Nicholas Barton

00343164
Accounting 2600
Case Study: The Enron Collapse
Why was it that Enron, a financial services company, in effect, could not release a
balance sheet with their earnings statement? -Jim Chanos, President Kynikos
Associates.
In the film Enron: The Smartest Guys in The Room, analyst Jim Chanos asks
why, the 7th largest company in the world at the time, could not supply investors
with basic financial statements. These statements as we learn in accounting are the
fundamental tools through which we communicate a corporations financial position.
So why was it that a corporation valued as much as $70 Billion at one time would
have ever achieved such success without performing basic accounting functions?
The CEO, Jeff Skillings caustic reply to the question foreshadowed the collapse of a
company that had been built on lies and deceit. While the Enron scandal is one of
the best known in the history of international business, the reasons for the collapse
were built into the company from its very roots. I will begin with an overview of the
company and the ensuing scandal, as well as touching on many of the events that
led up to the collapse of the company. I will also touch on events that contributed
to the companys inflated stock prices and their unethical and often desperate
business practices that undermined the foundation of their business. The
aforementioned film, Enron: The Smartest Guys in The Room was an excellent
resource as it was primarily historical footage and first-hand accounts from
individuals involved with the scandal. (http://www.youtube.com/watch?
v=_xIO731MAO4)
Enron was founded as a result of a merger of gas companies in 1985.
Founded by Kenneth Lay it originated in Omaha Nebraska. Despite promising to
keep the headquarters in Omaha, Lay almost immediately moved the company to
Houston Texas where they began consolidating much of their business into natural
gas. Lay was Chairman and CEO of Enron Corporation and had a PhD in Economics.
The first signs of trouble for Enron came early when Traders gambling with company
assets in the oil market lost $90 million in a period of five days. The company
reserves were gone and auditors from the companys accounting firm Arthur
Andersen saved the company by bluffing the numbers in other words misreporting the companys net-worth. This often overlooked event spoke to the
corporate culture that was beginning to develop at Enron. Company assets were
being gambled in extremely risky investments in order to turn high profits. With
company revenues hurting and a need for new life to be breathed into the company,
Ken Lay hired an up and coming Harvard Business School graduate Jeff Skilling.
Skilling had a big idea about trading energy, especially natural gas, as a commodity.
His plan to trade natural gas as a valued asset was only one of his brilliant ideas;

the other being adopting an accounting system that would ensure the success of
Enron for the foreseeable future.
Skilling had a condition on which he would work for Enron, the corporation
would have to adopt a new form of accounting called mark to market. Developed by
traders in the 1980s this new form of accounting allowed accounting for the fair
value of an asset or liability to be based on the current market price, however this
figure could also be obtained through any other objective process; in effect
accountants could value assets and liabilities at any value they saw fit. Because the
accounting system was a new and popular idea and so was the idea of trading
natural gas as a commodity, Arthur Andersen, Enrons accounting firm and the
Securities and Exchange Commission both signed off on approval for Enron to adopt
Mark to Market Accounting. Regardless of how much revenue Enron was earning,
Enron could speculate natural gas futures and record them on their books as earned
revenues. Amanda Martin Brock, an Enron Executive described the new system as
Very Subjective, and very, it left it open to manipulation. When Mark to Market
was approved the company immediately posted huge earnings and the Executives
took the first of many large bonuses from these inflated earnings. The Enron
executives literally threw a party when Mark to Market was approved; they
immediately paid themselves bonuses based on un-earned revenue. This event was
both the beginning, and the beginning of the end for Enron; Enron executives would
spend the next 10 years trying to fill the financial void created by their accounting
practices, eventually leading to the corporations demise.
Skilling was an innovator; he brought a corporate culture to Enron that was
Darwinian to the point of near insanity. His survival of the fittest tactics were
reflected in his PRC policies or Performance Review Committees. These committees
would rate their peers on a 1-5 scale and the bottom 10% or so of employees would
be systematically fired each year. Ken Lay described their culture by saying Our
culture is a tough culture, its a very uh, very aggressive culture. This statement
rang true as rumors of Enrons reputation spread through the financial world. Enron
traders wouldnt do business with entities that defied them or disagreed with their
speculations; they were the biggest bull in the market and Jeff Skillings macho
culture fueled the cutthroat attitudes of his employees. Skilling encouraged risk
taking and extreme behaviors. Corporate retreats were often spent engaging in
extreme sports and the macho persona was reflected and rewarded in the company.
The trading floor at Enron was staffed by individuals who would put in 12 hour days
and then stay late to do more research, stepping on each others throats if it meant
getting closer to their bonuses.
This aggressive corporate culture was backed by a huge media and PR
campaign in order to further project the successful image that was Enron. Skilling
wanted to bolster investor confidence so much that the price of Enron stock would
never go down. Promising 10-15% returns annually, Skilling pushed into different
markets and different types of energy in order to continually drive the price of their

