Enron Scandal: Ethics, GAAP Violations, and Corporate Fraud

Introduction: Ethics and Corporate Misconduct

Companies that do not behave in the ethical manner that society expects will eventually suffer in terms of profit. The temporary gain in profit that companies see because of their unethical behavior is erased one hundredfold if the deception is discovered. Yet so many CEOs practice this type of behavior. They manipulate the financial position of the company to influence share prices. One of the more elaborate situations in recent years involved Enron. The company's executives so badly wanted to leverage debt that they dumped it into tailor-made limited liability partnerships (LLPs) and skirted all kinds of financial laws.

CEOs make moves every day to try to affect the price of stock. In a way, these actions are a testament to the growth and power of the stock market. It can also be said that the influence of the stock market has too much power over CEOs. This is because a large portion of their pay, in the form of stock options, is connected with the performance of their company's stock.

Their vision — a good indicator of how the stock is perceived — becomes blurred because of their overwhelming concern with stock prices. The reason Enron drew public attention on a grand scale was the magnitude to which the trust of the country was violated. Enron violated practically every known ethical rule, and there was no end to the deception. As a result, employees, companies that conducted business with Enron, and the country as a whole suffered enormous losses.

The key to controlling ethics in the workforce is to have a set of internal and external controls in place that are consistently enforced. Had these controls been enforced in the case of Enron, the damage would have been contained far sooner.

The Root of Unethical Behavior in the Financial Community

Misrepresentation of Financial Information

Unethical policies provide a company with unearned cash flow. However, the financial ramifications are devastating when those policies and the fraud behind them are discovered. Enron is a classic example of a company that made a fortune through unethical means, only to see those fortunes evaporate and criminal charges placed against those involved. As a result, Enron ended up in a considerably worse financial situation because of its unethical policies. Before examining the financial ramifications Enron suffered and the procedures needed to prevent such an outcome, it is important to explain why individuals in positions of power — such as CEOs and CFOs — push the envelope to reach their goals.

Generally Accepted Accounting Principles

The basic objectives of financial reporting are guided by Generally Accepted Accounting Principles (GAAP), which provide information on how economic entities should identify, measure, and communicate financial information to a reasonably knowledgeable user. This information is interpreted by investors and creditors who make decisions on the viability of a company. Because GAAP standards are uniform, each company is measured against the same criteria. If companies circumvent the provisions of GAAP to provide fraudulent information, the economic system on which investment decisions are based becomes built on deception.

There are well-documented cases illustrating what happens when financial reporting is not widely accepted or when the rules governing it are not followed. One of the earliest examples is the stock market crash of 1929. There are many theories about why the market crashed, but one widely shared explanation involves financial reporting: companies simply failed to clearly and accurately report their financial condition. People are still discussing the crash decades later. Sadly, the same dishonest reporting continues today.

This dishonest reporting is the source of poor ethics in the financial community. The most recent large-scale example is Enron. The case was widely reported in the news and described how the company distorted earnings by creating subsidiary companies to bury debt. The full extent of the debacle is still not entirely known. The question remains: why do CEOs take the risk of reporting dishonest information?

The Conflict Between CEO Interests and Stock Option Compensation

The main reason that CEOs behave unethically is the power and growth of the stock market. As the stock market has grown, more companies have begun tying their CEOs' salaries to stock options. The conflict of interest is clear: the better a company can make its stock appear, the more money the CEO receives. Unethical CEOs accomplish this through financial manipulation — essentially hiding debt and creating false income. Reporting inflated information causes stocks to be overvalued, which puts more money in executives' pockets. As one study notes, "managers who receive cash compensation may act differently than those who receive long-term incentives (options and shares) because short-term compensation is awarded based on earnings, while long-term compensation is awarded based on long-run performance" (Supanvanij, 2005).

A CEO who receives a salary and an occasional bonus has less incentive to act unethically than one whose earnings are tied to stock options. The CEO focused on stock options will ensure that the stock price is as high as possible. This can be either positive or negative. On the positive side, the CEO will be motivated to do a genuinely good job for the company. On the negative side, stock options present a hidden danger because they tempt the CEO to act unethically in order to enrich themselves. In the end, it takes only one CEO behaving unethically for the effects to be felt by everyone associated with the company.

The trend continues to move toward stock options as the primary form of executive compensation, and another alarming factor is that the base salary is often minuscule compared to the value of those options (Supanvanij, 2005). The question becomes whether it is wise to essentially give executives an open checkbook on how much they can earn. In a nutshell, this is what Enron did. The temptation is simply too great in most instances for CEOs not to devise plans to transfer wealth from shareholders to themselves. With this context established, it is worth examining how Enron became one of the most powerful companies in the world — through fraud.

The Rise and Fall of Enron

The Early Years

Enron Corporation began with the merger of Houston Natural Gas and InterNorth in 1985. Under ordinary circumstances, this would have been a strong merger. Enron would have been able to control much of the natural gas infrastructure in the region. However, because natural gas was deregulated, other companies had the opportunity to use Enron's infrastructure, which weakened its potential market advantage (Akhigbe, Madura, & Martin, 2005).

