The merger between Houston Natural Gas and InterNorth produced Enron in 1985. The founder, Kenneth Lay became its chairman. It started off slowly specializing in natural gas. It grew to start increasing its product range. The management saw the need to grow faster and increase investor confidence. The process would attract more investments and increase their credit rating. The company pushed for the change of the constitution. The legislature removed the law that allowed the regulation of the industry. They changed the accounting methods to suit their preference. The merchant method allowed Enron to inflate the revenue. The market-to-market method made the company accountants record income that it had not received. The company also vouched for the special purpose entities. It used these partnerships and or companies to hide its debt. The governance issue was also an impediment to the company’s growth. The auditing firm colluded with the company officials to give the wrong report. The results of the malpractices were not good for the company. The court sentenced most of the top management people to prison. Employees lost their pensions and their jobs. The company filed for bankruptcy but later had to close down. It did not have a promising ending.
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Keywords: Enron, merchant, revenue
Kenneth Lay founded the Enron Company by merging two natural gas pipeline companies in 1985. The companies included Houston Natural Gas and InterNorth. The company grew and became one of the biggest players in natural gas distribution. It added other products to its offerings. But there arose major problems with its financial status. The directors, the auditors, and the finance team tampered with the financial records. They provided wrong information to the banks, the Securities and Exchange Commission and the analysts. It led to the steady downfall of the company. The paper would discuss the independent and dependent variables of Enron’s fall.
The Causes of Enron’s Downfall
Enron and its director pushed for the deregulation of the natural gas. The United States Congress approved the legislation. Enron was able to sell natural gas and electricity at higher prices. Due to the decreased regulation, Enron made exorbitant proceeds from its sales (Benston & Hartgraves, 2002).
Enron used the merchant method of accounting to recognize revenue. The model allowed Enron to record the revenue collection from all its tradings. It, therefore, inflated its revenue and led to recording income that the company had not received. The reporting allowed Enron to appear falsely in the wealthiest 50 of the Fortune 500. The company’s revenues grew by over 700% between 1996 and 2000. The industry’s growth was about 2.5% per year, but Enron’s growth was over 50% (Benston & Hartgraves, 2002).
The company started using the market-to-market accounting method. The method allowed the company to recognize income from the long-term projects. For instance, the company came up with and recorded the present income from its estimated future value. The income was not guaranteed. But the income in the books was increasing every year. The company had to make more deals to illustrate the growth in its income. The SEC approved the accounting method for application on the natural gas futures only. Enron expanded the use of the method on all its trading activities. Mr. Skilling wanted to meet Wall Street projections. Enron continued to list revenues even from projects that resulted in losses (Unerman & O’Dwyer, 2004).
Enron came up with special purpose entities. They were either partnerships or limited companies. The company used them to fulfill temporary and or specific purposes. It was to fund or manage risks associated with specific assets. The executive decided not to give information and clarification about these specific purpose entities. Enron used many of these special purpose entities to keep the public from knowing the truth. The action prompted Enron to overstate its revenue, understate its liabilities and equity. In reality, the special purpose entities were consuming the company’s stock and guarantees. Some of these special entities were JEDI and Whitewing. They contributed to the increased risk of the company’s fall. Enron also booked costs of canceled projects and included them in its reports as assets (Gailey, 2007).
The company had problems with how it conducted its internal governance. Its model board of directors was only on paper. It had conflicting issues on how it attracted investors and built investor confidence. The corporate culture was not working because of the unscrupulous deals with the employees. They were only concerned with short-term earnings. They attracted high bonus payments and stock options. The pursuit of better ratings during performance review caused them to disregard the company’s profits. The management created a notion that the company’s revenues were increasing. They used erroneous means to develop the target earnings. The management made the employees think that the company had so much money. The expenditure accounts of the employees, the management, and the executives went up. The executives earned twice as much as their competitors. The salaries, bonuses, and the stock went up each year sometimes by about 50%.
Enron did not manage its risk in a professional way (Gailey, 2007). It hedged with itself in the guise of the special purpose entities. Therefore, it retained the risk within the company. The board was aware of most of the projects that the management initiated. In fact, they approved them. But they were not fully aware of the unscrupulous financial practices. The Finance Committee and the Board lacked the technical experience and knowledge about the accounts. Therefore, they could not question the account’s presentation methods. The reports featured mostly on profitability and cashback for the board and the executive. They approved them without strict and careful analysis.