stock. The stock price drove the company and was prominently displayed as a
constant reminder to employees what the company was worth. The employees
themselves were encouraged to invest in Enron and many did, some of whom
gambled their entire 401ks and other personal investments. Because of their PR
campaign and their public image campaigns, the company was in fact incurring
losses while the stock price continued to grow. Enron built a natural gas power plant
in India where other investors wouldnt. The ego of skilling and the bullish culture of
the company were beginning to affect major business decisions. The company lost
over $1 Billion on the project when the local population could not afford the power
the plant supplied. Meanwhile Enron executives had already paid themselves
bonuses based on the potential earnings of the power plant. This loss encouraged
Enrons next big move, a merger with Portland General Electric, the electric
company that controlled California and most of the Pacific Northwest. With a wealth
of new employees to invest their retirements in the company Enron continued to
cover the tracks of its accounting follies by expanding into new markets and
creating new revenue streams, even if they were investments from their own
employees.
Stock market analysts would use certified documents from Enrons
accounting firm in order to make buy and sell recommendations on Enrons stock,
the only problem was the company continually had a buy rating, thus driving the
price higher. The first person to notice this otherwise unheard of financial anomaly
was a Merrill Lynch analyst named John Olsen. When he raised questions about the
companies reporting practices he was fired, it was said that in return Merrill Lynch
was given two analyst jobs that paid $50 Million each; $100 Million in order to
silence anyone who would raise suspicion about their company. Around this time
Lou Pai, a sort of hidden Enron CEO became prevalent in the public eye. As CEO of
Enron Energy Services, he netted around $120 Million for the company before
leaving shortly thereafter following a scandal in his private life. He later was among
the first executive to sell his stock to the tune of around $250 Million. Pai saw an
opportunity to leave the company while it was still strong, or while it still appeared
so to the public. As the PR campaign continued to advance Enron as a greater
company than its earnings reflected, CEO Skilling, in an attempt to continue the
companys growth, advanced new ideas into the market before the technology was
even developed.
In the year 2000 Enron announced a plan to trade bandwidth; as it had
developed a market for energy so it would with the tech revolution of the turn of the
century. Enron formed a deal with Blockbuster to stream movies via the internet to
customers using idle bandwidth, claiming to have developed the technology and
instilling themselves as the new industry leader. Enrons PR campaign was so
effective at this point that the stock price rose to a new record high; despite the fact
that the blockbuster deal fell through completely. It turns out that Enron had not in
fact developed the technology to stream videos, and the idea of trading bandwidth

was mostly smoke and mirrors. Despite not earning any revenue from the
Blockbuster deal, Enron posted $53 Million in earnings based on projections from
the deal. Executive bonuses were paid out based on this figure and despite the loss,
the stock price continued to rise. In the wake of the failed Blockbuster deal, insiders,
mostly Enron top executives started to sell off large quantities of their stock. The
public image of the company continued to improve while the executives sold nearly
$1 Billion in personal stock, Ken Lay and Jeff Skilling leading the charge selling
around $300 Million and $200 Million of their own shares respectively. On August
23rd 2000, Enron announced that they would be speculating and trading weather
reports in Enrons newest scheme to expand into new markets. Enron stock was
trading at $90/share, but this most recent ploy was a desperate almost comical
move, despite this they were once again named the worlds most innovative
company by Fortune Magazine.
Analyst Jim Chanos was among the first to see through the deception, he
contacted Bethany Mclean, a writer for Fortune Magazine. Mclean was writing an
article about Enron and at the behest of Chanos examined Enrons financial
statements more closely. In short Mclean couldnt detect any fraud but somehow
knew something was amiss. It was effectively unclear how Enron was actually
making any money. When interviewing Jeff Skilling for the article she brought this
up, only to be told that he wasnt an accountant and did not have the answers she
was looking for, he then bullied her out of the interview. At the threat of printing the
article without their input, the next day Mclean and her editor met with Andrew
Fastow and two other Enron executives in New York in order to get the answers
Skilling could not or would not provide. Andy Fastow proceeded to lay out detailed
accounts of the companys business dealings over the next three hours, he even
went so far as to include accounts of partnerships he was engaged in that existed
solely to do business with Enron; Mclean didnt mention these in her article thinking
that the higher ups must surely know about these practices if they knew about the
rest. At the end of the interview the Enron executives were leaving when Fastow
turned and said to Mclean I dont care what you write about the company, just
dont make me look bad.
As CFO Fastows responsibility was to report the companys earnings, or
rather in this case, to fabricate the companys earnings and cover the tracks of the
failing company. There are some who feel Fastow was set up as the fall guy in this
situation, as someone who lacked a strong moral compass he would be the
perfect point man to make all of Enrons problems disappear. Fastow was young and
ambitious but posting gains year after year when Enron was in fact losing money
landed them $30 Billion in debt. Fastow began layering liabilitys in order to post
gains for Enron. While this is normally common business practice, the layers that
Fastow was creating were in fact shadow companies used to siphon off Enrons debt.
In this way the liabilities of the shadow companies grew exponentially while Enron
was able to continually post gains quarter after quarter. Eventually Fastows idea

