CONTINUOUS INTERNAL ASSESSMENT III – CORPORATE FINANCE (HONS.

ENRON ACCOUNTING SCANDAL – THE AFTERMATH

Submitted To: Submitted

By:

Mr. MAYANK SHRIVASTAVA KIRTI SHARMA

Assistant Professor Roll No. 81, Section-C

Faculty of Corporate Finance (Hons.) Semester: VIII

ID: 1920192095

HIDAYATULLAH NATIONAL LAW

UNIVERSITY NAYA RAIPUR, CHHATTISGARH

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 DECLARATION OF ORIGINALITY
I, Kirti Sharma, hereby undertake that this work titled “Enron Accounting Sandal – The
Aftermath” has been carried out by me independently and this is my original work. I
certify to its originality.

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 TABLE OF CONTENTS

S. NO. CHAPTERIZATION PAGE NO.

1. “INTRODUCTION 4

1.1 I. History 4

2. ENRON ACCOUNTING SCANDAL – THE 5

AFTERMATH
I. The Growth Precedent
2.1 II. The Incidental Turbulence 5
III. The Dawn of Bankruptcy

UNDERLYING RATIONALE BEHIND THE

3. 6
SCANDAL

3.1 I. Rationale behind such Marginalization 6

4. THE AFTERMATH” 7-8

I. Emergence of “Enronomics” and “Enroned”

II. “Formulation of Legislations
4.1 III. Inculcated Scepticism for the Stock Market 7-8
IV. Paved path of investing from Public to Private Market”

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 INTRODUCTION
The Enron accounting scandal was a corporate scandal involving the energy company Enron
Corporation, which was one of the largest and most successful companies in the United
States prior to its bankruptcy in 2001. The scandal was a result of fraudulent accounting
practices, including the manipulation of financial statements and the concealment of debts
and losses.

The scandal led to the bankruptcy of Enron, which was at the time the largest corporate
bankruptcy in U.S. history, and caused significant financial losses for investors and
employees. It also led to the dissolution of Arthur Andersen and the passage of the Sarbanes-
Oxley Act, which introduced stricter regulations for corporate accounting and governance in
the United States.

I. History
Enron was established as a company in the energy sector in 1986 as a result of the merger of
“Houston Natural Gas Company” and “InterNorth Incorporated”, which was headquartered in
Omaha. Subsequent to the merger, the CEO of Houston Natural Gas, Kenneth Lay, assumed
the position of CEO and chairman of Enron. Lay promptly transformed Enron into a provider
and trader of energy. The liberalization of the energy markets enabled corporations to
speculate on the future prices of energy products. In 1990, Lay founded the Enron Finance
Corporation, which offered various utility and energy services across the globe. However,
Enron used “specialized vehicles”, entities, “mark to market accounting”, and “financial
reporting loopholes” to its advantage and became one of the most prosperous businesses
globally. The firm ultimately collapsed following the detection of its fraudulent activities.
Before the fraud became public knowledge, Enron shares were being traded at a peak of
$90.75, but they plummeted to approximately $0.26 after the scandal became exposed.1

1
“Liesman, S., Weil, J, & Schroeder, M. Accounting Profession Faces a Credibility Crisis, (2002, March 7),
The Wall Street Journal Online.”

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 ENRON ACCOUNTING SCANDAL FIASCO
Enron was engaging in the fabrication of financial records and misrepresenting its success
before it was publicly revealed. Although the company experienced success in its operations
throughout the 1990s, its fraudulent behavior was eventually exposed in 2001.

I. The Growth Precedent

Before the scandal was exposed, Enron's business was prospering as it became the largest
provider of natural gas in North America in 1992. Additionally, EnronOnline, the company's
trading website, was launched a few months before 2000, which helped in enhancing contract
management.

II. The Incidental Turbulence

In February 2001, Kenneth Lay resigned as CEO, and Jeffrey Skilling replaced him, which
were among the initial warning signs of trouble for the company. During this period, Enron
Broadband incurred considerable financial losses. Despite this, Lay disposed of 93,000 shares
of Enron shares at a cost of about $2 million. Meanwhile, he advised employees via
electronic mail to maintain their purchase of Enron stock, projecting a substantial increase in
its value. Ultimately, Lay sold more than 350,000 Enron shares, netting over $20 million.
During this same time, Sherron Watkins had voiced apprehensions about Enron's
bookkeeping procedures. Enron eventually disclosed a third-quarter deficit of $618 million
by October 2001.

III. The Dawn of Bankruptcy

Enron faced a significant setback on 28th November, 2001, when credit rating agencies
downgraded its credit rating to a level regarded as worthless. This decision marked a crucial
turning point for the company, as it effectively signaled its impending insolvency.

