Enron’s Monstrous Failure: Critical Analysis

Enron was one of the biggest companies in the United States, but it fell apart almost immediately due to one of the most notorious business failures in history. The former CEO of Enron, Jeffrey Skilling, described Enron as pursuing an “asset-light” business strategy according to “Making Sense of the Enron Nonsense.” Within this strategy, Enron’s main focus was to make profits off their employees’ ability to comprehend and anticipate what organizations that produced and used electricity and natural gases may do. In other words, Enron frequently benefitted from successfully leveraging and taking advantage of arbitrage, meaning they bought and sold contracts across the energy markets faster than the rest of the market could and made profits off price differences. According to the article, “there were three reasons” for anyone to believe that Enron’s business model was profitable. First off, Enron was the leader in restructuring the US energy industry. Secondly, Enron had more experience as a multinational firm than its competitors. Lastly, arbitrage opportunities were profitable during this stage of the evolving energy markets. Early on, Enron wasn’t so “asset-light” in their strategy or business model, as can be seen above in exhibit 1, which outlines Enron’s plans regarding pipelines throughout the US. Enron initially strived to provide many end-users with natural gas and electricity through their power plants, pipelines and other energy products. Over time, though, their “asset-light” business model took shape, and Enron began to focus on the trading of commodities, such as energy, in order to make a profit off basically acting as a broker in their markets.

Even before it declared bankruptcy, Enron was known for its “opaque accounting practices,” according to “Making Sense of the Enron Nonsense.” According to this article, the 1990s were a time in which a lot of growth was taking place related to energy trading. Enron frequently exploited profitable trading strategies, such as those arbitrage opportunities mentioned above, and showed solid and consistent revenue growth on financial statements. With the help of Arthur Anderson, they portrayed the image of a healthy and strong company, even though their balance sheets and other financial statements were considered by many to be “indecipherable,” according to the article mentioned earlier in this paragraph. In the end, Skilling and other Enron executives wanted to transform Enron into a money-making machine, and Enron became what most people thought was just that and an industry leader for several years. Enron’s business practices throughout the 1990’s led them to the inevitable declaration of their bankruptcy. What really started this was when Enron was allowed to use mark-to-market accounting. This allowed Enron to record potential future revenues on the day a deal was agreed on. This, combined with a lacking ethical structure from the top down, allowed Enron to falsely inflate their revenues. Many people at Enron including Jeff Skilling were brilliant, but many of them clearly let their desire for money get in the way of Enron’s long-term financial well-being. For example, while stock prices across the market were going up, Enron was losing money and not showing that fact on financial statements. At the same time, many executives at Enron and other organizations were selling their shares. When Portland General Electric (PGE) and Enron merged, this madness rose to another degree. With access to the west coast energy markets through PGE, Enron now had access to California’s deregulated market. Around the same time, Skilling was proposing ideas like trading unused bandwidth or even weather in attempts to make Enron more money. For example, when Enron released news about its project with Blockbuster, aimed at delivering movies on demand, Enron’s stock soared even though the idea never even worked out. Furthermore, Enron was able to use mark-to-market accounting to record millions in profit from the venture despite it losing money. By the end of 2000, internet stocks were falling, yet Enron’s stock remained on the rise and it was still unclear to many skeptical stakeholders as to how Enron made money.

We now know that Andy Fastow, Enron’s CFO, lead various companies that conducted business with Enron. These companies took on Enron’s debt, which made it look like Enron was seeing cash come in. That wasn’t the case at all, as the debt was simply hidden within Fastow’s companies. Many major banks invested in these companies, and accountants and lawyers went along with all of it. An example of this fraudulent activity occurred during California’s national emergency regarding their lack of power due to Enron’s dirty business practices. Enron was exporting power out of California during the power shortage they created by having power plants shut down. When the prices went up from this shortage, they would sell the energy off at the inflated prices. At the same time, traders at Enron were betting on the price of energy to go up, which was clearly mostly under their control at the time. Enron wasn’t the only company doing these things, but the extent to which they committed fraud vastly outweighs other examples. Under Skilling, Enron employees either didn’t care or didn’t know about the extent of their wrongdoing.

