The Enron Corporation Analysis Report

Introduction

Upon its inception in 1985, Enron Corporation managed to attain market leadership within the American Energy industry (Enron 2002). The firm experienced fast growth due to business diversification. Apart from energy, Enron ventured into other business lines such as fiber optic, newsprint, and broadband cable. In addition to product diversification, Enron also ventured into the international market such as Japan, South America, Australia, and Europe (Enron 2002). Its diversification strategy enabled it to attain high profitability levels. From 1985 to 2000, the firm’s assets grew from $12.1 billion to $33 billion. Additionally, the number of its power projects increased from 1 to 14 in 11 countries during the same period (Enron 2001).

The firm’s share price increased significantly, thus making it an attractive investment option. By 2000, the firm ranked 22^nd on the list of the 100 best companies, in the U.S. However, between 1999 and 2000, the firm’s revenue level increased from $40 billion to $101 billion (Enron 2002). This high rate of revenue growth during these two years became questionable amongst many shareholders because the firm did not undertake any additional investment such as installing new power plants or pipelines. According to a report released by Enron (2002), probably the firm’s management team engaged in unprofitable businesses in addition to forging the accounting practices in order to shroud its actual financial position. Some of the accounting irregularities that the firm engaged itself in were disclosed by Sherron Watkins who was the firm’s Corporate Development Executive.

Aim and scope

In a quest to understand Enron’s collapse, this report seeks to conduct an independent analysis on the events leading to the firm’s collapse, identify four questionable business deals that Enron engaged in, and provide a summary on how these deals were structured and accounted for in the firm’s financial statement. The report includes business deals between Enron and Condor, Enron, and Raptor. Additionally, the report evaluates the assertion; made by Sherron Watkins, and thus provides a summary of three fraudulent accounting practices and their effects on the reported results. Ultimately, the paper outlines a summary of the study and a number of recommendations on how to prevent such occurrences.

Analysis of events leading to the collapse of the firm and the questionable deals that Enron engaged in

The corporate governance fabric integrated into an organization is critical in nurturing an environment that minimizes the occurrence of risk of fraud through implementation of fraud detection, deterrence, and prevention mechanisms and techniques (Enron 2002). Effective corporate governance is also paramount in the development of nurturing and sustaining an organizational culture that is characterized by high levels of ethics and honesty. On the other hand, fraudulent deals will always lead to sad endings because without transparency, individuals seek to benefit themselves, which violates business objectives. This assertion comes out clearly in the case of Enron after some few individuals sought to engage in fraudulent deals for personal gains at the expense of the company and the shareholders.

The collapse of Enron Corporation in 2000 is perhaps the largest and worst business failure. The firm’s failure emanated from the propagation of unethical practices by the firm’s workforce especially those in the top management (Sloan et al. 2006). During the 1990s, the firm adopted a diversification strategy by venturing into other sectors. Additionally, the firm entered Special Purpose Entities (SPEs) with other firms. It is estimated that the firm established more than 3000 SPEs. SPEs seek to undertake a particular project such as research and development through a partnership with other entities. However, Enron established the SPEs with the sole purpose of shoving risks and liabilities in such a way that investors could not note. Consequently, the firm engaged in off-balance-sheet reporting by hiding liabilities from its financial records. Through the SPEs, Enron engaged in manipulative accounting practices. The partnerships established allowed the firm “to remove its losses legally from its financial records and the investment money received by its partnerships was recorded as profits in the firm’s books despite the investment being linked to particular business ventures that were not yet operational” (Enron 2002, p.9). By engaging in such practices, the firm successfully enlarged its profit, decreased losses, and kept debts out of its financial reports. This aspect played a significant role in enhancing the firm’s credit rating, hence protecting its market credibility. The firm’s decision to adopt such practices hinged on “the need to accomplish favorable financial reports and not to transfer risk or achieve economic objectives” (Enron 2002, p.9). This move was suicidal and bound to fail for ultimately the truth would come out. Pretense cannot hold water for long as the Enron management team would inevitably learn.

The high rate of growth by Enron required the firm to have a substantial amount of capital, and thus the firm engaged in more borrowing without exposing its debt. Due to its increased reliance on debt finance, Enron Corporation became highly leveraged, which means that the firm depended on debt finance to finance its daily operations (Gore & Murthy 2011). At this level, firms cannot function effectively because the borrowed money attracts interest and it might be difficult for any firm under such conditions to make enough revenue to service the loan and make a profit at the same time.

Deal with Wall Street Analysts and Arthur Andersen

The firm’s collapse also hinged on the fact that its executives colluded with other stakeholders such as Wall Street Staff and its main auditor, Arthur Andersen. Considering Enron’s rampant growth and expansion, the need to make optimal decisions continuously was inevitable. The firm sought the services of the Wall Street analysts for expert advice. However, the Wall Street analysts did not provide the actual value of the firm’s stock. The Wall Street analysts carried the responsibility of conducting a comprehensive analysis of the firm’s actual position (Sloan et al. 2002).

