Introduction to Finance

ASSIGNMENT on
ENRON Corporation

Submitted by –
Saif Saem Islam, 1420659030
Sanjida Binta Jahid, 1230962630
Afra Nawar Chaity, 1230754630
Mehnaz Awlad Mou, 1410371030
 ENRON: A True Story of False Profits

 In your own
words, summarize
this case.

This case is about the Enron Scandal which

is considered to be one of the most
notorious within American history. It
is considered by many historians and
economists as an unofficial blueprint for a case study on White Collar Crime. Enron's origins
date back to 1985 when it began life as an interstate pipeline company through the merger of
Houston Natural Gas and InterNorth. In 1986, Kenneth Lay, the former chairman of Houston
Natural Gas, emerged as the top executive of this newly created firm. Lay hired Jeffrey Skilling
to serve as one of his top subordinates.
From the pipeline sector, Enron began moving into new fields. In late 1999, the company
launched a B2B electronic marketplace called Enron Online, the company's website for trading
commodities, which soon became the largest business site in the world. It increased Energy
Wholesale Service’s income by 60 percent which ranked as the largest revenue producer of this
company. Growth for Enron was rapid in 2000. It ranked as the seventh-largest company in
America and the largest e-commerce company in the whole world.

However, cracks began to appear in 2001. In August of that year, Jeffrey Skilling, a driving force
in Enron's revamp and the company's CEO of six months, announced his departure, and Lay
resumed the post of CEO. In November 2001, Enron reported a loss of $600 million— its first
quarterly loss in five years. Chief financial officer Andrew Fastow was replaced, and the U.S.
Securities and Exchange commission launched an investigation into investment partnerships led
by Fastow. That investigation would later show that a complex web of partnerships was designed
to hide Enron's debt. By late November, investors had lost billions of dollars.

On December 2001, Enron filed for bankruptcy protection in the biggest case of bankruptcy in
the United States up to that point. Numerous Enron employees subsequently lost their jobs. The
next month, the U.S. Justice Department opened its investigation of the company's dealings, and
Kenneth Lay quit as chairman and CEO. Many executives at Enron were indicted for a variety of
charges and were later sentenced to prison.

Three years later, Enron's auditor, Arthur Andersen, was found guilty in a United States District
Court, but by the time the ruling was overturned at the U.S. Supreme Court, the company had
lost the majority of its customers and had ceased operating. In 2006, Fastow received a 10-year
prison time which was reduced to six years after he testified against Skilling and Lay. He
pleaded guilty to conspiracy to commit securities fraud as well as to other charges. Skilling and
Lay were convicted on multiple counts of fraud and conspiracy in May 2006. In September
2006, Skilling was sentenced to 24 years in prison. Keneth Lay who was to be sentenced at the
same time, died of a massive heart attack July in 2006. Three months later, a federal judge
overturned Lay’s conviction since Lay was no longer able to pursue his appeal of that conviction.
This is how the Enron story ended.

 What is your understanding of Fraud in Accounting?

Any act or attempt to alter an accounting statement for financial increase is known as accounting
fraud. A regular example of accounting fraud is the deliberate manipulation of accounting record
in order to overprice a company’s asset to increase its share price. It makes a company’s
financial performance or condition look better than it’s actual. Another way is to fill bankruptcy
in order to avoid dept. because of financial hardship. Among all frauds in accounting history the
fraud of Enron that occurred in 2001 is one of the biggest.
Some examples of accounting frauds are:
i) Over recording sales revenue

ii) Under-recording expenses (i.e. depreciation expense)

Some examples of high profile fraud cases:

i) Xerox- Falsifying financial results for five years, boosting income by $1.5 billion.

ii) Lehman Brothers- Failure to disclose an accounting maneuver that resulted in short-
term loans being reported as sales.

 What are the facts that lead to the ENRON scandal?

