Fraud Analysis: Enron Corporation Report

Introduction

Enron Corporation is an American Energy Company whose main offices are in Houston Texas. The company was formed in 1985 following the merger of Houston Natural Gas and InterNorth. Enron expanded rapidly in the United States and around the globe to become one of the worlds’ largest corporations. With a short period between 1995 and 2000, the company’s revenues rose from $9 billion to 100 billion to the level of making it one of the fastest growing companies in the United States.¹However, in 2001, it was revealed that the company had misreported its financial status and balance sheets through a systematic, institutionalized, and creatively planned accounting fraud. Following the revelation, the company’s shares dropped from a high of $90 per share to less than $1 per share by the end of 2001. The result was more than $11 billion losses of shareholder investment. When the company revised its financial statements for the previous five years, losses amounting to $586 million were revealed. Consequently, the company filed for bankruptcy on December 2, 2001 (Li 37).² At the time, Enron scandal, as it came to be known, was the largest fraud case in the US history. The key individuals and organizations involved in the scandal were the former CEO Jeffrey Skilling, Chief Financial Officer, Andrew Fastow among other executives and its Auditors, and Arthur Andersen.

Fraud Risk Factors in Enron Scandal

The process of sustaining profitability and ensuring high returns to investors is a major goal for all organizations. The pressure is even higher for publicly traded companies that must strive to ensure that they have a good public standing and reputation in terms of the returns that they can generate to their investors. In the case of Enron, many factors indicate incentive to commit fraud.

Incentives or Pressure to Commit Fraud

Under the leadership of Jeffrey Skilling, the company adopted a tough corporate and performance-based management approach where employees were put under immense pressure to perform. Those who did not perform as expected were fired at the end of the year. In this case, employees had no option but to do whatever was possible in their capacity to bring deals to the company or to attain the performance that would ensure that they received their bonuses and/or were retained in the organization. At the same time, the company was involved in PR activities and programs that aimed at creating an image of a prosperous company that was not collapsible (Matoussi and Jardak 3).³ Indeed, Skilling often promised investors 10-15% returns on their investments. This corporate culture opened the doors to fraud, which would take the organization down.

Another major incentive to commit fraud was the desire of the executives to protect their reputations as the leaders of the most successful corporation in the United States. To achieve this goal, the executives were prepared to ensure that Enron remained or appeared profitable to its investors around the world. The executives introduced the ‘mark to market’ accounting strategy for reporting its financials. Under this approach, the price or value of a security is determined on a daily basis to project profits and losses (Li 39).⁴ In this case, Enron was able to count the projected earnings from its long-term investments and projects as current earnings. The inclusion of such projected earnings meant that the company had to ensure that it had ‘profitable’ future projects since the previously projected earnings could not be included in the financial statement once they had been received. Such a practice provided an incentive for Enron to continue including long-term projects as profitable. Hence, any future failures or losses in the previously projected profitable ventures would not appear on the financial statement. The method among other techniques allowed Enron to inflate revenue by manipulating projections for future revenues.

Opportunities to Commit Fraud

The case of Enron highlights many factors and weaknesses that provided an opportunity to commit Fraud. Initially, the regulations that governed the management of organizations had some gaps that needed to be addressed. They could be manipulated easily. For instance, the composition of the Board of Directors (BoDs) of publicly traded companies was not well defined. In this case, many BoDs were composed of administrators who had an interest in the company. In this case, even today, any company whose directors are shareholders in the same business is bound to witness conflicts of interest where the stakeholders are in a position to undertake many ethical, unethical, as well as legal or illegal activities to ensure that they have the highest returns on their investments. In the case of Enron, the majority of the directors were also major shareholders in the company. Hence, this situation opened an opportunity for fraudulent activities.

Another important opportunity to commit fraud resulted from the poor regulatory framework that guided the accounting methods that publicly traded companies would use in reporting their financial positions. For instance, Enron Corporation was the first non-brokerage and trading company in the United States to be allowed to use the ‘mark to market’ accounting technique to report its financials. Despite the fact that the method had known shortcomings, the US Securities and Exchange Commission (SEC) approved the method in 1992. During the following close to ten years, the company continued to use the method. SEC never raised any concerns or repealed its wrong decision of allowing the method for a publicly traded company.

The company’s risk management approaches also proved a major weakness that led to opportunities for fraud. Due to the sensitive nature of the industry in which the business operates, it was important for the company to put in place risk management strategies to cushion investors from fluctuations in energy prices that characterized the sector. In this case, the company established long-term fixed commitments that were hedged by its derivatives and special-purpose entities.