In 1986, Ken Lay became the CEO of Enron and envisioned transforming it into more than a natural gas company. Motivated largely by the challenges deregulation presented, he sought additional opportunities and wanted Enron to become a player in the investment market. To pursue this vision, Lay hired the consulting firm McKinsey & Co., from which came the young consultant Jeff Skilling. Skilling advised Enron on ways to make the company profitable, primarily by setting up a system of predictable profits and returns through arrangements with outside contractors in the gas business. Lay was impressed with Skilling's work and offered him a position at the newly formed Enron Finance Corporation.

The Glory Years

The efforts of Ken Lay and Jeff Skilling propelled Enron into a major corporation (Akhigbe, Madura, & Martin, 2005). They surrounded themselves with young, energetic talent, and revenues skyrocketed in the 1990s. The company's stock price quadrupled, and Enron became one of the most envied companies in the world. Skilling eventually became Enron's CEO, and the transformation Lay had envisioned came full circle. The company had grown far beyond an energy business, trading commodities, Internet bandwidth, and other items.

Yet Enron's profitability was not what it seemed. The company was operating with manipulated finances and inflated numbers. Enron is a perfect example of what happens when the highest ethical standards are not upheld. In the short run, the company thrived — but when the lies and deception were discovered, its fate was sealed. As the broader market climbed in 2001, Enron fell sharply (Hamilton, 2004). Its stock price had been at eighty dollars per share just twelve months before the collapse.

The Fall

In the late 1990s and early 2000, Enron began to unravel (Hamilton, 2004). Jeff Skilling resigned as CEO and the stock price began to tumble. It became clear that Enron had been reporting revenue it was not actually generating in order to make the company appear more profitable than it was.

Enron concealed most of its debts by establishing numerous LLPs, some of which were secretly managed by Andrew Fastow, Enron's CFO. By recording only the gains and losses within those entities — while keeping the LLPs off Enron's consolidated financial statements — the company's financial position appeared sound. Consolidating the statements would have defeated the purpose, since the goal was to conceal debt rather than disclose it. To avoid consolidation requirements, Enron ensured that an outside party held at least a three-percent stake in the LLPs — the minimum investment threshold required to exclude them from Enron's financial statements.

The company needed to reduce its reported debt in order to preserve its investment-grade credit ratings. It could have issued additional stock, but this would have diluted earnings per share and reduced the stock's value — and since most executive compensation was tied to stock options, issuing more shares would have directly reduced executives' personal wealth. To protect that wealth, unethical behavior spiraled out of control. The company used its stock to fund some of the LLPs and entered into questionable guarantees with those entities at arm's length. This activity raised suspicions and triggered a federal investigation.

Around this time, Enron pension plan participants were prevented from moving their 401(k) assets between October 29 and November 13 — ostensibly to allow for a transition to a new plan administrator (Glassman, 2002). Meanwhile, Enron's local rival, Dynergy Inc., announced a bid to acquire the company but withdrew after conducting due diligence. On November 29, Moody's downgraded Enron's debt to junk status, forcing the company to seek protection from its creditors within days (Hamilton, 2004). Everything Enron had done unethically to maintain its credit rating ultimately proved futile. The company ended up with the very junk rating it had worked so hard to avoid — underscoring the point that unethical behavior does not pay in the end.

The End

Enron created more and more LLPs to cover its mounting debt (Wilson & Campbell, 2003). When it could no longer hide the debt, executives began restating income and restructuring the LLPs. This caused the stock price to fall to near zero, and the company was eventually forced to file for bankruptcy. Congress and the federal government launched investigations. Arthur Andersen, Enron's auditor, bore responsibility as well — either by turning a blind eye to or actively participating in the fraud. Andersen further complicated matters by shredding Enron's audited documents. Many questions remain unanswered, and the full extent of Enron's deceit has never been completely determined.

One clear lesson from the Enron case is that internal controls at the company were virtually nonexistent. The company was ripe for financial fraud. The following section outlines the controls that should have been in place.

Conclusion

After reviewing the factors and the importance of ethics in this case, one conclusion is clear: all the actions taken at Enron were designed to keep the stock price strong. In order to manipulate stock prices, the company's leaders uprooted and disregarded the foundation of GAAP. This means that the top executives were not merely behaving unethically — as they would later learn, they were behaving criminally.

The true tragedy of the Enron story is the fate of the investors and employees who were left virtually penniless. A robust framework of corporate governance — including independent auditing, proper separation of duties, and executive compensation structures that do not reward short-term manipulation — is essential to preventing such outcomes. Ethical behavior in business is not simply a moral obligation; it is a prerequisite for sustainable success.

References

Akhigbe, A., Madura, J., & Martin, A. D. (2005, July 1). Accounting contagion: The case of Enron. Journal of Economics and Finance, 29(2), 187–202.

Glassman, J. K. (2002, January 18). Diversify, diversify, diversify. Wall Street Journal [Eastern edition], p. A10.

Hamilton, S. (2004, June 4). Enron unravelled. European Business Forum, 66–71.

Supanvanij, J. (2005). Does the composition of CEO compensation influence the firm's advertising budgeting? Journal of American Academy of Business, Cambridge, 117–123.

Wilson, A., & Campbell, W. (2003, January–March). Enron exposed: Why it took so long. Business and Economic Review, 6–10.