Final Paper

Enron Corporation Scandal

Enron Corporation was an American energy, services and commodities company that was
based in Houston, Texas. Enron was a company that was founded on 1985 in Omaha, Nebraska
as a merger between two small regional companies, which were: Houston Natural Gas Company
and Inter North Company. Enron’s founder and CEO was Kenneth Lay and Jeffrey Skilling was
their COO at the time. The first years after Enron Corporation was formed were normal and
nothing impressive, but it all changed in the 1990’s. From the middle of the 1990’s until 2001,
Enron became a highly praised and successful company, reaching their all-time high share price
of 90.56 dollars in 2000. Enron received mentions like “America’s Most Innovative Company”

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and was number one in the “100 Best Companies to work in America” for several years, until

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their corporate and accounting fraud was exposed.

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Enron Corporation’s Scandal started in 2001, after many analysts started to doubt Enron’s

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balance sheets, transparency and started to notice irregularities on their accounting actions.
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The first analyst to question Enron’s credibility was Daniel Scotto, who issued a note criticizing
Enron and made people start questioning the company as well. Later in 2001, Enron started to
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publish reports that they had been inflating income and some of their divisions started to report
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millions in losses, which made their stock price fall to around 30 dollars. Some days after, Enron
Corporation reported a 618 million dollar loss and a 1.2 billion dollar value write off. These
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actions made the SEC (Securities and Exchange Commission) start to investigate Enron
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Corporation and their accounting firm: Arthur Andersen. The corrupted activities they found
and the revelations they gave of Enron were incredibly surprising and devastating to all of their
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employees and shareholders.

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In a brief description, Enron and Arthur Andersen’s fraud could be summarized with three
strategies they used to fool the public. First, Enron used a legal technique approved by the SEC
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called Mark-to-Market. Even though this was legal, Enron manipulated it to the point where it
was just corrupted. Mark-to-Market is defined by Kimberly Amadeo as “an accounting method
that values an asset to its current market level. It shows how much a company would receive if
it sold the asset today”. In other words, companies could recognize on their financial statements

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 that one year they had millions in revenue, but that revenue was still not real, it was just
expected. For example, Enron signed a contract with Blockbuster related to internet streaming,
and it was expected to bring a lot of revenue to Enron. At the end, the contract didn’t end up
working out and Blockbuster ended the contract, but the fraud was presented when Enron
recognized in that year’s revenue over 100 million dollars, even though they didn’t earn almost
any money.
Second, Enron used SPVs, also legal, to hide their debt from investors, so that they kept
seeing Enron as an elite and successful organization. An SPV is “a separate entity created for a
specific and narrow objective, which is held off the company’s balance sheet and is often used
to isolate financial risk” (corporatefinanceinstitute). Enron used SPVs during their “triumphant”

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years to push off all their debt problems to these side companies. Doing this, they obviously

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kept having enormous amounts of debt, but now it didn’t appeared on their financial reports

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and investors kept getting fooled by their accounting tricks.

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Third and last, Arthur Anderson, Enron’s accounting firm, was committing fraud by falsely
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auditing Enron’s financial statements. The job of an auditor is to check a company’s financial
statements and make sure that they are fairly representing their numbers and that no red flags
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are shown. Arthur Anderson’s auditors obviously knew what was going on at Enron, but they
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were being paid to keep quiet. As well, when questions were starting to rise about Enron’s
transparency, Arthur Anderson ordered their auditors to destroy all Enron files, except Enron’s
most basic documents. These actions were critical to the fraud, since investors always looked at
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Enron’s financial statements and believed they were correct, considering that Arthur Anderson
was one of the major five accounting firms in the United States and had immense credibility at
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the time. At the end, Arthur Anderson was convicted of obstructing justice. On Enron’s hand,
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the two executives who were heavily blamed for these actions and were found guilty of
conspiracy and fraud were Kenneth Lay and Jeffrey Skilling. When all of this corrupted strategies
were revealed by the SEC, Enron ended up filling for Chapter 11 bankruptcy, the largest in
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history at the time, on December 2, 2001 and their stock price ended up closing at just 26 cents.
After doing a lot of research and understanding Enron’s scandal, I can see how it can relate
to what we are learning in Finance 305W, specially with what we learned on separation of

