What contributed to the financial collapse of Enron

Introduction

Accounting is the language of business. It allows executives to share and articulate the performance of a business from a financial perspective to shareholders. It also provides management with valuable insights into the overall success of their business franchise relative to peers in the industry. It is this financial information that help to inform and solidify business strategy and future initiatives. Shareholders use this information to evaluate the overall effectiveness of both management and their respective business strategy. When reviewing the figures shareholder and other stakeholders believe these figures to be reported in good faith. In fact, thanks to Enron, management must now sign documents that attest to their truthfulness. Prior to Enron, investors, regulators, and shareholders believe this information to be presented truthfully and in a manner that reflects the true underlying performance of the business. As history has shown, many companies, including Enron, did not deserve such trust (Cruver, 2003).

Accounting standards themselves are in a precarious position. Due to the overall variability of business, accounting standards must provide a certain degree of flexibility. They cannot be too rigid as it would restrict certain businesses from representing their true value to shareholders in a prudent and ethical manner. They also cannot be too loose, as companies could potentially take advantage of the rules to allow companies to appear more profitable than they really are. Because of this, accounting standards such GAAP must strike an interest balance between rigid standards and truthfulness. Unfortunately, Enron encapsulates many of the arguments that prevailed related to having more flexibility standards. In this instance Enron mispresented its financial performance materially using many rules that were deemed fraudulent at the time. The company for example heavily used off-balance sheet transactions that enhance debt but never appeared on the balance sheet. The company also relied heavily on special purpose entities that obfuscated the overall corporate debt and performance of the business franchise. The company acquired other companies to help hide decline performance to investors. Finally, on the more egregious side, the company committed outright fraud by paying auditors to show a profit on its accounting books. Due in part to the flexibility afforded by the accounting rules of the time, the company was able to deceive investors for many years. It ultimately bankruptcy, the loss of many jobs, and a decline in the overall integrity of the capital markets.

Define the problem

To begin, Enron was founded in 1985 through a merger to two regional natural gas companies in Houston, Texas. Though multiple acquisitions the company quickly became a global energy, commodities, and services company. Following the mergers, Kenneth Lay, who had been the chief executive office of Houston Natural Gas, became Enron's CEO and chairman. Lay quickly rebranded Enron into an energy trader and supplier. Deregulation of the energy markets allowed companies to place bets on future prices, and Enron was poised to take advantage. In 1990, Lay created the Enron Finance Corporation and appointed Jeffrey Skilling, whose work as a McKinsey & Company consultant had impressed Lay, to head the new corporation. Skilling was then one of the youngest partners at McKinsey. Once Skilling became CEO, the culture and moral of the organization began much more entrenched leading to the eventual downfall of Enron. At its high, Enron employed over 29,000 people and had revenues of over $100 billion dollars.

Unfortunately, these revenues and ultimately profits were achieved through unethical and fraudulent means. As it relates to defining the problem, the most obvious issues were with management. As it relates to Enron, management perpetrated and ultimately allowed unethical practices to help the company appear much more profitable than it ultimately was. Leadership provides the mission and the guideposts for subordinate behavior. If leadership allows questionable behavior and even rewards it, so too will subordinates down the line. This created a toxic culture which proved to be detrimental to society, the capital markets, 29,000 employees, and the communities in which they serve. The CEO at the time of the scandal was Jeffrey Skilling. Jeffrey Skilling first developed a staff of executives that, using accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions of dollars in debt from failed deals and projects. These deals were effectively hidden in financial footnotes and disclosures that most investor rarely, if ever, see. Next, the Andres Fastow, the CFO of the company took the unethical behavior further by misleading the companies board of directors and audit committed. Here, Fastow pressured accounting firms to use aggressive accounting techniques, show profits, and ultimately undermine the overall intent of the rules. As both the CEO and CFO fostered a culture of unethical behavior, they are the primary problem as it relates to Enron. In addition, this behavior was ultimately rewarded by ironically shareholders. As stated earlier, shareholders were not aware of this behavior due in part to lack of proper oversight on the part of auditing firms, but also as many of these techniques were hidden in the financial statements. Investors only say the top line numbers which were advocated by the financial press, media publications, and other investors. In fact, Enron was awarded America’s most innovative company by Fortune magazine for six consecutive years. It was all named to the 100 Best Companies to Work for by Fortune in the year 2000. If this wasn’t enough corporate executives paid $680 million just before the corporate collapse in 2001. Sharron Watkins, the Vice President of Corporate Development was the only individual to question accounting, culture, and business practices of leadership. She questioned leadership in both 2000 and 2001 as it related to financial reporting irregularities. First Sharron submitted a memo detailing her thoughts related to the practices of the company. This memo was ignored by corporate management. During her testimony to congress, Watkins illustrated a culture of intimidation as it relates to the management. Her initial inquiries were met with disdain and anger. As it relates to defining the problem, the first issue is related to leadership. As indicated above leadership created an unethical that permeated throughout the organization. In addition, anyone who opposed the behavior was either fired, intimidated, or ignores. Next, the behavior was rewarded through increase salaries, share compensation, and bonuses. The oversight was very lacking as the board of directors were mislead by the CFO as it related to the overall financial performance of the company (Dirk, 2002).

