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HT120095 - Accountants in the profession

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10/16/2015
Table of Contents

1. Abstract: ................................................................................................................................................ 3
2. Introduction .......................................................................................................................................... 4
3. Demise of Enron:................................................................................................................................... 5
3.1 An admired company .......................................................................................................................... 5
3.2 What led to fall.................................................................................................................................... 6
3.3 Failed Check and Balances ........................................................................................................... 7
3.4 Breach of accounting and ethical conduct .................................................................................... 8
3.5 Board of Directors......................................................................................................................... 8
3.6 Corporate Culture................................................................................................................................ 9
3.7 Lessons Learnt .................................................................................................................................... 9
4. Conclusion: .......................................................................................................................................... 10
5. References: ......................................................................................................................................... 12

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1. Abstract:

This case is about the analysis of Enron’s accounting malpractices, related to its trading business.
The company was the 7th largest corporation in the United States by revenue in 2001. Enron
transformed from a regulated natural gas distribution company to a worldwide energy trading
company. The company was a globally dominated energy trader with more than $100 Billion
revenue(Healy and Palepu, 2013). Enron got bankrupt in 2001 due to obscured huge debts which
were kept off the Balance sheet and mark-to-mark accounting for its commodity trading business
and this led to $74 Billion wiping out of Enron’s shareholder(Benston and Hartgraves, 2002).
The case analysis is based on existing research finding, theoretical concepts and other authentic
online resources. We read journals related to the Enron bankruptcy case explaining different
aspects of business. To understand the impact of the scandal on society. The case highlights four
key learning points as an accounting professional that are related Enron financial misled and
obscured accounting practices. The case argues that had there been transparent accounting, an
astute level of financial analysis and a more realistic view about the company’s business
operation and related return, bankruptcy could have been avoided. This is a live case of
undermining the objective of accounting and accompanied unethical practices by its
professionals. It looks into the role of the Enron’s board of director, auditors and existing
regulations at that time. Company’s corporate culture also stimulated to continuance of practice
to report inflated revenue, net income, shareholder equity and understate its liabilities. This case,
therefore also reveals the weakness in our corporate system. The case is great learning for
accounting professionals shows the conflict of interest between parties can lead to manipulation
of overall operating structure.

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2. Introduction

Enron was recognized as a global player in energy trading and international energy-asset
construction. It was founded in 1985 as a natural gas pipeline company by recognizing the
opportunity after deregulation of natural gas and trade like a commodity.

The Enron was one of the most reputed companies known for employing bright and talented
employees. The companies' boards of directors were constituted of Kenneth Lay as a chairman of
the board and CEO. There were Emeriti, Professors and former Secretaries of State. Kenneth Lay
was the person behind establishing Enron in 1985. One of the key spokesman of deregulation.
He was known for his social and charitable activities. Jeffrey Skilling was chief operating officer
of Enron. He was the man behind implementing mark-to-market accounting in the organization.
Under his supervision, Enron launched an internet based platform EnronOnline, for trading of
Energy contract, which lost all of its invested capital. Andrew Fastow was the Chief Financial
Officer of Enron; under his supervision hundreds of SPE’s were born to facilitate the illegal
trades. McKinsey was Enron’s strategic client, Vinson and Elkins acted as a legal advisor,
financial manoeuvred by investment bank including J.P. Morgan and Citibank. Arthur Andersen
was the accounting firm which was liable for its internal and external Auditing since the
inception of the firm in 1985. In 2000 Enron was the second largest client of the CPA firm.

The company was known for its aggressive compensation structure. The compensation was
closely pegged to closing deals. As a result, executives focused much more on sales rather
than on the long term cash flow generated during the projects’ implementation (Silveria,
2013). Kenneth Lay was one of the highest paid CEOs of America, earning a $42.4 million
compensation package in 1999. Senior Executives were used to exploiting company’s asset for
personal benefit.

“Prior to 1985, the Federal Energy Regulatory Commission (FERC) required interstate pipeline
firms to make long term commitments to purchase minimum gas volumes from wellhead
producers at regulated prices that exceeded market spot prices (Healy and Palepu, 2013)”. The
deregulation of gas increased the risk of price volatility in high demand season. Enron started
making contracts with its customer as an intermediary to provide the long-term gas contracts at

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prior fixed price and thus taking the risk of price volatility. In these circumstances, Enron used
long-term fixed-price contracts with gas producer and financial derivatives like swaps, and
forward and future contracts, to hedge the risks of volatility. This provided the stage to begin an
Enron Journey from a pipeline company to a largest energy trading company of the world.

Enron was working through many special purpose entities (SPE) which used to work as counter
party of Enron. The asset of the SPE’s was Enron restricted stock and loan guarantees, but did
not qualify for consolidation in the financial statement. The company took a number of
simultaneous transactions with SPE’s for hedging its risk and making operation essentially a loan
transaction.

