Enron Scandal: Accounting Fraud, Ethics, and Collapse

Introduction

Accounting is the language of business. It allows executives to share and articulate the financial performance of a business to shareholders. It also provides management with valuable insights into the overall success of their business relative to peers in the industry. It is this financial information that helps 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 strategies. When reviewing financial figures, shareholders and other stakeholders believe those figures to be reported in good faith. In fact, thanks to Enron, management must now sign documents attesting to their truthfulness. Prior to Enron, investors, regulators, and shareholders believed this information to be presented truthfully and in a manner that reflected 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 occupy a precarious position. Due to the overall variability of business, they must provide a certain degree of flexibility — they cannot be too rigid, as that would restrict certain businesses from representing their true value to shareholders in a prudent and ethical manner. Nor can they be too loose, as companies could potentially exploit the rules to appear more profitable than they really are. Because of this, standards such as GAAP must strike a careful balance between rigidity and truthfulness. Unfortunately, Enron encapsulates many of the arguments in favor of flexible standards gone wrong. In this instance, Enron materially misrepresented its financial performance using methods that were ultimately deemed fraudulent. The company heavily used off-balance sheet transactions that enhanced apparent debt levels without those figures appearing on the balance sheet. The company also relied heavily on special purpose entities that obscured overall corporate debt and operating performance. It acquired other companies to help hide declining performance from investors. Finally, and most egregiously, the company committed outright fraud by paying auditors to report a profit on its 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 — ultimately resulting in bankruptcy, the loss of thousands of jobs, and a serious decline in the integrity of the capital markets.

Defining the Problem: Leadership and Corporate Culture

Enron was founded in 1985 through a merger of two regional natural gas companies based in Houston, Texas. Through multiple acquisitions, the company quickly became a global energy, commodities, and services firm. Following the merger, Kenneth Lay, who had been the chief executive of Houston Natural Gas, became Enron's CEO and chairman. Lay quickly rebranded Enron as an energy trader and supplier. Deregulation of energy markets allowed companies to place bets on future prices, and Enron was positioned 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 lead the new entity. Skilling was then one of the youngest partners at McKinsey. Once Skilling ascended to CEO, the culture and moral character of the organization became increasingly entrenched in questionable practices, leading to Enron's eventual downfall. At its peak, Enron employed over 29,000 people and reported revenues of over $100 billion.

Unfortunately, those revenues and profits were achieved through unethical and fraudulent means. The most obvious problems were with management. Enron's leadership perpetrated and ultimately permitted unethical practices to make the company appear far more profitable than it was. Leadership sets the mission and the standards for subordinate behavior. If leadership allows — and rewards — questionable conduct, subordinates throughout the organization will follow. This created a toxic culture that proved deeply harmful to society, the capital markets, 29,000 employees, and the communities they served.

Jeffrey Skilling, the CEO at the time of the scandal, first developed a cadre of executives who, 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 were effectively buried in financial footnotes and disclosures that most investors rarely, if ever, read. Andrew Fastow, the CFO, took the unethical behavior further by misleading the company's board of directors and audit committee. Fastow pressured accounting firms to employ aggressive accounting techniques, report profits, and ultimately undermine the intent of the rules. As both the CEO and CFO fostered a culture of unethical behavior, they bear primary responsibility for Enron's misconduct.

Compounding the problem, this behavior was ironically rewarded by shareholders — not because they endorsed it, but because they were unaware of it, due in part to inadequate auditing oversight and the concealment of these techniques within the financial statements. Investors saw only the top-line numbers, which were championed by the financial press and media. Enron was named America's most innovative company by Fortune magazine for six consecutive years and was listed among the "100 Best Companies to Work For" in 2000. Despite this, corporate executives paid themselves $680 million just before the company's collapse in 2001.

Sherron Watkins, the Vice President of Corporate Development, was the only individual to openly question the company's accounting, culture, and business practices. She raised concerns in both 2000 and 2001 regarding financial reporting irregularities, first submitting a memo detailing her observations — a memo that was ignored by corporate management. During her congressional testimony, Watkins described a culture of intimidation, noting that her initial inquiries were met with disdain and anger. In summary, the first core problem at Enron was leadership: an unethical tone that permeated the entire organization, where dissent was punished through termination, intimidation, or willful neglect, while misconduct was rewarded through increased salaries, equity compensation, and bonuses. The board of directors, meanwhile, was misled by the CFO regarding the company's true financial performance (Dirk, 2002).