There are a number of facts that finally leads to the Enron Scandal. But the most important fact
would be the set ups of Special Purpose Entities commonly known as SPEs. Enron used these
SPEs to issue notes receivable, which would be swapped with Enron stocks, by showing that the
SPEs invested on limited partnerships organized and sponsored by Enron. Enron used the SPEs,
creatively named like Brave heart and Raptor, to raise funds without being required to show
these debts in Enron’s Financial Statements thus showing higher Profits than the company
actually made. This could only be achieved because of the so-called 3 percent rule, which
allowed Enron to omit the SPE’s assets and liabilities in its Financial Reports as long as other
independent parties provided 3 percent of the SPE’s capital. Using this to their advantage, Enron
would arrange other third parties to pay for this 3 percent capital for the SPEs and then sell
underperforming assets to these SPEs which would be financed by loans collateralized by
Enron’s common stocks.

Enron also sold assets on grossly inflated prices to the SPEs to get large unrealized capital gains.
And the nominal owners of these SPEs even made hefty profits due to undisclosed side
agreements. Enron only showed nominal financial statements of its SPEs and presented them in
cryptic, confusing ways making it hard to understand the fraud. Enron also, to retain a high stock
price level, had the so-called price “triggers” integrated on the SPE loan agreements. So, if the
price of Enron stocks fell below the “trigger”, Enron had to provide additional stock to
collateralize the given loan. Besides these fraudulent uses of the SPEs, Enron also misused the
market-to-market accounting method. For long-term contracts, which could even be for 20 years,
Enron would make assumptions that would inflate the profits provided in the contracts.

Using these creative ways of using SPEs and market-to-market accounting method, Enron
showed healthy profits with a high credit rating while maintaining high stock prices.

 In your view which parties are responsible for this?

Defend your answer.

 Enron’s Management And It’s Corporate Culture:

Enron’s top three management, Kenneth Lay, Jeffrey Skilling and Andrew Fastow, has groomed
a “Corporate Culture” that encouraged its employees to twist the rules in such a way that it
benefited the organization and its executives to constantly project a profitable scenario in its
financial statements that the top level management instilled a culture of “Rule Breaking” that
gave employees the freedom to “Cook” the financial statements in order to show a favorable
financial performance to its shareholders. Not only that Enron’s management discouraged any of
its employees from reporting and investing ethical lapses and questionable business dealings
which was further illustrated when Sherron Watkins, Vice President Of Corporate Development,
tried to alarm one of Kenneth Lay’s senior subordinates about the ethical misconduct in
accounting decisions made by Enron but instead of listening the senior subordinate scoffed at
Watkins’s proposition and said “He Would Rather Not See It”.
Enron’s management was so dead set on showing profitable results that it would resort to unfair
means such as selling electricity at inflated prices to the Golden State of California in order to
increase its profits.

Another such instance is when Enron abused “Mark-To Market” accounting methods for its long
term energy contracts which involved Enron’s traders booking profits from a supply contract,
that spanned for as long as 20 years, in the quarter in which the deal is made thus increasing
profits in its financial statements by using unrealistic price forecast.

In order to satisfy Enron’s Cash needs and to maintain a high credit rating Enron CFO Andrew
Fastow searched for loopholes for “Debt Avoidance” and he found one when he created SPEs
(Special Purpose Entities) which allowed Enron to remove the debts of its underperforming
assets from Enron’s Financial Statement to that of the SPEs thus allowing it to “Window Dress”
Enron’s Balance Sheet.

Enron’s Management is also guilty of misleading its investors as only six months before Enron
was spiraling downwards Enron’s CEO Jeffrey Skilling assured investors that the business would
be able to sustain its record growth in the near future when he clearly had an idea of Enron’s
Financial turmoil that was about to follow. Also Enron is alleged to have presented its nominal
financial disclosures for its SPE transactions in very confusing language which was very difficult
for its investors to interpret.

 ANDERSEN & CO.