culminated in the founding of LJM, a shadow company started by Fastow in order to

sell Enrons assets to major banks. By temporarily removing certain assets from the
books Fastow could continue to make Enrons numbers look good. As partner in LJM
Fastow secured significant profits and bonuses for himself, he sold the idea to major
banks by insuring the assets with Enron stock. It was effectively a guaranteed
money maker, backed by stock options so the legality of the plan was overlooked by
96 of the worlds major banks who invested as much as $25 Million each in the
project. At this point the major banks of the world knew that Enron was engaging in
unethical and even illegal accounting practices, but like so many others they
wanted to take their share of the profits before exposing the scandal. The banks
jumped ship as soon as the scandal broke, mostly claiming ignorance.
As Fastows desperate plans to keep the company afloat in the public eye
began to unravel, we can consider all of the parties that have not brought the
situation to light at this point. The extreme corruption and deception on the part of
Enron Corporation was now being shared by 96 of the worlds leading banks. All of
whom knew that some things were too good to be true. Enrons accounting firm
Arthur Andersen was collecting nearly $1 Million in fees every week for their part in
the deception, and it is reported that their attorneys at Vincent and Elkins were
collecting similar fees. This is not to mention the Enron executives or even the top
level employees that did not blow the whistle when they realized the deception.
Motivated by many things, among them greed, literally dozens if not hundreds of
people could have spoken up at any time and decreased the magnitude of the
failure of Enron, instead they lined their pockets while they watched the company
sink into oblivion.
At his wits end, Skilling began to be visibly concerned with the condition of
the company. In 2001 he was quoted as saying I dont know what the hell Im going
to do meanwhile chairman Lay was buying a new corporate jet. Facing $500 Million
in losses, executive Tom White had a final desperate plan to make his numbers work
and that plan was California; the de-regulation of the energy market in California
allowed Enron to run said market as they saw fit, or in other words in a way that
would make them the most money. Enron would shut down power plants causing
rolling blackouts throughout California in order to make a profit. Driving the price of
energy upward they began trading energy surpluses across the Western states,
increasing the price even further. The problem with all this is California had more
than enough power generation capacity to meet their demand, so there should
never have been the blackouts that drove the price up. Public outrage and an
energy crisis in California eventually caused the governor to declare a state of
emergency, thus regaining control of the de-regulated energy market. The year-long
energy battle would cost the state of California over $30 Billion. Ken Lay met with
Arnold Schwarzenegger and other California politicians secretly in order to continue
to promote de-regulation of the energy market in California. Governor Davis was
recalled based on the state of Californias economy and Schwarzenegger won the

