A study of the Enron Scandal and Corporate Governance

Name: PAYANIANDY Muruganandam

Student ID: 1217700
Course: BSc (Hons) Financial Management

TABLE OF CONTENTS:
Introduction ............................................................................................................................................ 1
Downfall of Enron ................................................................................................................................... 2
Causes of the downfall of Enron and good corporate governance ............................................... 4
Accounting and transactional techniques ................................................................................... 4
Board of Directors......................................................................................................................... 5
Transparency................................................................................................................................. 6
Accountants and Auditors ............................................................................................................ 6
Conclusion ............................................................................................................................................... 7
References .............................................................................................................................................. 8

Introduction
Once the seventh largest company in America, Enron Corporation was born in the middle of a
recession in 1985, when Kenneth Lay, then-CEO of Houston Natural Gas Company (HNG),
engineered a merger with Internorth Incorporated (Free, Macintosh, Stein, 2007, p. 2). Within
six months of the merger, the CEO of Internorth Inc., Samuel Segner, resigned leaving Lay as
the CEO of the newly formed company. Shortly thereafter, HNG/Internorth was renamed
Enteron, a name which was later shortened to Enron in 1986. The new company, which
reported a first year loss of over $14 million, was made up of $12.1 billion in assets, 15,000
employees, the countrys second-largest gas pipeline network, and an enormous amount of debt
(p. 2).
In the initial years, Enron attempted to function as a traditional natural gas firm situated in a
competitive, yet regulated energy economy (Free, Macintosh, Stein, 2007, p. 2). Due to its
tremendous debt and early losses on oil futures, however, the company had to fight off a hostile
takeover and its stock did little to impress to the traders on Wall Street (p. 2). Fortunately for
Enron, things began to change in American governmental policy with respect to the way the
natural gas industry operated. At the core of Enrons historical rise to power, lies the concept
of policy-driven, market deregulation.
In the mid-to-late 1980s, the natural gas market was deregulated through a series of federal
policies. Each of these policies was designed to eliminate the regulatory constraints by the
federal government on the natural gas market, largely, to help avoid a repeat of the tough
economic issues resulting from the 1970s energy crisis (The History of Regulation, 2004).
Enron capitalized on the governmental deregulation of the natural gas market by providing
consumers with greater access to natural gas via their nationwide pipeline system. Due to
deregulation, as supplies increased and the price for natural gas fell by over 50 percent from
1985 to 1991, Enron was able to charge other firms for using their pipelines to transport gas.
Likewise, Enron was also able to transport gas through other companies pipelines (Culp and
Hanke, 2003, p. 8).
Around this time, Jeffrey Skilling, working for the consulting firm McKinsey and Company,
began working with Enron. Beginning in 1987, Skilling started his work in creating a forward
market for Enron in the deregulated natural gas sector. To help create this market, Skilling
argued that Enron needed to set up a gasbank to help intermediate gas purchases, sales, and
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deliveries (Culp and Hanke, p. 8). Skillings major selling point to Enron CEO Kenneth Lay
was that in an era of post deregulation, customers needed risk management solutions in the
form of a natural gas derivatives market or, a place where consumers could purchase forward
contracts to help alleviate price volatility commonly found in the natural gas industry.
In this regard, Skilling was, according to Culp and Hanke (2003), functioning as a classic
entrepreneur. Skilling spotted an opportunity to develop new markets. By introducing forward
markets, individuals could acquire information and knowledge about the future and express
their own expectations by either buying or selling forward (p. 8). Lay eventually went for
Skillings concept of the gasbank and the Enron GasBank was established (McLean and Elkind,
2003, pp. 35-37). Fortune Magazine selected Enron as "America's most innovative company"
for six straight years from 1996 to 2001.

Downfall of Enron
Enron employed around 21,000 people and was one of the world's leading electricity, natural
gas, pulp and paper, and communications companies, with claimed revenues of $111 billion in
2000. It was considered as Americas largest supplier of energy. In December 2001, Enron
filed for bankruptcy.

