Enron Scandal: Analysis Of Principles of Accounting

Assignment Question:

In spite of a robust accounting system, we have seen lapses, leading to many famous corporates collapsing overnight. With reference to the Enron scandal, point out the entire case leading to the scandal and subsequent laws passed by The US congress to deal with such failures.

Attempt Count: 1

Introduction:

Enron`s collapse was one of the biggest collapses in the U.S. History. It shocked billions and affected the lives of thousands across the nation. Enron was considered to be one of the most innovative companies with a very impressive turnover. It made use of illegal fraudulent accounting policies to cover up the firms debts. But, the company was fated for a fall, after reaching sky-rocketing heights. At the crest, Enron`s shares were $90.75 per share which plummeted to $0.26 when the firm went bankrupt. Anyhow, Enron`s fall remains to be one of the most popular cases of corporate fraud documented in America. It`s specifics went as follows.

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Origin:

Enron was formed by Kenneth Lay after merging InterNorth and Houston Natural Gas Company in 1985. Thus, Lay became the first Enron CEO. Initially, the company only acted as a natural gas provider, but , in 1989, it began providing natural gas commodities and subsequently, in 1994, it became an electricity provider. In 1990, Enron branched out as Lay created Enron Finance company to be headed by Jeffery Skilling. The minimum regulation in that era allowed Enron to flourish and the company was in full swing.

Innovation Encouraged:

In 1999, Enron launched Enron-Online, and online electronic trading website which brought in a lot of appreciation and encouragement. Enron was involved in every transaction on the Enron website, it was either the buyer or the seller. Enron attracted praises from many, at this point for its ambitious goals and was also listed as 'America`s most Innovative company' by Fortune for Six back-to-back years from 1996-2001. By 2001, it was carrying out $2.5 billion worth of transactions a day. t the end of the century, Enron had entered the list of the most successful companies in the world and held 25% market share of the energy-trading industry.

The Scandal:

Jeffery Skilling transformed the company`s accounting method from the historical cost concept to the Market-to-market method for which the company received the official US Securities and Exchange Commission`s approval in 1992 . This accounting method allows for the accounting calculations to be based on 'fair value' of its assets and liabilities rather than the 'actual cost'. The concept of fair value depends on market conditions which keep changing and as a result, the values of the assets and liabilities were also subject to change. It consider the current market price of the assets not the price paid. But, Enron misused this accounting method to overstate its profits and to mislead investors and stockholders. Some say that this was the first step, that would eventually lead to the dramatic collapse of the company as it allowed it to report estimated profit as actual profit.

Jeffery Skilling brushed the company`s losses under the carpet using the market-to-market method. In this case, the company claimed profits of its just finished plants on its books, even though the plant had not generated one dollar. If the plant made less than the projected value, the loss would be transferred to its subsidiary or shell companies, thus, going unreported. Enron thus, claimed profits from projects prematurely and transferred its losses to shell companies which do not have to produce financial statements in some cases. Thus, its balance sheet was a gist of all the profitable ventures, boosting revenues and not including or removing the unprofitable ones, keeping the revenue of the firm still high. This gave Enron unreasonably high profits.

By the autumn of 2000, Enron had started showings signs and flags resulting to its imminent collapse. Enron used SPVs or special purpose vehicles also known as SPEs or Special Purpose Entities, to cover up its escalating debt. It was using hundreds of SPVs to essentially hide its piling debt. It used the SPVs by transferring some of its drastically rising stock to the SPV, which would in turn give Enron cash or a note. The SPV would use this stock to hedge Enron's assets.

This started to backfire because Enron used its own stocks to hedge its assets using SPVs. This directly compromised the ability of SPVs to hedge its assets in case the value of Enron`s stock fell. Enron did include the existence of SPVs in its statements. It believed that its stock price would maintain its value. Therefore, when the stockholders trust declined, and with it the value of Enron stocks, the SPVs were no longer able to cushion the assets of Enron. The main problem arose when the analysts were not able to explain the statements of the firm. This fact led the Securities and Exchange Commission of the US to initiate an investigation in the company which revealed fraudulent practices. Hence, leading to the big crash.

Laws passed in the wake of the Enron scandal:

· Sarbanes-Oxley Act

The Sarbanes-Oxley act was passed in the aftermath of the Enron case to prevent the occurrences of such fraudulent practices in the future, safeguarding the interests of the stockholders and the investors. This law was drafted by U.S. Senator Paul Sarbanes and U.S. Representative Michael Oxley and hence, the name Sarbanes-Oxley.

Under this law, all publicly-traded companies are required to use and report the internal controls the company uses. it mandates the inclusion of Internal control reports in the financial reports.

Other main provisions are:

1. Chief Executive Officer and Chief Financial Officer must assess all financial statements of the firm.
2. Financial report does not contain any misrepresentations.
3. Information in the financial report is 'fairly presented'.
4. The responsibility of the internal accounting controls is given to the Chief Executive Officer and Chief Financial Officer.
5. It is the duty of the CEO and CFO to report any insufficiency in internal accounting controls, or any fraudulent practices relating to the administration of the audit committee.
6. CEO and CFO should specify any material modifications in internal accounting controls.

Timeline of the Enron Case:

• -1985: InterNorth and Houston Natural Gas merger forms Enron Corp. Kenneth Lay becomes CEO the following year.
• -1997: Enron purchases partner`s stake in a company known as JEDI, and transfers if to a firm created by Enron by the name, Chewco, an attempt to cover up debts and exaggerate profits. Jeffery skilling becomes COO or chief operating officer.
• -2000: Skilling made CEO.
• -2001-
  • -August 14: Skilling resigns from the post of CEO, Lay resumed the position of CEO.
  • -Oct 16: Enron announces $638 million in losses and reduction in shareholder equity by $1.2 billion.
  • -Oct 19: The Securities and Exchange board opens an investigation into Enron.
  • -Nov 8: Enron admits fault, hands in revised financial statements endorsing $586 millions in losses since 1997.
  • -Nov 9: Dynegy Inc. proposes to buy Enron for more than $8 billion.
  • -Nov 19: Enron restates third quarter earnings revealing $690 million debt due on Nov 27.
  • -Nov 28: Dynegy Inc. refuses to buy Enron, Enron`s stocks fall below $1.
  • - Dec 22: Enron files for bankruptcy
  • -June 15, 2002: Arthur Anderson convicted

Conclusion:

The Enron scandal pointed out the loopholes in the financial laws governing the corporate sector that could and were being used to mislead the investors and fool the government. Although there are still critics about the Sarbanes-Oxley Act, it does more good than harm.

The findings of the SEC revealed that the Auditing firm, Arthur Anderson had audited Enron`s statements and not reported the fraud. Consequently, the firm was sued and this led to the shutting down of the Arthur Anderson Audit firm.

References:

1. Palepu, P. M. (2003). 'The Fall of Enron'. Journal of Economic Perspectives , 3–26.
2. Peavler, R. (2019, November 16). The Enron Scandal That Prompted the Sarbanes-Oxley Act . Retrieved from https://www.thebalancesmb.com/: https://www.thebalancesmb.com/sarbanes-oxley-act-and-the-enron-scandal-393497
3. Segal, T. (2019 , May 29). Enron Scandal: The Fall of a Wall Street Darling . Retrieved from https://www.investopedia.com/: https://www.investopedia.com/updates/enron-scandal-summary/
4. Smith, R. (2018, December 10). The Enron Scandal. Retrieved from http://large.stanford.edu/: http://large.stanford.edu/courses/2018/ph240/smith1/