On the other hand, Arthur Andersen did not engage in free and fair auditing of the firm’s financial reports (Copeland 2003). Sloan et al (2002) are of the opinion that external auditors have the responsibility of ensuring that a particular entity’s financial reports adhere to the stipulated accounting standards. Consequently, they are required to provide investors, credit financiers, and other stakeholders with an accurate picture of a firm. The poor auditing conducted by Andersen was also due to organizational flaws and poor organizational culture (Barrett 2005).

Enron paid Arthur Andersen a huge amount in auditing fees (approximately $52 million) in order to conceal the actual position of the firm. Enron also colluded with the authorities charged with the responsibility of ensuring fair financial reporting through heavy political contributions. Enron had established strong links with the Bush administration at various levels (Enron 2002). Therefore, one can assert that the regulators were irresponsible while the firm’s board of directors did not direct (Sloan et al. 2002). The financial reports published by the firm did not provide adequate disclosure due to the existence of a conflict of interest between the firm’s top executives and investors. The top executives discovered that they were enriching themselves through fraud, and thus probably due to greed and lack of management ethics they decided to exploit the loophole. Unfortunately, Arthur Andersen, who otherwise would have rescued the company, decided to go the executives’ way and accepted a “bribe” to look the other way. At this point, it is clear that the Enron scandal transcended the company boundary and sucked in government officials, accountants, and consultants thus making it an intricate deal.

In a bid to hide its deals, the management team engaged in “sophisticated accounting techniques referred to as Aggressive Earning Management techniques” (Enron 2002, p.9). The objective of employing such techniques was to ensure that its share price remained high. Copeland (2003) asserts that the firm’s intention was to “raise investment against its own assets” (p.9). Additionally, Enron structured its financial transactions in a complex method, which made it difficult for perfect disclosure. Investors had to rely on the judgment of the firm’s management. However, the existence of a conflict of interest made it difficult for investors to get the actual information. Employing such techniques enabled Enron to create a perception of the firm is very successful amongst its investors (Li 2010). The chart below illustrates Enron’s accounts showing the extent of disclosure irregularities that the firm engaged in during its operations.

Source: (Enron 2002

Deals with Raptors

Enron entered into a partnership deal with Raptor with the objective of transacting in shares of other companies. Enron offered Raptor a loan of $500 million in the partnership and guaranteed to bail out Raptor in the event of its inability to pay the loan. The Raptors constituted a group of entities, which sought to safeguard Enron’s earnings from experiencing market-to-market write-downs. The appreciated Enron stock would be used to hedge the firm against volatile risk. Additionally, the deal would benefit a small group of Enron executives together with their friends (Enron 2002). The transaction between Enron and Raptor was kept off-balance sheet (Sloan et al. 2002). The firm recorded the loan issued as an asset. The deal was successful until the decline of the firm’s share, and due to its debts, Enron could not cover the cost of the loan it guaranteed Raptor.

Deals with Condor

Enron Corporation also established a Special Purpose Enterprise referred to as Condor (McLean 2001). The partnership is aimed at buying and selling assets at the highest price possible. The parties to the partnership would purchase assets from Enron Corporation. Enron Corporation issued money to Condor to assist it in purchasing its assets. Additionally, Enron Corporation loaned the partnership shares of its share. The deal resulted in Enron making $ 800 million in cash flow. Despite Enron making Condor a successful entity using its shares, the $ 800 million recognized by Enron as cash flow, was in essence part of stock issued (Enron 2002). In the two deals, Enron engaged in aggressive and creative accounting.

Accounting treatment of Enron’s deals with Condor and Raptor

Enron Corporation treated Raptor and Condor’s financial report separately. However, the firm should have incorporated Condor and Raptor’s financial reports in its consolidated financial statement because the entities did not operate autonomously. The entities made gains and losses, which did not appear in the firm’s consolidated statement. On the contrary, Enron organized the deals in such an approach that only gains would appear on the firm’s financial statement and not losses. The losses incurred did not affect the firm’s financial statement.

Analysis of the assertion made by Sherron Watkins.

Sherron Watkin’s act of disclosing the unethical practices that were being propagated in Enron Corporation does not amount to whistle-blowing. This assertion emanates from the fact that Watkins wrote an internal email to the firm’s Chief Executive Officer, Kenneth Lay, cautioning the CEO of the existence of potential whistleblowers within the firm. Additionally, Watkins stated that there were some accounting irregularities in the firm’s financial reports. The irregularities posed a threat to the firm’s future operations. Despite this aspect, the public did not access the memo sent to the CEO for a period of five months since it was written.

The assertion made by Watkins indicates that she was worried that the firm could not sustain its high stock market price. Upon a thorough analysis of the firm’s financial report, Watkins realized that the firm’s actual share price should have been set at $30 a share. However, the market price of the firm’s share was $90 by 2000 (Enron 2002). The high price of the share revolved around the fact that the firm did not indicate any form of expense in its financial statements. All the expenses that the firm had incurred were used for capitalization purposes. Due to the increased capitalization of its expenses, Enron increased the market price of its share.