Andersen being the independent auditing firm of Enron had the responsibility of finding and
reporting any accounting irregularities in Enron’s Financial Statement instead Andersen failed to
fulfill its responsibility and obligations in auditing Enron’s Financial Statement which included
Andersen overseeing the auditing of Enron’s shady SPE transactions but rather than Andersen
reporting such irregularities to the Enron board and regulatory authorities it let its judgment be
clouded by the hefty fee of $52 MILLION it received from Enron half of which was earned from
providing Enron consultancy services which represents a clear conflict of interest in the part of
Andersen & Co. Further evidence including Andersen’s colleague’s effort to shed a large
quantity of documents relating to Enron’s audits clears doubts that instead of Andersen
preventing Enron it helped them “Cook The Books”

 Regulatory Bodies:

The SEC (Securities And Exchange Commission) and FASB (Financial Accounting Standards
Board) despite a lot of debate and discussion implemented the controversial 3 percent rule which
further motivated Enron to exploit the accounting loophole as the rule allowed that outsider
needed to invest only 3 percent of a SPE’s capital for it to be independent and off a company’s
balance sheet. Furthermore SEC let itself be bullied by lobbying campaign by the “Big Five”
accounting firms to obstruct Arthur Levitt’s initiative to limit the scope of consultancy service
that accounting firms could provide to its clients. By the time SEC and FASB took action it was
all too late as Enron had become bankrupt and hundreds had already their job and their pensions.

 How could a Fraud like this have been prevented?

The Enron scandal could have been prevented if some measures were taken into account. One of
these measures could have been if Arthur Andersen & Co. the accounting firm for Enron could
only stick to auditing the financial statements rather than giving consulting services to Enron as
well. Since, consulting and auditing at the same firm could raise a conflict of interest. Public
reports showed that Anderson earned approximately $52 million in fees from Enron in 2000 and
of which only $25 million was for the auditing and the rest for consulting. This huge sum of
money could only jeopardize the independence of such an accounting firm thus deviating the
company from its main objective: Auditing.

Next, Securities And Exchange Commission (SEC) and Financial Accounting Standards Board
(FASB) could have tried to abolish the 3-percent-rule and encourage Financial Statements to be
prepared for entities controlled by a common ownership group. This way, Enron could not
misuse the SPEs to show higher profits or credit rating as they had to take the losses made by
their SPEs into the Financial Statements. The Financial Statements should also have been
prepared using a certain dose of transparency allowing other entities and regulators to easily find
the financial status of the company.

Also, Boards of Directors needed to pay closer attention to the behavior of the management and
the way the company was making money. It should have become acceptable and mandatory to
question management closely.

 If you were the Chief Financial Officer of ENRON

what would you have done differently if you knew
that the Fraud was going on? Keep in mind that if
you chose to disclose the Fraud then the company
most likely would have been bankrupt and you would
have been out of a job.

If I was the Chief Financial Officer of ENRON, I would have stopped the creation of the SPEs as
soon as I would have realized what their true purpose were. During my evaluation as a
comptroller I would have revealed the true profit figures, and state that the SPEs were being used
for inflating profits. I also would have evaluated the deceitful use of the Mark-to-Marketing, in
the sense that they were being used to count projected earnings from long-term energy contracts
as current income. I also would have made sure that this company is reporting accurate financial
information to the government, creditors, employees and shareholders because I am not only
responsible for writing my own accurate financial reports but making sure that all others are
accurate, too.

References –

i. http://en.wikipedia.org/wiki/Enron_scandal
ii. Documentary: Enron The Smartest Guys In The Room
iii. Managerial Accounting by Garrison, Noreen, Brewer
iv. Accounting Principles by Weygandt, Kimmel, Kieso
v. http://en.wikipedia.org/wiki/Olympus_scandal
vi. http://financial-dictionary.thefreedictionary.com/Accounting%20+%20fraud
vii. http://en.wikipedia.org/wiki/Chief_financial_officer