3. Demise of Enron:
The company was pioneer of energy trading and very soon became the largest. But fallen off the
cliff with a speed which no one expected.

3.1 An admired company


The company, which was founded in 1985 become the largest seller of natural gas in North
America and gas trading contributed $316 million to its earnings before interest and taxes by
1993 (Healy and Palepu, 2013). Enron Operating revenue was in excess of $100 Billion with
earnings of around $1 Billion and market capitalization more than $60 billion, a multiple of 64
times earnings and six times the book value (Healy and Palepu, 2013). The company’s revenue
grew by eight times during 1996 to 2000. It was recognized as one of the most innovative
companies by Fortune magazines for six years in a row. As per (Fortune, 2000) “No company
illustrates the transformative power of innovation more dramatically than Enron”.

Yet within a year, Enron’s reputation was ruined. Enron was the darling of wall street “as of Oct.
18, all 15 analysts tracked by Thomson Financial/First Call rated Enron a “buy”–12 of the 15
called it a “strong buy (Forbes, 2002).” The shareholder saw a dramatic decline in price. In
September 2000, Enron’s Stock price was around $85 to $90 range and declined to a virtually
worthless by November 2001 (See Exhibit 1). And, On December 2, 2001 Enron declared
bankruptcy under Chapter 11 of the United States Bankruptcy Code.

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3.2 What led to fall
In the earlier days, Enron has had a straightforward accounting where actual revenue and cost
was shown in the income statement. In 1997 Jeffery Skilling was appointed as the company’s
Chief operating Officer. He demanded to change the accounting to Mark-to-market accounting
system since he was recruited in 1990 as a managing director for a new division entitled Enron
Finance Corp. On January 30, 1992, Enron got the approval from The U.S. Securities and
Exchange Commission, to use the mark-to-market method. It became the first non-financial
company to use this accounting system. As described by the Wall Street Journal: “At issue is a
technique called "mark to market" accounting, under which the Financial Accounting Standards
Board has given energy traders wide discretion to include profits they expect to realize in future
periods from energy-related contracts and other derivative instruments as current earnings.”
Under this accounting method, the company estimates its present value of the anticipated cash
flow and treat it as an income from the project after making the longterm contract with customer,
even before the money was received. And any difference on estimation was adjusted in
subsequent periods. But it’s not possible to accurately estimate the cost and ultimately cash flow
related to the project. Any difference on estimation is adjusted in subsequent periods. But the
problem is that it’s not possible to accurately estimate the cost and ultimately cash flow related to
the project because there are many other external factors which affect the contract and
consequently make the cash flow estimation highly subjective (Healy and Palepu, 2013). And,
the company raised debt against the anticipated cash flow, which was projected after considering
many assumptions.

There were many irregularities which were supposed to be reported by Andersen but they failed
to do so. Enron sponsored many SPEs for being able to conduct its operations and business.
Large SPEs were used to conduct the business with Enron in the domestic market while other
SPEs were used to hide the taxable income from U.S tax system (Benston and Hartgraves, 2002).
Under GAAP reporting, SPE will be recognized as a separate identity if a third party had a
substantial controlling interest in the SPE, at least 3% of the SPE’s total debt and equity had to
come from outside (Healy and Palepu, 2013). So there were hundreds of SPE’s which were not
consolidated as part of the Enron balance sheet, but has the bank guarantee of Enron. Enron
guaranteed Bank loans of SPEs without proper investigation of Ownership and hence resulted

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the risk of almost all the debt in the scenario of default (Benston and Hartgraves, 2002). For
example, one of its joint ventures (JV) with The California Public Employees' Retirement
System (CalPERS), called JEDI, was meant to invest in energy related project. An equal
partnership in JV for both parties. JEDI assets included mark-to-market 12 million shares of
Enron. Since JEDI was a joint venture, Enron consequently did not consolidate it in the financial
statement, but showed any accompanied gain and loss of sale in its income statement as per
GAAP reporting (Healy and Palepu, 2013). Therefore, the income statement was overstating the
profit by mark-to-market share accounting, but understating the liability of bank guarantees. At
1997, Enron reached a consensus to buy its partner shares in JEDI for $383 million through a
new SPE named Chewco. There were loan guarantees made by Enron and the majority of
remaining amount was financed by the JEDI. “As it is not usual, the SPEs’ principal asset was
restricted Enron stock. When the market price of Enron’s stock declined, the SPEs’ assets were
insufficient to cover its debt (Benston and Hartgraves, 2002).

