• Thu. May 23rd, 2024

Enron: Scandal and Accounting Fraud

Before its demise, Enron was a large energy, commodities, and services company based in Houston, Texas. Its collapse affected over 20,000 employees and shook Wall Street. At Enron’s peak, its shares were worth $90.75. When it declared bankruptcy on Dec. 2, 2001, shares traded at $0.26.

Key Takeaways

  • Enron’s accounting method was revised from a traditional historical cost accounting method to a mark-to-market (MTM) accounting method in 1992.
  • Enron used special-purpose vehicles to hide its debt and toxic assets from investors and creditors.
  • The price of Enron’s shares went from $90.75 at its peak to $0.26 at bankruptcy.
  • The company paid its creditors over $21.8 billion from 2004 to 2012.

Enron’s History and Accounting Method

Enron was formed in 1985 following a merger between Houston Natural Gas and Omaha, Neb.-based InterNorth. Houston Natural Gas’ chief executive officer (CEO) Kenneth Lay became Enron’s CEO and chair. Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was poised to take advantage. In 1990, Lay created Enron Finance and appointed Jeffrey Skilling, to head the new corporation. 

Skilling transitioned Enron’s accounting from a traditional historical cost accounting method to a mark-to-market (MTM) accounting method, for which the company received official U.S. Securities and Exchange Commission (SEC) approval in 1992.

MTM measures the fair value of accounts that can change over time, such as assets and liabilities. MTM aims to provide a realistic appraisal of an institution’s or company’s current financial situation, and it is a legitimate and widely used practice. However, in some cases, the method can be manipulated, since MTM is not based on actual cost but on fair value, which is harder to pin down.

Investopedia / Source Data: Forbes / Created using Datawrapper

Enron’s Investments

During the 1990s, the dotcom bubble was in full swing, and the Nasdaq hit 5,000. Most investors and regulators accepted spiking share prices as the new normal. Enron created EnronOnline in October 1999. It was an electronic trading website that focused on commodities. Enron was the counterparty to every transaction on EOL; it was either the buyer or the seller. Enron offered its reputation, credit, and expertise in the energy sector to entice trading partners.

In July 2000, Enron Broadband Services and Blockbuster partnered to enter the burgeoning video-on-demand market. The VOD market was a sensible pick, but Enron started logging expected earnings based on the estimated growth of the VOD market, which vastly inflated the numbers.

By mid-2000, EOL was executing nearly $350 billion in trades. When the dot-com bubble began to burst, Enron decided to build high-speed broadband telecom networks. When the recession hit in 2000, Enron had significant exposure to the most volatile parts of the market. As a result, many trusting investors and creditors found themselves on the losing end of a vanishing market capitalization.

Hiding Loss With MTM

Skilling hid the financial losses of the trading business and other operations using MTM accounting. This technique measures the value of a security based on its current market value instead of its book value.

The company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though it didn’t reap positive returns. If the revenue from the power plant proved less than the projected amount, the company would transfer the asset to an off-the-books corporation instead of taking the loss. The loss would go unreported. This type of accounting enabled Enron to write off unprofitable activities without hurting its bottom line.

The MTM practice led to schemes designed to hide the losses and make the company appear profitable. To cope with the mounting liabilities, Andrew Fastow, chief financial officer (CFO) in 1998, developed a deliberate plan to show that the company was in sound financial shape even though many of its subsidiaries were losing money.

SPVs

Enron orchestrated a scheme to use off-balance-sheet special purpose vehicles (SPVs), also known as special purpose entities (SPEs), to hide Enron’s debt and toxic assets from investors and creditors.

Enron would transfer some of its rapidly rising stock to the SPV in exchange for cash or a note. The SPV would subsequently use the stock to hedge an asset listed on Enron’s balance sheet. Enron would guarantee the SPV’s value to reduce apparent counterparty risk.

The SPVs were not illegal but differed from standard debt securitization in several significant—and potentially disastrous—ways. SPVs were capitalized entirely with Enron stock. This directly compromised the ability of the SPVs to hedge if Enron’s share prices fell. Enron also failed to reveal conflicts of interest. While Enron disclosed the SPVs’ existence to the investing public, it failed to adequately disclose the non-arm’s-length deals between the company and the SPVs.

Investopedia

Lack of Oversight

In addition to CFO Andrew Fastow, a major player in the Enron scandal was Enron’s accounting firm, Arthur Andersen LLP, and partner David B. Duncan. As one of the five largest accounting firms in the United States at the time, Andersen had a reputation for high standards and quality risk management. Despite Enron’s poor accounting practices, Arthur Andersen approved Enron’s corporate reports. By April 2001, many analysts questioned Enron’s earnings and transparency.