Attitudes and Rationalization of Individuals involved in the Scandal

One of the unique characteristics of the Enron scandal is the fact that the collapse of the organization was because of deliberate actions of the executives and its other partners who were involved in one way or another in covering its fraudulent activities.

Firstly, following the investigation that led to the collapse of the company, it was revealed that the board of directors was aware of the accounting malpractices. The deliberate push for the ‘mark to market’ approach was a deliberate move by the executive management to use projections instead of its actual financial position to hoodwink investors and shareholders into believing that the company was on a positive balance sheet.

Secondly, the company’s auditor, Arthur Andersen, was involved in covering up the company’s poor performance. The main reason for this move was a conflict of interest on the part of the auditors who were more interested in the audit fees that they were receiving from Enron. For instance, in 2000, the audit firm received $27 million in consultancy fees and $25 million in audit charges from Enron. The figures represented approximately 30% of the revenues of the audit firm in its Houston Office (Nelson, Price, and Rountree 285).⁵ In this case, the company allowed itself to be manipulated by Enron to misreport the latter company’s financial position. When the scandal emerged, Arthur Andersen deleted more than 30,000 emails and shred thousands of documents in a deliberate move to cover up its mistakes and involvement in the scandal (Li 41).

Thirdly, the use of special-purpose entities (SPEs) by Enron to hide its debt was a deliberate effort by the executive to commit fraud. The company had created hundreds of SPEs to hide its debts and poor performances of specific projects in dubious arrangements. Through the entities, the company managed to circumvent accounting rules. Consequently, it understated its liabilities while overstating its equity and earnings.

Conclusion

Poor financial recording is a vice that can ruin the success of an organization. The analysis of the risk factors has revealed why Enron faced the scandal that led to its collapse. In terms of the pressure to commit fraud, the risk was very high since the organization was keen on maintaining a positive outlook for its investors. Secondly, on the opportunities to commit fraud, the risk was moderate and was dependent on the other risk factors as identified previously (Matoussi and Jardak 33).⁶ Lastly, the attitude and rationalization of individual involvement the management of the organization were a major driving force in the adoption of fraudulent activities. As the main decision makers, the management of the organization took deliberate measures to cover fraudulent activities that eventually led to the collapse of the organization.

Audit Procedures that Would have Detected the Fraud

The reason the fraud that Enron committed went for long is not that it was not detected early but that the audit firm in charge of undertaking audits was part of the scandal. In this case, the use of the single audit firm over the years meant that although the fraud was a known matter in the organization, it was never revealed to regulators or investors of the company. The only way the scandal would have been revealed was via undertaking a public inquiry into the company’s financial records. Further, another approach would have been the use of an independent auditor who would not have a conflict of interest on Enron. Another important process that would have allowed the detection of the fraud was a close monitoring by the SEC, which would have allowed the detection of the continuous rising of the value of the shares on the stock exchange. Overall, the Enron scandal reveals that deliberate efforts on the part of the management and its partners led to one of the largest fraud cases in the United States. However, the aftermath of the scandal led to new regulations and laws that govern the management of public organizations in the United States. It is also evident that without a good regulatory framework, the management of an institution can be a major perpetrator of large-scale frauds in organizations.

References

Li, Yuhao. “The case analysis of the scandal of Enron.” International Journal of Business and Management 5.10(2010): 37-43. Print.

Matoussi, Hamadi, and Maha Jardak. “International corporate governance and finance: Legal, cultural and political explanations.” The International Journal of Accounting 47.1(2012): 1-43. Print.

Nelson, Karen, Richard Price, and Brian Rountree. “The market reaction to Arthur Andersen’s role in the Enron scandal: Loss of reputation or confounding effects?” Journal of Accounting and Economics 46.2(2008): 279-293. Print.

Footnotes

1. See also Nelson, Price, and Rountree 281 for details on how Andersen manipulated the company’s reputation
2. See Li 37-39 for more information on the root of Enron’s bankruptcy
3. The last paragraph of page 3 reveals how such an image attracted doubts from investors
4. See also Li 40, especially the third paragraph, for more details on the meaning of ‘mark to market’
5. Revisit Nelson, Price, and Rountree 282, especially the section on ‘abnormal returns’
6. You can revisit Matoussi and Jardak 5-8 for more information on these risk factors