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    Enron Case Study PDF

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    NurulAdibah

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    © All Rights Reserved
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    of 2
    Enron’s Fall! In its April 2001 issue, Fortune magazine called Enron, then the seventh-Largest company in the United States, the “most innovative” company ia America. Six months later, ‘on December 2, 2001, Enron fied for bankruptcy the out- ‘come of what has been called the greatest accounting fraud of the 20th century. Twelve thousand employees lost not only their jobs bue their entire retirement and life savings, which had been invested in Enron stock. Other owners of Enron stock—including thousands of ordinary Americans ‘whose pensions were also invested in Enron stock—lost a total of $70 billion when the value oftheir stock collapsed to zero, Inside Enron, Sherron Watkins, an Enron vice president, watched in horror as the company she had struggled to save by alerting others to winat was going on, nevertheless crashed down sround her. ‘Kenneth Lay, an economist and former undersecretary at the U.S. Interior Department, formed Enron in 1985 by engineering the merger of two natural gas companies whose combined pipeline systems, when joined together, formed the first nationwide system capable of distributing natural gas to utilities around he country. Lay expanded the company by borrowing money to buy up other compa- nies, and by 1987 Enron’ debt was 75 percent of is stock market value, creating an ongoing problem for the com- pany. In 1989, Lay hired a young Harvard MBA named Jefirey Skilling to be head of Enron's finance department: ‘The U.S. government had only recently “deregu- lated” the energy business by lifting many of the regula- tons that had Kept energy prices fixed. With the lifting of all regulations, gas prices began to flucuate widely, mak- ing the natural gas market extremely risky for both buyers and sellers. Small gas producers, in particular, had trouble raising money for exploration and drilling because the risky markets drove lenders away. ‘Shilling came up with the innovative idea of having Enron serve asthe intermediary between buyers and sellers in a way that would reduce che risks deregulation created ‘Enron would sign contracts with sellers to buy their gas over 1 certain number of fucure years ata certain fixed price and then sign contracts with buyers to sell them gas during those years at the same price, plus a profit that Enron kept. Because these long-term contracts fixed the price of gs for several yeas, they removed the risk for both buyers and sellers s0 both groups began trading with Enron and Enron soon became the leading company in the profitable energy trading business. Skilling pur together a team of traders con- sisting mostly of MBAs whom he pushed hard with arathless system that each year fired the bottom 10 percent in per- formance and lavishly rewarded the top performers Skilling now decided to have Enron apply the same trading idea to other commodity markets, and eventually Enron's eager traders were buying and selling long-term contracts for electricity, coal, paper pulp, aluminum, steel, chemicals, lumber, water, broadband, and plastics— altogether a toal of 1,800 different kinds of products. The contracts in these commodities also reduced rsk by fixing the price of the underlying commodity for anywhere from ‘eo 12 years into the fatare In 1990, Skilling had hired Andrew Fastow; a financial ‘wizard, to help run the trading business, and the two had come ‘up with an ingenious idea for reporting the value of the long term contracts they were buying and seling. They persuaded the US, Securities and Exchange Commission tallow them to use che “mark to market” accounting method for these con- tracts In the “mark to market” method, the value of anasetis “marked” (reported) on the company’ financial reports as the carrent “market value” ofthe asset, that i, the amount for ‘which the asset theoretically would sll on the open market “To calculate the marker value of a contract, Enron traders ‘would forecast the future price ofthe underlying commodity (eg, gas, electricity, coal, etc.) daring the years ofthe con- sract. Using this forecast, they would then add up the theoret- ‘cal future eash flows of the contract, apply a disconnt rate, and compute the net present valve of the contract. This net present value was then reported as the “true value” ofthe con- tract Ifthe net present value was higher than what Enron had cxiginaly paid for the contact, then the diference could be reported as a “profit” on Enmn'’ financial sheets. Enron iraders were pressured to forecast high futare cash ows and Jow discount rates on their contracts, allowing Enron to re- port high asset (Contract) values and profits to investors, In 1996, Skiing was made president and chief operating officer cof Enron, and Festow became chief financial officer. Early on, Enron encountered 2 problem. In order to ‘enter many of the markets it traded in, it had to borrow substantial amounts of money to purchase the infrastructure needed to transpory, store, and deliver the commodities ic was trading. But if Engon took on large amounts of debt, in addition to the high debt it already carried, buyers and sell cers would be reluctant to sign agreements with the company since