In 2001, Lay retired in February, turning over the CEO position to Skilling. In August 2001, Skilling resigned as CEO, citing personal reasons. Around the same time, analysts began to downgrade their rating for Enron’s stock, and the stock descended to a 52-week low of $39.95. By October 16, the company reported its first quarterly loss and closed its Raptor I SPV. This action caught the attention of the SEC.

A few days later, Enron changed pension plan administrators, essentially forbidding employees from selling their shares for at least 30 days. Shortly after, the SEC announced it was investigating Enron and the SPVs created by Fastow. Fastow was fired from the company that day. The company also restated earnings back to 1997. Enron had losses of $591 million and $690 million in debt by the end of 2000. Dynegy, a company that previously announced it would merge with Enron, backed out of the deal on November 28. By Dec. 2, 2001, Enron filed for bankruptcy.

$74 billion

The amount that shareholders lost in the four years leading up to Enron’s bankruptcy.

Enron’s Bankruptcy and Criminal Charges

Enron’s Plan of Reorganization was approved by the U.S. Bankruptcy Court, and the new board of directors changed Enron’s name to Enron Creditors Recovery. The company’s new sole mission was “to reorganize and liquidate certain of the operations and assets of the pre-bankruptcy Enron for the benefit of creditors.” The company paid its creditors over $21.8 billion from 2004 to 2012. Its last payout was in May 2011.

  • In June 2002, Arthur Andersen LLP was found guilty of obstructing justice for shredding Enron’s financial documents. The conviction was overturned later on appeal but the firm was deeply disgraced by the scandal and dwindled into a holding company.
  • Kenneth Lay, Enron’s founder, and former CEO was convicted on six counts of fraud and conspiracy and four counts of bank fraud. Before sentencing, he died of a heart attack in Colorado.
  • Enron’s former CFO, Andrew Fastow, pleaded guilty to two counts of wire fraud and securities fraud for facilitating Enron’s corrupt business practices. He ultimately cut a deal for cooperating with federal authorities, served more than five years in prison, and was released in 2011.
  • Former CEO Jeffrey Skilling received the harshest sentence. He was convicted of conspiracy, fraud, and insider trading in 2006. Skilling received a 17½-year sentence which was reduced by 14 years in 2013. Skilling was required to give $42 million to the fraud victims to cease challenging his conviction. Skilling was released on Feb. 22, 2019.
Investopedia 

New Regulations After Enron

Enron’s collapse and the financial havoc it wreaked on its shareholders and employees led to new regulations and legislation to promote the accuracy of financial reporting for publicly held companies. In July 2002, then-President George W. Bush signed the Sarbanes–Oxley Act into law. The act heightened the consequences for destroying, altering, or fabricating financial statements and for trying to defraud shareholders.

The Enron scandal resulted in other new compliance measures. Additionally, the Financial Accounting Standards Board (FASB) substantially raised its levels of ethical conduct. Moreover, company boards of directors became more independent, monitoring the audit companies and quickly replacing poor managers. These new measures are important mechanisms to spot and close loopholes that companies have used to avoid accountability.

Did Anyone Profit From Enron’s Demise?

Jim Chanos of Kynikos Associates is a known short-seller. Chanos said his interest in Enron and other energy trading companies was “piqued” in October 2000 after a Wall Street Journal article pointed out that many of these firms employed the “gain-on-sale” accounting method for their long-term energy trades. His experience with companies using this accounting method often showed that “earnings” were created out of thin air if management used highly favorable assumptions. Chanos said that this mismatch between Enron’s cost of capital and its return on investment (ROI) became the cornerstone of his bearish view of Enron. His firm shorted Enron’s common stock in November 2000 and netted Chanos and his Kynikos firm hundreds of millions in gains when Enron went under.

Who Is Sherron Watkins?

Sherron Watkins, a vice president at Enron, wrote a letter to Lay in August 2001 warning that the company could implode in a wave of accounting scandals; a few months later, Enron had collapsed. Watkins’ role as a whistleblower in exposing Enron’s corporate misconduct led to her being recognized as one of three Time “Persons of the Year” in 2002.

Does Enron Still Exist?

Enron no longer exists. It sold its last business, Prisma Energy, in 2006.

The Bottom Line

Enron’s collapse was the biggest corporate bankruptcy hit the financial world. It has been surpassed by the bankruptcies of Lehman Brothers, Washington Mutual, WorldCom, and General Motors. The Enron scandal drew attention to accounting and corporate fraud as shareholders lost $74 billion in the four years leading up to its bankruptcy, and its employees lost billions in pension benefits.

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