In addition, the problem also revolved around aggressive accounting which circumvented the intended rules of accounting. One of the techniques used was the use of operating leases to hide of obfuscate the level of debt the company had. Operating leases are a form of off-balance sheet deb that differ materially from their more traditional finance leases. An operating lease allows a company to use a particular asset within its operations without conveying ownership of the asset. This is very similar to a rental and as such did not appear on the financial statements Enron. Instead the use of extensive operating leases was found in a footnote that many investors did not take the time to read. Since at the time, operating leases were economically like renting an asset, accounting standards allowed the company to appear more profitable than it was. As not asst or liability was recorded, the Enron’s return on assets were higher and its debt levels were lower. This directly impact its solvency ratios making the company appear more solvent than it was. On the statement of cash flows, the full lease payment is shown as it relates to financial reporting. As we will see, the variance between net income and cash flow from operations would have been a large red flag for investors. Essentially, through the use of operating leases, the company was able to show higher profits in early years of the lease, high return on assets as the company did not put the lease on the balance sheet, and stronger solvency figures as the company did not report the corresponding liability on within the financial statements. This, on the surface made the company appear much more profitability than it was. Unfortunately, the only way for investors to determine this is through reading the financial footnotes and looking at the cash flow from operations relative to net income (Fox, 2003).

The next problem occurred with the company’s excessive use of special purpose entities to help hide operating losses. In short special purpose entities are used to by sponsoring entities for specific and pre-determined arrangement. In this instance, Enron was the sponsoring entity which transferred assed to the SPE. In addition, Enron would receive the right to use the assets held in the SPE. In return capital providers would provide funding for the SPE as it is backed by assets provided by the sponsoring company. From an accounting standpoint SPE’s are legitimate ways to segregate risk activities from the sponsoring entity. This helps to reduce risk and make the company much nimble as it relates to it operations. In exchange, capital providers to the SPE are often given a fixed rate or return with additional benefits related to future economic benefit if the assets appreciated in value. In this instance Enron used its own stock to capitalize the SPE. In essence, Enron would transfer stock to the SPE in exchange for cash. The SPE would then be capitalized by Enron’s stock, which to this point was deemed investment grade by rating agencies. As such capital providers would be more willing to invest in the SPE as it was backed by a reputable organization with a rising asset. Enron would then place a guarantee on the SPV which was derived heavily from the value of the stock. Prior to the Enron scandal, accounting standards allowed companies to avoid consolidating these entities on their financial statements. This was because of nuance with the accounting standards at the time. Here, the sponsor could avoid consolidation if it did not have “control” over the special purpose entity. Control was defined as owning over 50% of the voting interest within the special purpose entity. As such, Enron structured the company to that it had financial control over the assets and operating activities, but other investors would retain the voting interest in the SPE. As a result, Enron was able avoid consolidating the corporations within its financial statements and avoided the guarantee disclosures mentioned above. As a result, much like the operating lease example mentioned above, the company was able to look much more viable and profitable than it otherwise was. In this instance, the company was able to avoid reporting the assets and liabilities of the organization. This would ultimately help improve many of the common ratios used to determine corporate performance such as asset turnover, return on assets, and leverage. In fact, the fall of Enron was heavily attributable to the guarantees of debt within the SPE’s it created. Because these elements were not disclosed debt investors, lender and other debt holders did not question the solvency and debt ratios of the company. As they were not disclosed the company appeared to have adequate coverage ratios (Northouse, 2016).

