and stock market instilled
arrogance within its executives who thought that maintaining the current status of the company
was much more important than company’s long term sustainability. The mark to market
accounting policy used by the company’s accountants manipulated the revenue figures of the
company as that reflected the current market values of the assets rather than the book value.
Many of the company’s assets were marked to model through estimated financial models that
manipulated the accounting results. It showed that the company had been achieving booming
growth, while in reality, a lot of their accounted cash flows and revenues were not achieved at
all. The focus of the company on short termed quarterly profits rather than long term creation of
value in sustainable way turned the fate of the company towards it devastation. This paper not
only provides a clear outlook of the Enron’s failure and the reasons behind such scandal but also
provide good lessons that should be practiced in each business models. The trust of the
consumers and investors on corporations were impeded and the confidence of investors was
destroyed after Enron’s scandal which needs to be rebuilt.