On August 4th, 2001, Skilling resigned as CEO of Enron. A day after this happened, Sharon Watkins sent a letter to Ken Lay regarding the information she had uncovered related to assets which were hedged with one of Fastow’s companies. She effectively “blew the whistle” because she knew that the financial statements didn’t make any sense the use of creative accounting had gone much too far. She referenced this strange accounting in a letter to Lay, which he didn’t seem to pay much attention to. Through the downfall of Enron, Arthur Anderson and other parties involved were also punished. It’s only right that Arthur Anderson was demoted from its “Big 5” status because employees of the firm shredded over 2,000 pounds or one ton of paper evidence related to the Enron scandal. As stated in the overview, Enron served in the energy trading industry, capitalizing on the fluctuation of the cost of energy in order to make their revenue. It’s important to realize how well Enron was doing before things went bad. At their peak, Enron’s common shares were trading for $90.75. By the day Enron declared bankruptcy on December 2, 2001, the shares were trading for $0.26. In the end, a combination of poor internal control processes as well as their auditors turning a blind eye to poor accounting practices led Enron to become the center of “one of America’s greatest business debacles,” according to NPR.org. Auditing standards were lacking & Enron actively lobbied to amend acts such as The Public Utilities Holding Company Act, which eventually eased up on various kinds of restrictions on investments Enron was interested in. Similarly, relationships with both the Bush family and Arnold Schwarzenager are suspected to be part of Enron’s business practices.

US GDP growth rate in 2000: 4.2%. 2001: 1.1%.

US unemployment in 2000: 4%. 2001: 4.2%. 2002: 5.7%.

US real interest rate in 2000: 6.8%. 2001: 4.54%. 2002: 3.09%.

US inflation rate in 2000: 3.39%. 2001: 1.55%. 2002: 2.38%.

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Enron portrayed the image of being an innovative and financially healthy company. This paired with rising stock prices made the 1990s, retrospectively, a mess in terms of investing. Also, financial statement users were not as knowledgeable before the Enron scandal & lacking oversight in accounting helped lead to Enron’s downfall, which lead to the development of the 2002 Sarbanes-Oxley Act. Under this act, financial statement users are more protected and informed than ever before.

Computerized accounting procedures are much more common than before, which, among other tremendous aspects, makes the true destruction of evidence more difficult.

Enron was an energy company that also generated revenue through energy market arbitrage. Enron’s management did not particularly stress sustainability with the energy is produced, and actually lobbied against renewable energy sources, showing their support for natural gas, oil and coal energy sources.

Enron frequently lobbied for their chosen causes, and the downfall of Enron, as mentioned above, under “sociocultural” aspects, helped bring about The Sarbanes-Oxley Act, which primarily protects financial statement users. According to the New York Times’ article, “Enron’s Many Strands: The Strategies; How Enron Got California to Buy Power it Didn’t Need,” Enron’s tactics that helped bring about its’ demise were “condemned” as “‘seemingly gaming the system’ and ‘very offensive’” by Enron’s former interim chairman, Norman P. Blake Jr. in front of the Senate. According to this same article, Enron was “get[ting] paid for moving energy to relieve congestion without actually moving any energy or relieving any congestion” in the state of California. In other words, Enron was essentially portraying the false image of energy congestion while taking advantage of arbitrage opportunities, resulting in Enron charging more than necessary for services they weren’t truly or completely providing. In the end, regulators were forced to fix this issue in 2001 through the implementation of price restraints throughout the West coast of the US. Before these price restraints, Enron took part in purchasing power in California at “capped prices” and subsequently offloading it at a profit. Furthermore, California laws required Enron, among all other sellers of power, to disclose the unique source(s) of the power that they would sell. This implies that, “in order to short the ancillary services it [was] necessary [for Enron] to submit false information that purport[ed] to identify the source[s] of the ancillary services.” This issue, unfortunately, was not unique to Enron. Luckily, changes like the Sarbanes-Oxley Act have been put into place since this era of financial statement messes.