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 ownership and management. When there is separation of ownership and management, two
disadvantages almost always occur. These are: 1) the principal-agent problem and 2)
Information Asymmetries. Enron’s scandal had a lot to do with the principal-agent problem.
John Stephan and Harold Star said: “"The agency problem states that because top managers are
typically not owners of a company, they can't be trusted to act in the best interest of those who
do own the company -- the shareholders,…But what the Enron case illustrates is that the agency
problem also exists within a company's board of directors”. In the Enron scandal, Kenneth Lay
was the chairman and the CEO. This shows the principal-agent problem because Kenneth Lay
being the CEO and also in the Board of directors, he could get people in the board to support
him and make decisions that weren’t embracing building long-term shareholder value. He was

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bringing distorted information to the Board of directors, so the Board wasn’t really asking the

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hard questions and tackling the problems of the company that could bring Enron’s stock price

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down.

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On the other hand, there were clearly information asymmetries during Enron’s accounting
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fraud. Information asymmetries happen when managers and shareholders have different
information about the firm. In Enron’s example, shareholders inside and outside of the company
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didn’t have a clue of the fraud that was taking place in the upper levels of the company. What
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investors saw and got really thrilled about was Enron’s exponential increase in revenues from
1996 to 2001 and also their increase in stock prices. As well, Enron were issuing statements to
the public talking about how they were going to close more million dollar deals and how their
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company would keep growing and increasing sales at impressive rates. Obviously, the managers
at the company knew they had an enormous amount of debt and that the company was
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performing poorly, but they were hiding it from the public and more specially, from their
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shareholders. All the people who had invested in Enron, shareholders at the time, and were
excited about it, had a significant amount of mislead information and were being fooled by the
top-level managers.
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In my opinion, I feel that Enron’s accounting fraud really affected not only them, but also the
market in general. Like Robert Mueller said: “The collapse of Enron was devastating to tens of
thousands of people and shook the public's confidence in corporate America”. I feel this is very

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 true, because Enron being such a huge company and being seen as an exemplary company to
the whole country, disappointed all of Americans. It made them be much more cautious when
investing in companies, because they didn’t trust accounting firms anymore, since Arthur
Anderson was one of the top five and had ended up screwing with Enron shareholder’s trust.
Also, Enron’s scandal ended up as a complete disadvantage for their employees, since all of
them had lost their jobs and their investments in Enron, such as their 401k funds.
In conclusion, I feel that there are plenty of ways to prevent these types of frauds in the
future. The first one I thought of was to implement stronger laws, which would give major
consequences if accounting tricks were used to fool the public. Indeed, after the Enron Scandal,
the government set a new law in 2002 to stop corporate fraud called: Sarbanes-Oxley Act. This

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new law protected investors by improving the reliability and accuracy of corporate disclosures,

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such as giving auditors much strictly independent rules and obligating the CEO and CFO to

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validate the company’s financial statements, so that later on they couldn’t deny that they never

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saw them. Besides, I feel that another way to prevent these scandal would be to create a
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friendly environment between the shareholders and the managers. I feel that a good solution
would be to give rewards to managers if they perform with quality and in the shareholder’s best
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interests. The last way I can think of about how to prevent these awful scandals is for the
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company just to take a setback. I feel that many CEOs in companies have huge pride and can’t
stand being seen as a failure. I feel that companies should just solve their difficulties and bounce
back in the market, instead of using tricks and corrupting their way into the top. I know this
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could work because there are stories about monumental companies, such as Apple, that were
almost at the verge of bankruptcy and losing it all, but then grinded their way up into the top
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with fairness and hard work, instead of fooling the public.

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Reference List

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  https://www.worldfinance.com/markets/top-5-biggest-financial-scandals-of-all-time
 https://www.britannica.com/topic/Enron-What-Happened-1517868
 https://www.investopedia.com/updates/enron-scandal-summary/
 https://www.youtube.com/watch?v=hwollZoVmUc
 https://corporatefinanceinstitute.com/resources/knowledge/strategy/special-purpose-

vehicle-spv/
 https://www.thebalance.com/mark-to-market-accounting-how-it-works-3305942
 http://www.buffalo.edu/news/releases/2002/01/5523.html
 https://www.brainyquote.com/topics/enron
 https://www.thebalance.com/sarbanes-oxley-act-of-2002-3306254

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