In another controversial case, in 1999, Enron created a firm called LJM where a third party
investor was CFO, Andrew Fastow. LJM was created to hedge against Enron’s position in
Rhythms NetConnections (Rhythms) stock. LJM sold the put option to Enron for $104 Million
on Rhythms stock backed by Enron restricted stock. The payment was through the Enron
restricted stock of $168 Million and LJM issued a $64 Million note to Enron. But, due to fall in
both the stock price the hedge could not work.

In both of the cases above mentioned, the entity willfully tried to hide the risk of its bank
guarantee’s and dominos effect of the falling stock price of Enron. “All along, though, Enron
really was hedging itself with itself––which, of course, is of no economic value to Enron’s
stockholders (Benston and Hartgraves, 2002).”

3.3 Failed Check and Balances


The Enron Auditor since 1985 has been Arthur Andersen LLP, but due to their conflict of
interest it failed to delineate the accounting irregularities (Nanda, 2003). As an auditor,
Andersen’s responsibility was to verify accuracy of accounting reports for it was representing the
investor side. Andersen also worked as an independent auditor as well as in internal auditing
since 1993 (Nanda, 2003), in addition to working as a consultant for non-audit work that paid

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$27 million in 2000, apart from $25 million in audit fees. Clearly, the Andersen company did not
adhere to its obligations as an impartial and professional auditor.

3.4 Breach of accounting and ethical conduct

The company tried to hide its associated risk through its mark-to-market accounting and off-
balance sheet loan guarantees. In Enron business ethics was replaced by greed to secure
individual profits while placing the interest of the company as a whole and its stockholder’s
interest in the corner. Auditor, Arthur Andersen LLP was indirectly involved in other business
activities than that of auditing which reflected in its clear conflict of interest. Its primary
responsibility should be that of auditing firm to serve in the best interest of the client by
impartially monitoring the firm's management (Nanda, 2003). Due to this criticism, the Audit
firms started considering restriction in certain type of activities which can lead to direct conflict
of interest (Benston and Hartgraves, 2002). In case of Chewco and LJM both, company’s senior
employees were invested as third party which created a serious conflict of interest which never
disclosed by the company.

3.5 Board of Directors


The ultimate responsibility lies with the board of directors and their most important objective is
to maximize the profit of shareholders (Nanda, 2003). The board of directors has the authority to
appoint a CEO or CFO and limit the decision making power as well. It also appoints internal and
external auditors. To make a vigilant auditing the company tends to have different firm internally
and externally. But in Enron, The board of directors failed to raise the question on
unconsolidated affiliates and its excessive undisclosed off -the book activity. It knowingly lets
the Enron work on high risk accounting practices. Enron excessive compensation payment was
also allowed without considering the economic impact of the project or a contract. There were
many large numbers of strategic mistakes, overpriced acquisitions and disastrous overseas
investments like Dahbol energy plant in India. The decisions of top management have a much
larger impact on company’s downfall than accounting manipulations, as the acquisitions were
necessary to keep the company afloat by showing anticipated cash flow (Silveria, 2013).

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3.6 Corporate Culture
The company’s salary and bonus structure was very aggressive. As an employee, you used to be
paid in cash and stock options, but only if you were a moneymaker employee. You have to
constantly keep generating revenue, because the environment was very competitive.
Consequently, the employee’s primary objective became profit, which resulted in surpassing the
company`s ethical code of conduct (Prentice, 2007). Any quick perusal of the “tell-all” books
penned by Enron insiders quickly show how readily many new employees were acculturated into
Enron’s fast-and-loose corporate style without fully recognizing the ethical implications of
company practices (Prentice, 2007). When a new employee comes in such organizational
culture, he does not stand a chance to even try to practice the code of ethics. Initially, people tend
to hesitate to break the ethical and other rules, but in such gradually aggressive corporate culture
than that of Enron`s which encouraged aggressive action by promising higher payment,
employees' actions gradually deteriorate. This additionally pushed the employee’s to sign bogus
SPE’s and engage in energy trading activities. (Bagley, 2005).

3.7 Lessons Learnt


The Enron scandal is one of the most important cases for learning as an accounting professional.
The four major lessons I have learned are:

1. The professional integrity should not be compromised with financial cleverness. The
professional should exercise the right and transparent decision without having any
conflict of interest.
2. Persuasion to aggressive compensation can tempt to unethical Practices. So, the clear role
and responsibility with accountability should be stated.
3. Company’s long term value creation plays a major role in the growth of the company. If
the focus will be on quarterly profit number only. The company managed to show profits
in a book due to accounting manipulation lead to short term benefit but without any value
addition.
4. Regulatory loopholes also played a major role, which was systematically exploited by
Enron.