Advice

After Enron filed for bankruptcy, they never reopened and this business is looked at as the prime example of why sound accounting principles are important and why they needed to be changed following this debacle. As mentioned before, Enron was shifting debt to its subsidiaries in order to keep their stock price rising, which was seemingly beneficial for all of their shareholders. Also, Enron pursued various other “creative accounting” techniques, as well as arbitrage opportunities to deceive financial statement users and turn a profit. If I were an auditor hired by Enron before their downfall, I would’ve advised Enron’s management not to hide debt for a multitude of reasons. First, it is illegal and immoral. In addition, you can only keep up appearances for so long, so this was a short-term solution/scheme at best. Deceiving shareholders into thinking your company is far better off than it is will never end well, so I would’ve advised Enron’s management to portray a more honest, if not conservative, view of the financials. When conservatism works, financial statement users get excited about outperforming target objectives. When conservatism goes too far, financials can get depressed by a high degree of misstatement. On the other end of the spectrum, though, Enron was being way too generous, which only brought down the stock price. In the end, I would’ve advised Enron’s management to portray the financial statements in more of a conservative light. The main issue regarding Enron’s fraudulent activities is the issue regarding Arthur Anderson’s lack of independence. Since The Sarbanes-Oxley Act, accounting has seen a more serious attitude towards ensuring the independence of auditors. Individuals at Arthur Anderson and management at Enron should’ve placed more emphasis on auditor objectivity and independence, and I would’ve advised them to do so. For example, it was not responsible for Enron or Arthur Anderson to undertake both consulting and auditing activities and duties. In the end, the off-the-books entities that Enron claimed to conduct business with went unnoticed by both representatives at Arthur Anderson and the board of directors of Enron. This, coupled with the lack of transparency that resulted, ended up bringing down both Enron and Arthur Anderson. Enron’s failure was undoubtedly warranted due to their poor business practices in combination with their accountant’s poor auditing practices. These poor auditing practices were a direct result of Arthur Anderson not maintaining independence throughout its business relationships as mentioned in the previous paragraph. Arthur Anderson was supplying business consulting advice as well as auditing Enron’s financial statements. That being said, there was incentive for Arthur Anderson representatives to help the business to perform well (at least on paper) and to pass their yearly audits. This failure had somewhat of a silver lining in that the accounting industry was heavily refined to ensure a squander of this magnitude could not be replicated. Now, independence from your accountant is a top priority since their main objective is to provide credibility to the financial statements, ensuring that they are fairly prepared and presented.

A key point from this same article is that “accounting is not an exact science.” This is the major counterpoint to the common argument that Arthur Anderson should’ve been held solely responsible, without question, for the Enron scandal. Most people may not realize that the job of an auditor is not to ensure the exactly correct portrayal of financial statements and reports. On the contrary, a company’s management is responsible for the preparation and fair presentation of financial statements with respect to the applicable reporting framework (such as US GAAP). Around the year 1990, Enron started reporting its energy sales revenue as gross revenue instead of net revenue. This helped boost the appearance of their financial well-being, and this practice trickled down through the industry to other similar companies. The most harmful aspect of this is that the users of financial statements were unaware of this unethical practice, and the share prices of companies like Enron went unchanged relative to this behavior for a long time because of a lack of communication of accurate information. Close to its demise, Enron once employed, according to their 2001 financial statements, 20,600 employees. According to the same statement, Enron also had 58,920 stockholders. By the time Enron had crumbled, some of these stakeholders had lost everything.

The last interesting point “Making Sense of the Enron Nonsense” brought up is, essentially, that the shareholders of Enron could be seen as being at fault for what transpired in relation to Enron’s eventual bankruptcy. As the article states, “Shareholders must exercise their responsibilities as owners of the firm to demand complete disclosure of all relevant information.” This is another way of saying “buyer beware,” which rings true in most circumstances without this being an exception.

Even though Enron executives were able to essentially steal hundreds of millions of dollars, this ended very ugly for most of them, with Skilling initially being sentenced to 24 years in prison, Lay reportedly dying of a heart attack while awaiting sentencing, and Fastow being sentenced to 10 years in prison. Another Enron higher-up, Cliff Baxter, also reportedly committed suicide after the incident. In addition to Enron executives, over $7 billion was paid by a group of banks to shareholders and investors because of the banks’ alleged participation in Enron’s fraud through funding activities. On the other hand, the best outcome of all of this was the Sarbanes-Oxley Act of 2002, as mentioned before. In the end, the whole Enron scandal is just a valuable lesson we can all hope to learn from.