In October 2001, Enron Corporation reported a loss of over $638 million. Additionally, the firm’s management admitted to having engaged in overstating its earnings for a period of four years. Additionally, the firm revealed that it had engaged in partnerships with the objective of concealing its $ 3 billion debt. Investors were shocked by the revelation, which culminated in the loss of investor confidence and consequent disposal of million of the firm’s stocks by the shareholders. The firm’s share price declined from a high of $90 to a low of $1. A majority of the firm’s employees were laid off (Enron 2002). On the other hand, credit financiers such as banks lost a large proportion of their capital through the firm’s failure to repay the loan issued t based on the “attractiveness” of its financial reports.

The revelation of the firm’s involvement in unethical accounting practices culminated in the massive investigation of the firm’s operations. There were allegations that some of the firm’s executives engaged in criminal activities. Therefore, the firm’s allegations degenerated into a case of corporate fraud, implementation of poor accounting and management practices, and poor leadership. For example, the creative accounting practices that the firm engaged in by overstating its profits and hiding its losses thus resulting in an increment in the market price of its share amount to the highest level of corporate fraud (Free, Stein & Macintosh 2007). The high rate of expansion experienced by the firm provided an opportunity for the firm’s top executives to dispose of stocks thus making gains of over $ 1 billion dollars. The US government charged the firms’ executives of conspiracy and money laundering for they engaged in such practices (Sloan et al. 2006). The above issues illustrate why Sherron Watkins was worried by the revelation of the firm’s engagement in unethical operational practices and failure to follow the generally accepted accounting principles.

Conclusion

From the above analysis, the importance of implementing corporate governance in a firm’s course of operation comes out clearly. Enron’s failure arose from the existence of a conflict of interest between the firm’s management team, the auditors, and the consulting firms. The firm’s management team engaged in a material conflict of interest in an effort to gain financial benefits. In the course of executing their duties, accounting firms such as consultants and auditors should ensure fairness and transparency. Firms’ management teams should appreciate and understand their stewardship role. Consequently, they should not engage in unethical practices that seek to attain personal benefits at the expense of investors. Adherence to ethical standards will play a significant role in preventing the occurrence of agency problems such as in the case of Enron Corporation. The firm’s failure was due to its management team colluding with analysts from Wall Street and the external auditors, Arthur Andersen. Enron’s management team should have been committed to developing and nurturing a strong organizational culture that adheres to the stipulated codes of conduct.

The importance of firms’ management teams to disclose their securitization and other structured finance transactions also stands out conspicuously. The securitization transactions should be disclosed in a detailed and in-depth method to provide an opportunity for investors to develop a comprehensive understanding of the same. In the course of its operation, Enron Corporation employed aggressive and creative accounting practices as illustrated by the case of Raptor and Condor business deals. This element made it difficult for investors to understand the financial transactions that the firm embraced in its operations, which means that Enron did not follow the generally accepted standards and principles in the course of undertaking its financial reporting.

Recommendations

In a bid to prevent the occurrence of such organizational collapse, it is critical for a firm’s management team to consider the following.

• A high level of transparency and financial information disclosure should be outstanding in firms’ financial reporting processes. This aspect will provide all the interested stakeholders with an opportunity to evaluate a firm’s operations, and thus make an optimal investment decision.
• Firms’ accountants, analysts, and auditors should follow the generally accepted accounting standards and principles in their financial reporting, provision of expert advice, and auditing. This element will ensure that the true and fair value of the firm’s financial position comes out.
• The firm’s employees and other stakeholders should continuously act as watchdogs to identify possible areas of irregularities that can cause firms to fail.
• The firm’s management teams and other stakeholders should observe high ethical standards in executing their duties, which will safeguard the firm against engaging in off-balance-sheet reporting.
• The authorities charged with the responsibility of regulating firms’ operations should implement strict measures for firms to follow in various economic sectors.

References

Barret, M 2005, Enron and Andersen- What went wrong and why similar audit failures could happen again, Notre Dame Law School, New York.

Copeland, J 2003, ‘Post Enron challenges for the auditing profession’, Vital Speeches of the Day, vol. 69 no.12, pp. 360-63.

Enron: The fall from Enron grace, the world’s biggest fraud 2002. Web.

Free, C, Stein, M & Macintosh, N 2007, Management controls: The organizational fraud triangle of leadership, culture and control in Enron. Web.

Gore, A & Murthy, G 2011, The Enron case study: A case of corporate deceit, the Enron way. Web.

Li, Y 2010, ‘The case analysis of the scandal of Enron’, International Journal of Business Management, vol. 5 no.10, pp. 37-43.

McLean, B 2001, ‘Is Enron overpriced? It’s in a bunch of complex businesses. Its financial statements are nearly impenetrable. So why is Enron trading such as huge multiple’, Factiva, vol. 143 no. 5, pp.1-3.

Sloan, A, Naughton, K, Peraino, K, Ehrenfed, T, Foote, D & Reno, R 2002, ‘Who killed Enron’, Newsweek, vol. 139 no. 3, p. 18-20.

Sloan, A, Rust, C, Naughton, K, Ordonez, J & Ganeles, J 2006, ‘Laying Enron to rest’, Newsweek, vol. 147 no. 23, pp. 24-30.