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Financial Accounting Team O2 (Oxytocin, Inc.) Enron Analysis What makes a good company go bad?

Before December 2, 2001, Enron was one of the most well renowned companies in the United States, and its executives were known as the most powerful in the nation. Ken Lay and Andrew Fastow were the toast of the town for their creative financing approach. Risk had left the building while Enron had found ways to produce profits out of thin air. Irresponsibility from Enrons corporate culture caused its collapse, and the aftershocks were felt throughout the US economy. To begin properly assessing Enrons role in our society, it is important to understand what happened. From 1997 to the 3rd quarter of 2001 Enron used prepay transactions known as market-to-market accounting to overstate income by over $5 billion. In addition, CFO Andrew Fastows Special Purpose Entities (SPEs) were created to improperly exclude debt from financial statements. This imbalance of including unrealized revenue and excluding realized debt from the balance sheets had a domino effect on the valuation of the SPEs and they quickly collapsed. The collapse of these accounts had to be recognized on Enron's financial statements. Enron's poor performance triggered loan paybacks (note calls) that the company didn't have in cash reserves and couldn't raise the funds to cover. Enrons incredible rise and monumental collapse can be greatly attributed to CFO Andy Fastows use of Special Purpose Entities. SPEs are vehicles for a company to separate high-risk ventures from their own balance sheet by creating an ad-hoc equity that must be partially owned by an atrisk entity. Since the Enron scandal, they've been used to produce mortgage-backed securities and other assets that can be sold on the market to reduce risk. Enron used their mark-to-market accounting strategy to realize profits immediately. If the venture was considered at risk, Fastow would create SPEs (Chewco, JEDI, Raptors, LJM 1&2) to hide the ventures risk from shareholders, analysts, the SEC, etc. While Fastow claimed to have an at-risk entity investing in the asset with Enron, the assets were actually held by Fastow, which represented

a tremendous conflict of interest. They were marketed as a zero-risk high reward entity because Fastow could claim that he controlled how much support the SPE would receive from Enron. Standard accounting practices requires that off-balance-sheet treatment of SPEs could only be achieved if an independent third-party investor(s) committed substantial capital in the venture (typically at least 3%). In this case, the outside equity requirement was not met and SPEs should have been included on Enrons balance sheets. This greatly distorted the valuation of Enron in order to appeal to Wall Street investment analysts and other financial institutions. An example of this distortion of Enrons value is exemplified in Andy Fastows SPE called LJM 1&2. Under this scheme Fastow dumped poorly performing assets into the LJM Entities in order to improve Enrons financial results, which in turn yielded bonuses, prestige, and increases in salary for Fastow. Side agreements were arranged between Enron and LJM Entities to ensure that LJM would always make money on their transactions with Enron. From these transactions, Fastow and others at LJM acquired large management fees and deal profits. Fastow was essentially hedging Enron against Enron. A lot of these transactions involved conflicts of interest and did not fully meet the legal requirements of SPEs for off loading losses. These activities were encouraged under the corporate leadership of Enron and the head of the company Ken Lay. It is important to understand how the leadership of the company created the culture that caused so much chaos. Ken Lay had served as Chairman and CEO of Houston Natural Gas, which merged with Enron in 1986. Enron decided to continue with Lay as Chairman and CEO. He remained as CEO until February 2001 and returned from August 2001 until January 2002. Lay's key motivator was success and the money that followed, reflected in more than $217 million in four years from stock options and $19 million in salary and bonuses. Rebecca Leung, Enron's Ken Lay: I Was Fooled, CBS News, February 11, 2009. He believed in success and profit at all costs and was willing to consider unethical and illegal conduct as a means to an end. O. C. Ferrell & Linda Ferrell, The Responsibility and Accountability of CEOs: The Last Interview with Ken Lay, Journal of Business Ethics 210, 2010.

Lay has portrayed himself as a passive Chairman and CEO, claiming that he was not informed of the conduct of other executives. Rebecca Leung, CBS News. Many accounts of Enron employees reflect that Lay kept his distance from Enron's fraudulent conduct, either intentionally or ignorantly. Ferrell & Ferrell, Journal of Business Ethics 210. He blames another executive for Enron's collapse and loss of public confidence. Andrew Fastow, Lay said in an interview with 60 Minutes, lied to him and the Board of Directors about his actions that led to Enron's downfall. Leung, CBS News. However, the SEC disagreed with Lay, alleging that Lay and other Enron executives manipulated Enrons publicly reported financial results and made false and misleading public statements about Enrons financial condition and its actual performance. SEC Complaint, US District Court for Southern District of Texas 1 (2004). Lay's jury decided that as Chairman and CEO, he should have known about the conduct of his employees and found him guilty of conspiracy and fraud. Ferrell, Journal of Business Ethics 214. Lay died of a heart attack in July 2006 while awaiting sentencing. Pasha, CNN Money. Ken Lay blamed Enron's demise on Andrew Fastow, CFO of Enron from March 1998 to October 2001. SEC Complaint, US District Court for Southern District of Texas 1 (2002). Under the request of Enron President Jeff Skilling for Enron to become more asset light in order to engage in rapid trade, Fastow created special-purpose entities (SPE's). These SPE's transferred debt off of Enron's balance sheet while still keeping control of the assets that created that debt. Bill Saporito, How Fastow Helped Enron Fall, Time, February 10, 2002. Accounting rules allow SPE transactions to remain off balance sheets as long as they were invested in by independent investors. SEC Complaint (2002). Some of the SPE's created by Fastow, however, should have been on Enron's balance sheet. Their investors were controlled by Fastow and thus, they were not truly independent. Id. These schemes became known as Friends of Enron deals because the supposedly independent investors were in fact, friends of Enron. Id. The liberties granted to Fastow and the success of SPE's made it easy for Fastow to skim off the top of Enron's revenue. Fastow and other executives used these SPE's to also secretly generate millions of dollars in revenue for themselves. Id. The SEC filed a complaint on October 2, 2002 claiming that Fastow defrauded shareholders and enriched himself by forming side corporations that inflated Enron's earnings through fraudulent

