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 corporation’s 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 Skilling’s 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 company’s 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 company’s accounting firm Arthur
Andersen saved the company by “bluffing the numbers” in other words mis-reporting the
company’s 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 1980’s 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, Enron’s 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 corporation’s 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, it’s a very uh, very aggressive culture.”
This statement rang true as rumors of Enron’s reputation spread through the financial world.
Enron traders wouldn’t do business with entities that defied them or disagreed with their
speculations; they were the biggest bull in the market and Jeff Skilling’s 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 other’s
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 401k’s 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 wouldn’t.
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
Enron’s 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 Enron’s accounting firm in
order to make buy and sell recommendations on Enron’s 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 company’s 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.
Enron’s 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 Enron’s
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 world’s 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 Enron’s financial statements more closely. In short Mclean
couldn’t 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 wasn’t 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 company’s 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 didn’t 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 don’t care what you write about the company, just don’t make me
look bad.”

As CFO Fastow’s responsibility was to report the company’s earnings, or rather in this
case, to fabricate the company’s 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 Enron’s 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 liability’s 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 Enron’s debt. In this way the
liabilities of the shadow companies grew exponentially while Enron was able to continually post
gains quarter after quarter. Eventually Fastow’s idea culminated in the founding of LJM, a
shadow company started by Fastow in order to sell Enron’s assets to major banks. By
temporarily removing certain assets from the books Fastow could continue to make Enron’s
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 world’s 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 Fastow’s 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 world’s leading banks. All of whom knew that some things were too good to
be true. Enron’s 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 don’t know what the hell I’m 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 California’s economy and Schwarzenegger won the Governor’s
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 Enron’s numbers
once again. It wasn’t 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 Fastow’s
department. She discovered Fastow’s intricate web of assets and “couldn’t 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 Fastow’s deception and the SEC
launched an investigation as a result; I’ll 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, Enron’s 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 dis-regard 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 Enron’s 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 Enron’s 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 Enron’s miss-
dealings, 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 Country’s oldest accounting firm voluntarily gave up their license in the
wake of handling Enron’s accounting audit function. Over 22,000 Arthur Andersen employees
lost their jobs over night and the company’s and therefore the employee’s reputations were
tarnished forever, whether they were involved with the Enron Audit or not. The intangibles such
as employees of Enron’s subsidiaries, other shareholders and countless other individuals were
likely negatively impacted by Enron’s 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 don’t 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 Mark-Jusbasche 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 it’s stock. Other
employees including Mark-Jusbasche 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, Enron’s 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 it’s 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 wouldn’t 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 master’s
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-they-are-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