Accounting Mechanisms Used to Conceal Losses

The problem at Enron also revolved around aggressive accounting that circumvented the intended rules of the profession. One key technique was the use of operating leases to hide or obscure the level of debt the company carried. Operating leases are a form of off-balance sheet debt that differ materially from traditional finance leases. An operating lease allows a company to use an asset in its operations without conveying ownership of that asset — similar in concept to a rental arrangement. As such, these obligations did not appear on Enron's financial statements; instead, the company's extensive use of operating leases was disclosed only in footnotes that most investors did not read.

Because operating leases were economically analogous to renting an asset, accounting standards of the time allowed companies to exclude them from the balance sheet. With no asset or liability recorded, Enron's return on assets appeared higher and its debt levels appeared lower than they truly were. This directly improved its solvency ratios, making the company appear more financially sound than it was. On the statement of cash flows, full lease payments are reflected — and the resulting gap between reported net income and cash flow from operations would have been a significant red flag for attentive investors. In essence, through the use of operating leases, Enron was able to report higher early-period profits, stronger return-on-asset figures, and better solvency metrics — all without reflecting the true burden of its obligations (Fox, 2003).

The next major problem involved the company's excessive use of special purpose entities (SPEs) to conceal operating losses. In brief, SPEs are legal structures used by sponsoring entities for specific, pre-determined arrangements. In Enron's case, the company was the sponsoring entity that transferred assets to the SPE. Capital providers would then fund the SPE, which was backed by those assets. From an accounting standpoint, SPEs can be a legitimate way to segregate risky activities from a sponsoring entity, reducing operational risk and providing capital providers with a fixed rate of return plus potential upside if asset values appreciated.

However, Enron used its own stock to capitalize its SPEs. The company would transfer stock to the SPE in exchange for cash, and the SPE would be capitalized by Enron's stock — which, at the time, was rated investment grade. This made the SPEs attractive to outside capital providers. Enron would then place a guarantee on the SPE that was heavily dependent on the value of its stock. Prior to the Enron scandal, accounting standards allowed companies to avoid consolidating SPEs on their financial statements, provided they did not have "control" — defined as owning more than 50% of the voting interest. Enron structured these entities so that it retained financial and operational control while outside investors held the voting interest, thereby avoiding consolidation. As a result, the liabilities and assets held in these entities were kept off Enron's consolidated balance sheet, improving key ratios such as asset turnover, return on assets, and leverage. When the SPE guarantees ultimately came due and Enron's stock price fell, the scale of the hidden debt became apparent and accelerated the company's collapse (Northouse, 2016).

The next issue involved mark-to-market accounting and its role in inflating the assets Enron reported. While the previous mechanisms were used to keep liabilities off the balance sheet, mark-to-market accounting was used to inflate the value of the assets that did appear on it. Mark-to-market measures the value of a security based on its current market value rather than its historical 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 if the company had not earned a single dollar from it. If the actual revenue from the power plant fell short of projections, instead of recognizing the loss, the company would transfer the asset to an off-the-books entity where the loss went unreported. This enabled Enron to write off unprofitable activities without affecting its reported bottom line: profitable businesses remained on the balance sheet while unprofitable businesses were transferred to the SPEs described above (CNN Library, 2016).

References

1. Avolio, B. J., & Locke, E. E. (2002). Contrasting different philosophies of leader motivation: Altruism versus egoism. Leadership Quarterly.

2. Cruver, B. (2003). Enron: Anatomy of greed: The unshredded truth from an Enron insider. Arrow. 365 pp.

3. CNN Library. (2016). Enron fast facts. http://www.cnn.com/2013/07/02/us/enron-fast-facts/

4. Dirk, J. B. (2002). The Enron collapse: Creative accounting, wrong economics or criminal acts? iUniverse. 223 pp.

5. Fox, L. (2003). Enron: The rise and fall. John Wiley and Sons. 370 pp.

6. Northouse, P. G. (2016). Leadership: Theory and practice. Sage.