high debe levels increase the possibility that a company ‘ill fil. Higher debe levels would also lower its investment grade with lenders and possibly rigger banks to recall their current Enron loans. To get around these problems, Enron had to find a way to access borrowed money without having to report the debt oni ov financial satements. "Andrew Fastow found a clever way of getting around the debe problem and simultancously getting rid of the ‘many overvalued contracts on Enron’ fnancial sheets while generating additional “revenues.” Paying handsomely (sev- eral million dollars) for consulting expertise provided by ‘Arthur Andersen’ consulting division, Fastow, with Arthur Andersen’ expert assistance, setup a series of "limited part- nerships” called “Special Purpose Entities.” Accounting rules allow a company to exclude a specisl purpose entity from its own financial statements if an independent party has control of the special purpose entity, and if cis inde pendent party owns at least 3 percent ofthe special purpose entiy, To meet these conditions, Fastow appointed himself and other Enron people as heads of the special purpose enti- ties. These individuals then invested enough of their own ‘money in the special purpose entities to satisfy che 3 percent rule, and Fastow transferred enough Enron stock into the entity to make up the other 97 pereent. The special purpose entities then borrowed large sums of money, using their Enron stock as eollteral. The borrowed money was then paid to Enron to “buy” the overvalued contracts on Enron's ‘books and other failing investments, and Enron was able to record the money as “sales revenues” instead of debe. The special purpose entities also agreed to take over large amounts of Enron’s existing debe and in rerurn, Enron transfered more of its stock to the special purpose entities, Fastow gave the entities unusual names like “Cheweo, “Jedi,” “Talon,” “Condor,” and “Raptor,” and he and other Enron people paid themselves millions of dollars as salaries and income from their 3 pereent ownership ofthe entities. ‘The end resule was that the special purpose entities were left holding debt, secured by Enron stock, and aso holding the overvalued contracts and other failing invest- ‘ments a5 “assets.” Since the debts and assets purchased from Enron by the special purpose entities did not have to be reported on Enron’ financial reports, stockholders be- lieved that Enron's own debts were not increasing, thatthe company was profiting handsomely on the sale of these contracts and other assets to these entities, and that rev- ems were increasing each year. As the company’s auditor and “outside” accountant, Arthur Andersen's auditing divi- sion certified that the company’s financial reports provided an accurate secounting of the firm. Sherron Watkins, an honest, ouspoken, and straight= forward person who had begun working for Enron in 1993 and who was now working as a vice president under Fastow, became alarmed by the accounting practices Fastow had in- troduced. So long as the price of Enron's stock remained high enoogh, its value would be sufficient to belance the debt the special purpose entities held and the debt could re- main off of Enron’ books. Bur she knew that ifthe stock declined sufficiently, this would trigger rules that would force the company to dissolve che entities and bring the debts and overvalued assets biel onto its financial repos. Unfortunately, in the second half of 2001, Enron stock began to decline from its high of $80 4 share, partially as a result of a March 5, 2001 story in Fortune ‘Magazine which argued that Enron's fnancial statements were “nearly impenetrable” and that the stock was over- priced, As its stock price declined, Enron accountants struggled to regroup the debts and assets of the special purpose entities so as to avoid having to include them on the company’s financial statements. Sherron Watkins was horrified both by the increasing risks the decline created and Fastow’ attempts to cover them over. In July of 2001, as investors became more suspicious and the company’ stock price dropped to $47 a share, Silling suddenly resigned as president and CEO for “per~ sonal reasons.” Now sore thatthe company was headed to- ‘ward diester, Sherron Watkins on August 2 personally met with Ken Lay and the legal department and handed over a six-page letter describing the accounting irregularities re- Jated tothe special purpose entities and alerting them to what she later termed “the worst accounting fraud I had ever seen,” “Tam incredibly nervous,” she wrote, “that we wil im plode in wave of accounting scandals.” Lay and his stor- neys, however, decided nothing was amiss elthough the spe- ial porpose entities might have to be dismantled eventually sf Enron’ stock continued to slide, Publidly, Lay announced to employees and investors thatthe farure growth of the company “has never been more certain” and urged them and ‘other investors to continue o invest in Enron stock. Lay and other executives, however, began to quietly sell much oftheir Enron stock. Watkins also contacted a friend at Arthur An~ dersen who discussed her concerns with Andersen's head Enron auditor. Nothing, however, was done. ‘As Watkins on the inside continved trying to get the ‘company to act, the price of Enron stock continued to fll. ‘On October 16, 2001, Enron announced that it had de-

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