Baker (2003) has analysed the fall of Enron from different perspectives, he discussed the
business model of Enron and external factors such as deregulation of industry in that era. He
has examined the growth of Enron which transformed itself from regulated gas distribution
Company into an international trading company and through all the stages of its collapse and
he investigated Enron as American public private partnership
Joanne and John (2006) discussed the some issue and use the term Hypermodern
Organization as they argued that the continuous growth of Enron as an organization was based
on hyper flexibility in terms of size and survival of its business units. In reaction to the market
opportunities Enron acquired and disposed off businesses. It acquired Portland General
Corporation to enter to the market of utility electricity.
Coffee (2004) has discussed the same issue in his working paper what caused Enron . He
identified that, in late as October 2001, 16 or 17 security analysts recommended buy or strong
buy for Enrons stock however the stock price of Enron already in 2000 was 6 times of its book
value and 70 times earnings, however the first brokerage firm which recommended sell
recommendation for Enron was prudential securities which at that time was not engaged in the
investment banking business.
Following the revelation of the involvement of the CEO Keneth Lay and Jeff Skilling, CFO
Andrew Fastow and the audit firm Arthur Anderson, Higgs (2003) recommended that half of
the board members should be non-executive directors and the role of CEO and the chairman
should be separate. In his view independence of auditors and directors is very important. Luca
Enrique (2003) discussed the developments in EU countries in the post Enron era. On May 25,
2003, the European commission issued to council and European parliament setting out its
agenda to modernize European Corporate Law and to enhance corporate governance in E.U.
With respect to U.K post Enron corporate Governance reform there has been study on nonexecutive directors commissioned by government funded organization sand also some
initiatives on audit and accounting issues.

Causes of the downfall of Enron and good corporate governance

Corporate governance is concerned with the relationships between a businesss management
and its Board of Directors, its shareholders and lenders, and its other stakeholders such as
employees, customers, suppliers and the community of which it is a part. The subject thus
concerns the framework through which business objectives are set, the means of attaining them,
and of determining performance monitoring. Good corporate governance follows principles
that still vary significantly among countries, and are currently the subject of various initiatives
designed to achieve agreement on an acceptable framework of basic standards in which a
central role is attributed to the Principles of Corporate Governance.
Accounting and transactional techniques
Seven different accounting and transactional techniques was used by Enron, which shows how
much it overstepped the limit imposed by the financial regulations of the Financial Accounting
Standards. Not all the seven techniques was in conflict with the accepted accounting rules and
regulation, but a great deal of it was classified as questionable while investigating the
bankruptcy of the firm.
Financial Accounting Standards transactions were used by Enron to convert liquid assets on its
balance sheet, while in fact retaining control over them. This was achieved by the sale of the
assets through a number of steps to a Special Purpose Entity (SPE) not consolidated in its
financial statements. Enron also hedged the value of its investments by entering into derivative
contracts with counter-parties related to itself. The acceptability of a hedge from the point of
view of accounting rules turns on the existence of an unrelated party prepared to assume
through a contract part or all of the economic risk of the position being hedged. These
conditions are not fulfilled if one of the counter-parties to the contract is closely related to the
firm. These conditions were thus not fulfilled for a number of important hedges entered into
by Enron since, first, the counter-parties to the hedges were entities in which Enron employees
participated and over which they exercised managerial control; and, second, the resources of
these entities were largely Enron stock, forward contracts to purchase such stock, and warrants
on the stocks of firms in which Enron had controlling investments.

How does a SPE work?