The next issue occurred with mark to market accounting and its impact on inflating the assets that were reported by Enron. Up to this point, the financial chicanery discussed was used to hide assets and liabilities from the financial statements to make the company appear to more profitable. With mark to market accounting, the firm enhances the value of the assets that it did report to further increase turnover and solvency ratios. Mark to market accounting measures the value of a security based on its current market value instead of its book value. In Enron's case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though the company had not made one dime from the asset. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer the asset to an off-the-books corporation where the loss would go unreported. This type of accounting enabled Enron to write off unprofitable activities without hurting its bottom line. In essence the profitable businesses would stay on the balance sheet while the unprofitable businesses would be transferred to the SPE’s mentioned in detail above (CNN Library, 2016).

Finally, an element that is often missed in the discussion of Enron and its collapse is related to its accounting firm Author Anderson. At the time, this accounting firm was one of the “Big Five” firms which commanded large market share within the accounting profession. As part of its financial reporting requirements, and auditor is selected to sign off on the financial statements of the organization. They must attest that the financial statements reflect true and appropriate use of the standards employed at the time. As it relates to Enron, Arthur Anderson approved of the company’s aggressive and unethical accounting practices, further validating them to unsuspecting investors. According to court documents, Enron and Arthur Andersen had improperly categorized hundreds of millions of dollars as increases in shareholder equity, thereby misrepresenting the true value of the corporation. Arthur Andersen also did not follow generally accepted accounting principles (GAAP) when it considered Enron's dealings with related partnerships. These dealings helped Enron to conceal some of its losses. To further add to the unethical behavior, Arthur Anderson destroyed email and physical documents related to correspondence with senior executives, financial disclosures, and other incriminating evidence. This activity was so egregious that the United States Department of Justice indicted the firm for obstruction of justice. Later in 2002 the company was found guilty an paid a $500,000 fine. The unethical practices of Arthur Anderson are arguable the most egregious of the problems outlined above. The auditing firm is the publics last defense against unethical behavior. They are used to instill confidence and integrity within the capital markets. The failure of Arthur Anderson not only harmed Enron, but it harmed the entire integrity of the capital markets as investors questions the financial data of all companies. “If the auditors are compromised, they who represents the interest of shareholders,” investors started to ask themselves. In the case of Enron, all the checks and balances thought to help protect investors where actually compromised. The board of directors did not protect investors, corporate leadership did not protect investors, and now, the auditors did not protect investors. This causes massive uncertainty as many market participants questioned the validity of auditors overall (Avolio, 2002).

Alternatives that Enron’s Executives Could have Taken

The firm and most obvious alternative relate to company disclosure. Simply put, the leadership of the company should have been honest with corporate performance. The schemes discussed above can not last forever. Thankfully, these is limit to how many SPE’s can be used to hided debt. There is also a limit to the use of off-balance sheet transactions, and mark to market accounting. Each of these techniques had a finite life before investors, analysts and other corporate executives began to question their overall validity. Corporate leadership should have known they would not get away with the unethical and fraudulent practices forever. Ultimately is was corporate leaderships hubris that ultimately led to their downfall. As an alternative, the company should have disclosed the losses and the efforts they intend to use to mitigate their impacts on the company. For example, the company could have ceased all guarantees on SPE dead going forward. They could have sold non-performing businesses to competitors who might be able to turn the operations around. Although they would be sold at a discount to their value, the cash could then be used to pay down the massive amounts of debt on the corporation. Although painful, the company could have downsized, furloughing, or reducing headcount to accommodate a much smaller and nimble company. All these initiatives should be clearly communicated to the capital markets and clear and concise manner. The stock price would fall, and rightfully so. However, the company could avoid bankruptcy and the overall negative impact on the capital markets by being honest. Although individuals would lose their jobs, this would be more acceptable to the alternative to bankruptcy. Businesses that were sold, would help keep people employed while also allowing the operations to thrive under new management.