The first domino to fall was Enron Europe, which declared bankruptcy after the close of
business on 30th November. By 2006, Enron had sold off all its remaining business ventures,
including Prisma Energy. The following year, the company rebranded itself as the Enron
Creditors Recovery Corporation, with the primary objective of reimbursing its outstanding
creditors and fulfilling any remaining financial obligations in the context of the bankruptcy
proceedings.2

2
“Jonathan, B. Don’t Forget Enron’s Bean Counters, (2001, Dec. 7)”

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 UNDERLYING RATIONALE BEHIND THE SCANDAL
Enron exerted considerable effort to improve its financial records, conceal its deceptive
behavior, and present intricate organizational frameworks in order to mislead investors and
obscure the truth. The reasons behind the Enron controversy encompass several factors,
among which are the following-

A. “Special Purpose Vehicles”

The fundamental problem with Enron involved the absence of clarity regarding the utilization
of SPVs. Enron would transfer its shares to the SPV, receiving either cash or a promissory
note in return. The SPV would then employ these shares to safeguard an asset against Enron's
financial statement. When the value of Enron's shares began to decline, they could no longer
serve as suitable collateral to be carried by the SPV.

B. “Inaccurate Financial Reporting Practices”

Enron engaged in misleading financial reporting practices by misrepresenting its dealings
with customers in numerous contracts. Collaborating with external parties, including the
auditing firm, enabled Enron to inaccurately record transactions, violating not only GAAP
but also contractual agreements.

C. “Poorly Constructed Compensation Agreements”

Enron's incentive structures for employees were also poorly designed, with rewards based on
short-term sales goals and the quantity of closed deals, without regard for long-term
outcomes and actual cash flows.

D. “Market-to-Market Accounting”
Another contributing factor to Enron's downfall was mark-to-market accounting, a valuation
method that relies heavily on management's estimation of the market value of long-term
contracts or assets. Enron exploited this method by inflating the value of non-standardized,
complex contracts involving the international distribution of various forms of energy.
Additionally, failing to periodically evaluate the value and likelihood of revenue collection
could lead to overstatement of expected revenue, which Enron failed to recognize.3

THE AFTERMATH
3
“Yuhao, Li. (2010), The Case Analysis of the Scandal of Enron. International Journal of Business and
Management.”

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A. Emergence of “Enronomics” and “Enroned”
Following the Enron scandal, a term emerged known as “Enronomics”. This phrase denotes
dubious accounting methods that involve a parent company conducting false, paper-only
transactions with its subsidiaries to conceal losses that the parent firm has incurred through
other business operations.

Enron’s downfall also gave birth to the term “Enroned”, a slang expression used to refer to
anyone negatively impacted by the inappropriate decisions or actions of senior management.
This includes employees, shareholders, or suppliers. For example, a person who loses their
job due to the illegal activities of their employer, which they had no involvement in, can be
said to have been “Enroned”.

B. Formulation of Legislations
To prevent such incidents from occurring again, lawmakers introduced a range of new
protective measures. One of them was the Sarbanes-Oxley Act of 2002, which seeks to
increase corporate transparency and outlaw financial manipulation. Furthermore, the
Financial Accounting Standards Board (FASB) amended its regulations to curb the use of
questionable accounting practices, and corporate boards were assigned greater responsibility
as management watchdogs.

C. Inculcated Scepticism for the Stock Market

The confidence of the American people in the stock market has been shaken. The fall of
Enron made many ordinary citizens question the safety of investing. If such a large
corporation could crumble, how could they rely on any investment? A considerable
proportion of the population has abstained from taking part in the substantial gains in the
stock market experienced over the last twenty years. As per the Survey of Consumer
Finances conducted by the U.S. Federal Reserve, in the year 2000, 60% of the population had
the ownership of shares such as “401Ks and IRAs”. However, in 2020, this number has
dropped to slightly over half (55%).

D. Paved path of investing from Public to Private Market

In the aftermath of the bankruptcy, the Sarbanes-Oxley legislation was created by Congress
to make senior executives answerable for the economic reports of “listed companies”. This

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resulted in CEOs and CFOs being held responsible for the accuracy of “income statements
and balance sheets”. However, the legislation also brought about a lot of bureaucratic
paperwork for public companies and made executives less likely to take risks. Furthermore,
there is confusion surrounding the law, its limitations, and the consequences of non-
compliance.

As a result, the stock market underwent two major changes: less companies went public and
companies waited until they were much larger before doing so. Instead, startups turned to
“venture capital firms or private equity” for growth. This postponement in going public
affected individual investors on Main Street who missed out on investing in fast-growing
companies like Facebook and Uber. Essentially, the Sarbanes-Oxley regulations caused some
investment opportunities to move from the public market to the private market.4

4
“Lori Zulauf, Enron: The Good, The Bad, The Lessons, Vol 1, No. 1, IBERJ, 2008.”