Governors ballot. Meanwhile Ken Lay became energy secretary under President
George W. Bush, from this position all he had to do was make sure that the federal
government stayed out of state matters and thus perpetuated the energy crisis in
California in order to bolster Enrons numbers once again. It wasnt until elections
gave democrats a majority in the senate that the Federal Energy Regulation
Commission stepped in to end the stand-off.
By now investor confidence was weakening after the public outrage over
energy in California, Jeff Skilling was losing control of his traders as the cutthroat
culture he had helped foster were managing to trade the company out from under
him. In a hearing with a congressional sub-committee Skilling stated On The day I
left, on August 14, 2001 I believe that the company was in strong financial
condition, two days later the price of Enron stock dropped to $36.85. Skilling was a
rat jumping from a ship that he knew was sinking. He resigned without a PR
campaign or a plan on August 14th; Ken Lay returned as CEO and stated that The
Business is Doing Great.
The whistle was finally blown by an Enron insider. An Enron Vice President
named Sherron Watkins was given a list of asset accounts to manage when she
moved into Fastows department. She discovered Fastows intricate web of assets
and couldnt believe Arthur Andersen signed off on it, the assets she was to
manage were owned by banks at the time and were even guaranteed by Enron
stock. In an anonymous letter to Ken Lay Watkins disclosed her findings. The Wall
Street Journal printed findings detailing Fastows deception and the SEC launched an
investigation as a result; Ill resist commenting further on a government agency
failing to act until they see it in the Journal or on CNN. Billions in mark to market
profits should have actually been recorded as losses and new financial statements
were issued by Enron. By October 23, Enrons stock price had fallen to $19/share.
While Ken Lay addressed the company in order to answer questions and reassure
his employees, representatives of Arthur Andersen were shredding documents a few
blocks away. In one day they destroyed over one ton on financial records. As the
company was going under, Ken Lay still managed to sell $26 million of personal
stock while all other shareholders were frozen out of their accounts. The next day on
October 24th Enron fired Andrew Fastow when they learned that his company LJM
had siphoned off over $45 Million in profits from his various raptor accounts. When
asked by the subcommittee how he could conduct himself with such blatant disregard for personal or business ethics he plead the fifth amendment and refused
further statement. On December 3rd the stock price dropped to a scant $0.40/share
and the next day Enron declared bankruptcy.
The main contributing factor to the failure of Enron as a company was greed.
It started from the moment that Jeff Skilling incorporated mark to market accounting
into Enrons policies, and then that system was immediately taken advantage of.
The initial bonuses paid out to executives were based on speculations in futures
that were never realized. The company spent the next ten years trying to generate

new revenue streams in order to make their company as successful as they always
said it was. Often times these revenue streams were sustained through unethical or
even illegal dealings on the part of Enron and the companies they did business with.
Greed and cutthroat attitudes were ingrained into Enrons corporate culture and at
every turn employees were manipulating the system in order to make bonuses, or
mis-represent numbers from their department. When this is the corporate culture
and your corporation is one of the largest in the world, it is difficult for individuals
within the company to stand up for their own system of values. Whenever a
problem arose it would be sent up the ladder and would end with a let me run it by
Jeff. Because Jeff Skilling was the infallible head of the corporation this was
sufficient to put the concerned party at ease. As I had mentioned before, Arthur
Andersen and the Law Firm Vincent and Elkins were both privy to Enrons missdealings, but the appeal of over $50 million a year in billable fees was too great a
price for either firm to oust their client publicly. This culture of greed was
perpetrated by the executives to such an extent that shareholders were left with
almost nothing in the end.
Enron executives sold over $1 Billion in personal stock options in the two
years leading up to the collapse of the corporation. When the corporation went
bankrupt 20,000 employees working directly for Enron lost their jobs. The average
severance pay was $4500 while the top executives collected final bonuses totaling
$55 Million. In 2001 employees of Enron Corporation lost $1.2 Billion in retirement
funds and retirees lost over $2 Billion in pension funds. Meanwhile executives sold
$116 Million in stock as the company was going under. Despite making remorseful
statements about the employees of the company, executives showed throughout
the life of the company that there was no end to their corporate greed. If you visit
the Enron website now, it is a link to an investor relations site in which former Enron
shareholders are still engaged in a lawsuit with the former executives. Many of
these investors are former employees seeking some semblance of retribution for
how they were treated and for being lied to for so long. Another major outcome of
the Enron scandal for line level employees was the dissolution of Arthur Andersen.
The Countrys oldest accounting firm voluntarily gave up their license in the wake of
handling Enrons accounting audit function. Over 22,000 Arthur Andersen
employees lost their jobs over night and the companys and therefore the
employees reputations were tarnished forever, whether they were involved with the
Enron Audit or not. The intangibles such as employees of Enrons subsidiaries, other
shareholders and countless other individuals were likely negatively impacted by
Enrons greed and failure to accurately represent their company.
While I think the right people were brought to trial to answer for their crimes I
would have further investigated other executives who left the company even before
Jeff Skilling, such as Lou Pai and Rebecca Mark-Jusbasche, former CEO of Enron
International. Both parties escaped criminal charges and cashed in large amounts of
company stock in the years leading up to the collapse. I also dont feel that the