Board of Directors
A fundamental role in the achievement of good corporate governance is attributed to actors in
the Board of Directors and independent external auditors. Key functions of the Board of
Directors, which were particularly relevant in the case of Enron, include the selection and
remuneration of executives, being alert to potential conflicts of interest adversely affecting the
firm, and ensuring the integrity of the companys systems of accounting and financial reporting.
Fundamentals for satisfactory performance include access to accurate and timely information
bearing on the fulfilment of these responsibilities. The role of the Board in the area of conflicts
of interest clearly includes the monitoring needed to avoid self-dealing by management. The
primary finding of a report to a committee of the United States Senate on the role of the Enrons
Board in its collapse is damning (United States Senate, 2002, p. 11):
The Enron Board of Directors failed to safeguard Enron shareholders and contributed to the
collapse of the seventh largest public company in the United States, by allowing Enron to
engage in high risk accounting, inappropriate conflict of interest transactions, extensive
undisclosed off the- books activities, and excessive executive compensation. The Board
witnessed numerous indications of questionable practices by Enron management over several
years, but chose to ignore them to the detriment of Enron shareholders, employees and business
associates.

In 2001, the Enron board consisted of fifteen members, many of them with fifteen or more
years of experience on the Board of Enron and its predecessor companies, and many of them
also members of the Boards of other companies. Of the five committees of the Enron Board,
the key Audit and Compliance Committee had six members, of whom two had formal
accounting training and professional experience and only one had limited familiarity with
complex accounting principles; and the Compensation Committee had five members, three
with at least fifteen years of experience with Enron (United States Senate, 2002, pp. 12, 9).
Transparency
David Baker (2005) views Enrons bankruptcy as an accounting failure in which the investors
and creditors of the company were deceived and presented with false financial information .In
his view the bankruptcy losses of the investors could have been reduced to some extent if they
had been provided with the transparent financial information and its result.
Accountants and Auditors
Regarding auditing, good corporate governance requires high quality standards for preparation
and disclosure, and independence for the external auditor. Enrons external auditor was Arthur
Andersen, which also provided the firm with extensive internal auditing and consulting
services. Some idea of its relative importance in these different roles during the period leading
up to Enrons insolvency is indicated by the fact that in the year 2000, consultancy fees (at
US$27 million) accounted for more than 50 per cent of the approximately US$52 million
earned by Andersen for work on Enron. The history of relations between Enron and Arthur
Andersen suggests that they were frequently considered by tensions due to the latters
difficulties concerning several features of Enrons accounting. However, overall, Andersens
performance, revelations concerning which were to lead to the break-up of the firm, led to the
following assessment by the Powers Committee: The evidence available to us suggests that
Andersen did not fulfil its professional responsibilities in connection with its audits of Enrons
financial statements, or its obligation to bring to the attention of Enrons Board (or the Audit
and Compliance Committee) concerns about Enrons internal contracts over the related-party
transactions (Powers et al., 2002, p. 24). Both the Powers Committee and bodies of the United
States Senate that have investigated Enrons collapse have taken the view that lack of
independence linked to its multiple consultancy roles was a crucial factor in Andersens failure
to fulfil its obligations as Enrons external auditor (United States Senate, 2002, pp. 578).

Conclusion
Through the analysis of Enron case, it showed that how the directors of the Enron used financial
reporting to mask the real financial position of the company. Auditors independence,
deregulation energy industry in USA, flaws in US Generally Accepted Accounting Principles
(GAAP), Accounting Standards and poor corporate Governance, ultimately led to the downfall
of Enron. But there is consensus that Enron executives used financial reporting as a tool to
mask the real financial position of the company and also all these factors are linked directly or
indirectly with financial reporting.
Transparency and Accountability are the two key words and lack of both in the financial
systems result in scandals like the Enron. It is a basic notion in finance that increased debts
can increase the financial risk of an entity but how the investors of a company would know if
debts do not appear on the financial statements of the company? Therefore it can be argued that
if Enron had presented their financial reports with transparency and had shown their assets and
liabilities accordingly, the financial losses to the investors would have been minimised.
Financial analysts use financial information for valuations purposes and forecast the earnings
of the company which has impact on the security prices. The Enrons earnings were inflated
fraudulently and debts were shown as profits. Which in turn inflated the stock prices but it did
not create value to the shareholders as these prices were based on false information. Therefore
it can be argued that quality reporting can lead to quality forecast and estimates, which will be
based on true and fair view and can help investors in quality decisions and it can create value
to shareholders and value to corporate in the long run.

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