transactions. SEC Litigation Release, Securities and Exchange Commission v. Andrew S. Fastow (2004). Fastow agreed no longer violate federal securities laws, and to never again act as an officer or director of a public company as well as to serve a ten-year prison sentence, to return over $23 million and to cooperate with the government's continuing investigation. SEC Litigation Release (2004). Ken Lay and Fastow did get prosecuted for their financial crimes. Fastow served time in prison and Lay died mysteriously while awaiting sentencing. It is impossible to say whether the punishment was enough for the havoc and economic impact they caused in many peoples life. The following paragraghs briefly explains some of the impact of Enrons collapse and ethical implications. The way a company is managed brings positive or negative effects to its stakeholders, which include all the actors related to the functioning of the company, including shareholders, trustees, partners, suppliers, employees, community and government. When any of these agents gets involved in a company, they trust the company to proceed in the most ethical way, in order to take care of everyones interests. The ethical implications of Enrons fraud affected the entire economy; the following will describe how the direct stakeholders were affected: Shareholders suffered one of the most visible impacts of Enrons collapse. It has been calculated that the total loss of shareholders adds up to $ 62 billion. In ten years since the price went from an initial $ 7 when Enron started its operations, to a high of $ 90 and then a big drop at the end, when irregularities were discovered, bringing the price per share down to $ 0.70 cents. During the time Enron was an operative company, many shareholders were misled by the way the financial information was publicly presented, factor that made them believe in Enron leaders and encourage them to maintain their investment in the company. After the scandal, the market as a whole was affected in a more subjective way, the trust in American businesses was broken which was shown in the performance of the stock market during the last months of year 2001. More than 20,000 employees were affected by the bankruptcy of Enron. The employees lost their jobs, reputation, and funds saved for retirement through Enrons 401(k) defined contribution plan. In terms of jobs and reputation, it can be argued that not only their immediate income source had disappeared, their chances of getting a new job were reduced as well, since the fraud also brought

the employees reputation down. The biggest impact faced by the employees was the sudden and drastic reduction of their retirement savings and investments made through the defined contribution plan Enron 401(k) which was in a 65% percent conformed by Enron stocks. The loss of a big part of their funds for retirement was one of the biggest impacts for these individual since those funds were destined to be used for future survival. The other entity that went down with Enron was the accounting firm Arthur Andersen. This firm provided consultancy and auditing services to Enron such as internal and external auditor services, tax consultancy and advisory services in the structuring of SPE transactions. Andersen was aware of all the fraudulent practices executed by Enron. Arthur became the partner in crime of Enron. As an auditing firm Andersens main responsibility was to inform the irregularities in the disclosure of financial information presented in the financial statements of the company, but they did not do so. The business made between Enron and Arthur Andersen damaged the reputation of the accounting firm, harming their own business. As a consequence of the fraud the Sarbanes and Oxley Act was enacted, one of the biggest requirement of compliance of the act mentions that if the firm participates as a consultant or advisor, it can not participate as a auditor. This measure tries to prevent fraud by having two different firms take responsibility for the actions executed and the disclosure of accurate financial information. According to Right based type of ethical thinking also known as duty based ethics we are all obliged to fulfill our duties and to act to fulfill these duties. (Laura Bishop Ph.d Kennedy institute of Ethics). It is doing the right thing even when no one is looking. In the Enron case, as CEO and CFO of the company Ken lay and Andy Fastow failed to meet their obligation to disclose the company's financial status and its assets and debt to its investors and to the SEC. As enforcement agency SEC has failed to investigate about Enron's financial. Seemingly as the auditor Ather Andersen did not fulfil their duty in fully auditing the company, financial incentives of doing business with Enron seems to have overshadowed their obligation of fairly auditing the company's fiancials. At each and every level of controls right based ethics was violated in Enron's case from Enron's mangement, Auditors, SEC. Every check and balance process put in place for fair financial reporting and for ensuring free market spirit had been compromised by greed, high ambitions and personal gains. It may seem easier to point a finger at one entity or person, however, Enron's

collapse resulted from irresponsibility of its key leaders Ken Lay and Andy Fastow, conflict of interest of auditors Arthur Andersen, lack of oversight from SEC, greed, and capitalism blindness that caused many to look the other way as long as Enron was reporting profitable quarters. As stated throughout this paper the main cause of the Enrons collapse was due to negligence and hands of approach culture of Enron and the culture of greed that promoted deal making and shortterm profits. We see this through the accounting structure that made it impossible for Enron to publicly realize a loss. The shock of Enrons collapse impacted many lives. It wiped out the life savings of many and destroyed the dream of many retirees.