punishment fit the crime. According to the article in Financial News The Enron Cast:
Where are they now? Jeff Skilling former CEO and COO paid attorneys a $23 Million
retainer to defend his innocent plea. He was found guilty of fraud and insider
trading; he is currently serving a 24 year prison sentence that his lawyers are still
fighting at every level of court and on every ground for appeal available to them. If
he were to serve those 24 years in a proper federal penitentiary that might be
sufficient recourse for his actions. Ken Lay was convicted of 10 counts of fraud and
2 cases of conspiracy; he faced up to 165 years in prison but died of a heart attack
before he could ever be processed. Fittingly he died on a ski vacation in Colorado,
likely paid for with the money he effectively stole from Enron investors. CFO Andrew
Fastow served just over 5 years in exchange for cooperation with prosecutors and
testimony against other Enron executives. Barely a slap on the wrist, Fastow should
be spending the same 25 years in prison that Skilling is, and again in a proper
federal penitentiary. Our justice system rewards rats and Fastow is just another
sociopath trying to save his own skin. Fastow along with Lou Pai and Rebecca MarkJusbasche paid significant sums of money in civil suits from former shareholders;
however none of these figures were anything close to the amount of money they
had made off of Enron and the sale if its stock. Other employees including MarkJusbasche went on to other successful careers, many of which for other energy
companies. Sherron Watkins, the VP who blew the whistle in the end started her
own consulting firm and speaks publicly about corporate social responsibility. In a
tragic but fitting end, Cliff Baxter, Enrons top salesman and Chief Strategy Officer
committed suicide on January 25th 2002, just weeks after Enron declared
bankruptcy. In his suicide note he referenced his dealings with Enron, Where there
was once great pride, now its gone.
The Sarbanes Oxley Act of 2002 was signed into law in order to encourage
trust in publicly traded companies. In the wake of the Enron scandal more concise
accounting and reporting practices are now required. According to the SEC website
The Act mandated a number of reforms to enhance corporate responsibility,
enhance financial disclosures and combat corporate and accounting fraud, and
created the "Public Company Accounting Oversight Board," also known as the
PCAOB, to oversee the activities of the auditing profession. The creation of PCAOB
would hopefully prevent another Arthur Andersen situation from occurring in the
future. While some argue that the cost of implementing the higher standards of
Sarbanes Oxley is too expensive for small businesses, the overall effect of the
legislation could be considered effective. Investor confidence was temporarily
restored, until security speculation much like commodity speculation in the Enron
case sent the U.S. financial system spiraling once again in 2008. The resulting
policies do require more accurate accounting principles, and greater regulation of
oversight companies providing accounting audits for that company. (www.sec.gov)
In conclusion, Greed and a lack of fundamental ethical values drove a
potentially successful company into the ground. Had the executives of the

corporation instilled values into their corporate culture that reflected dealings with
them and others in a value driven and ethical light; Enron might have never
collapsed and tens of thousands of lives wouldnt have been ruined. In this day and
age people are hopefully running out of ways to defraud investors out of billions of
dollars, but we prove every few years that there is no end to the potential for
human greed. Working toward degrees in both the college of business and the
college of health I am shocked to see the difference between the two curriculums.
While some argue that different types of people are attracted to different majors,
business majors have a bad reputation for being cold, unethical, greedy, cutthroats.
And knowing a few of them, especially in the masters program, I would tend to
agree with this stereotype. Frankly I pity people that subscribe to this ideal, history
has shown time and time again that the most successful businesses in the long
term are those that are honest and deal fairly with customers and employees. I am
sickened by the millions Enron executives skimmed off for themselves while
simultaneously running their own corporation into the ground. And on top of it all
they lied about it. By defrauding the American public, their investors and their
employees, a few people made untold fortunes from the Enron Empire; the cost of
which was calculated in many lives and billions of dollars but in reality cost more
than we will ever know. It is my hope that my fellow students and I will see the merit
of ethical dealings in business in order to further the ideals of business ethics and
corporate social responsibility. By holding one another accountable we might be
able to see problems like Enron become less common in the future.

References
Enron: The Smartest Guys in the Room
Jigsaw Productions (Producers), Alex Gibney (Director), Peter Elkind (Writer),
Bethany Mclean (Writer), 2005. Enron: The Smartest Guys in the Room [Motion
Picture]. USA: Magnolia Pictures.
The Enron Cast: Where are they now?
Partington, Richard (2011, December). The Enron Cast: Where are they now?.
Financial News Retrieved March 20, 2012 from
http://www.efinancialnews.com/story/2011-12-01/enron-ten-years-on-where-theyare-now
Sarbanes Oxley Act
U.S. Securities and Exchange Commission. (Modified 2/15/2012). The Laws that
Govern the Securities Industry. Retrieved March 18, 2012, from
http://www.sec.gov/about/laws.shtml#sox2002