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When a large corporate collapse it affects the perception of people towards free markets and
capitalism. After one year of chapter 11 by Enron, a stricter US federal law came into existence
know as Sarbanes-Oxley Act of 2002 (Bratton, 2002). The law was primarily aimed on the
participation of accounting firms in audits of a corporation. It was passed due to the occurrence
of many accounting scandals during 2000 to 2002 including Enron, there were other large and
known firms which failed due to accounting fraud scandals such as Adelphia, WorldCom, and
Tyco. The act led the new standards for regulating public accounting firms, public company
boards and its management(Bratton, 2002).

“The impact of the collapse was disastrous to its shareholders and stakeholders, including the
firing of the approximately 30,000 employees (Silveria, 2013).” The employees were getting
hefty salary and were paid in stock options as well. The values of the stock options become
worthless, which used to be valued in the billions. Employees’ pension fund 401(K)s was heavily
invested in the company’s stock and by employees cross 55 years of age, they were not allowed
to sell the stocks (Hirsch, 2003). Many large investment funds were used to invest in the
company’s share, particularly pension funds that sought to invest by industry segment and the
estimated loss of these firms was $1.5 billion (Hirsch, 2003). Being one of the Fortune 500
Company, no one expected to go bankrupt.

4. Conclusion:

The Enron scandal is one that left a deep and ugly scar on the face of the corporate world. The
case is rich with learning for professional accountants and business managers. Enron was the
most emblematic corporate scandal due to mismanaging the regulatory and accounting system
for the benefits for company’s senior executive and related parties. It comprised of illegal
activity, irregular accounting and unethical practices. The company’s top executive could not
manage to put their ethics ahead of financial greed. A company must have a vigilant way of
scrutinising the company’s performance. The focus of wealth creation is far more important than
just profit making. There were many such instances where the company took the wrong
decisions from buying assets to accounting manipulation. The sound corporate governance from
top to bottom is the most important requisite for a systematic strong company. The employee

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will try to do go beyond the business ethics if the company aggressively pays only based on the
sales. There must be clear role and responsibility of each employee in the company. The internal
and external parties conflict of interest gives birth to an opaque system of business operation.
Excessive concentration of power, poor regulation, passive investors and their representative like
Credit rating, Analyst and government body are some of the major reasons for corporate
scandals. Even after many years of the Enron scandal, there have been many cases which were
due to inappropriate governance. The impact of such scandals on employees and shareholder is a
painful condition. The employees' retirement funds vanish with the company.

I think the Enron fall was caused by numerous factors. Mark-to- Market accounting manipulation
was done extensively, the company’s culture and top executive ethical values are the majors.

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5. References:
 Archive.fortune.com, (2002). The World's Most Admired Companies How do you make
the Most Admired list? Innovate, innovate, and innovate. The winners in this year's list,
compiled by the Hay Group consultancy, tell how they do it. - October 2, 2000. [online]
Available at:
http://archive.fortune.com/magazines/fortune/fortune_archive/2000/10/02/288448/index.
htm [Accessed 14 Oct. 2015].
 Bagley, C., Clarkson, G. and Power, R. (n.d.). Deep Links: Business School Students'
Perceptions of the Role of Law and Ethics in Business. SSRN Electronic Journal.
 Bankingblawg.com, (2013). Mark-to-Market: The Key to Enron’s Downfall |
BankingBlawg. [online] Available at: http://www.bankingblawg.com/banking-and-
finance/mark-to-market-the-key-to-enrons-downfall/ [Accessed 14 Oct. 2015].
 Benston, G. and Hartgraves, A. (2002). Enron: what happened and what we can learn
from it. Journal of Accounting and Public Policy, 21(2), pp.105-127.
 Bratton, W. (2003), “Enron, Sarbanes-Oxley and Accounting: Rules Versus
Principles Versus Rents,” Villanova Law ,48 (1), pp.1023–1056.
 da Silveira, A. (2013). The Enron Scandal a Decade Later: Lessons Learned?. SSRN
Electronic Journal.
 Forbes.com, (2002). Enron Analysts: We Was Duped. [online] Available at:
http://www.forbes.com/2002/02/27/0227analysts.html [Accessed 14 Oct. 2015].
 Healy, P. and Palepu, K. (2003). The Fall of Enron. Journal of Economic Perspectives,
17(2), pp.3-26.
 Hirsch, P. (2003). The Dark Side of Alliances: The Enron Story. Organization, 10(3),
pp.565-567.
 Journal, J. (2001). 'Mark to Market' AccountingIs Under Increased Scrutiny. [online]
WSJ. Available at: http://www.wsj.com/articles/SB1007415841827496880 [Accessed 14
Oct. 2015].
 Nanda, A. (2002). Broken Trust: Role of Professionals in the Enron Debacle. Harvard
Business Review.

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Exhibit 1 Enron Ending Monthly Stock Prices and S&P Index from December 1989 to December
2001.

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