The Auditing firm could not give proper audit report (Prebble, 2010). It had a conflict of interest in the affairs with Enron. Arthur Andersen acted both as a consulting firm and an auditing firm to Enron. As a result, it received large sums of money for payment of services. The auditor may have worked just to earn the annual fees. The firm could also have lacked the expertise to review Enron’s books. Enron also hired several accountants who understood the accounting loopholes. They helped the company to maximize on the loopholes in the Generally Accepted Accounting Principles (Rapoport, Van Niel & Dharan, 2009).
The accountants did not write-off the losses from the special purposes entities. They only deferred the charges from them. Enron would sometimes invite Ernst & Young or PricewaterhouseCoopers to finish the auditing process. It was to create an illusion that they were changing their auditors. It was only supposed to build confidence in its shareholders and potential investors. Enron’s Corporate Audit Committee held very brief meetings (Prebble, 2010). They did not carefully analyze the large amounts of material. They also missed the technical knowledge to question the reports properly. They did not have time to get information from the company’s management team.
The Consequences of Enron’s Downfall
The company started selling the lower margin stocks. It wanted to concentrate on its core business of gas and electricity. It sold Portland General Electric and Northwest Natural Gas. It also sold its share in the Dabhol project in India.
Enron started restructuring its statements because of SEC’s investigations (Prebble, 2010). It was correcting its accounting violations. The restatements reduced the earnings by over $600 million and increased the liabilities by about $620 million. The equities went down by $1.2 billion.
The revelations made the credit rating for Enron start going down. The analysts and observers continued having problems assessing the company’s records (Friedrichs, 2004). They claimed that the financial statements had very many problems. Moody’s and Fitch downgraded the company’s credit rating to junk status.
The situation had gotten very bad that even the proposed buyout failed. It had received very many rejections in its plan to sell. Dynegy had accepted to buy the company. It was based on the revelation that there would still be some cash to run the business. But the reports kept revealing more losses, liabilities, and debts. Dynegy had to pull out.
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Enron’s creditors and other energy companies lost several points. The exposure was rising. Enron had billions of dollars lost through its liabilities. It had to file for the largest bankruptcy in the history of America (Rapoport, Van Niel & Dharan, 2009).
Trials and sentencing of the top management began. Jeffrey Skilling went to jail for more than a decade. Kenneth Lay died before he would serve a sentence of 45 years in prison. The court also found other executives and employees guilty and sentenced them. The Auditor, Arthur Andersen shred thousands of documents related to the case (Prebble, 2010). He also deleted valuable information. The court found him to have obstructed justice.
A new law came into force as a result of the Enron scandal. The Senate committee and the House committee concerned passed the Sarbanes-Oxley Act (Unerman & O’Dwyer, 2004). It provided for the establishment of the Public Company Accounting Oversight Board. It would develop standards for operations of public companies. The SEC also made some changes to the stock exchange’s regulations.
Summary and Conclusion
The company began a very successful journey to productivity. The merging of the two very successful companies made Enron a very strong competitor in the market. The management failed in its obligation to nurture the company.
The changes in the methods of reporting brought about this mess. The executive and the management made wrong decisions based on their greed. They manipulated records and involved the bankers in their scheme. The pensioners and the shareholders suffered great losses.
It would seem like Enron never existed at all. But the pains it left behind provide great lessons about corporate governance. There should be the need always to monitor the public companies closely. It would hinder the decision makers from attempting to do malpractices.
Benston, G., & Hartgraves, A. (2002). Enron: What happened and what we can learn from it. Journal of Accounting And Public Policy, 21(2), 105-127.
Friedrichs, D. (2004). Enron Et Al: Paradigmatic white collar crime cases for the new century. Critical Criminology, 12(2), 113-132.
Gailey, J. (2007). Exposing Enron: Media representations of ritualized deviance in corporate culture. Crime, Media, Culture, 3(2), 226-230.
Prebble, L. (2010). Enron. London: A & C Black.
Rapoport, N., Van Niel, J., & Dharan, B. (2009). Enron and other corporate fiascos. New York: Thomson Reuters/Foundation Press.
Unerman, J., & O’Dwyer, B. (2004). Enron, WorldCom, Andersen et al: A challenge to modernity. Critical Perspectives on Accounting, 15(6-7), 971-993.