Nicholas Barton
00343164
Accounting 2600
Case Study: The Enron Collapse
“Why was it that Enron, a financial services company, in effect, could not release a balance sheet with their earnings statement?” -Jim Chanos, President Kynikos Associates.
In the film “Enron: The Smartest Guys in The Room,” analyst Jim Chanos asks why, the 7th largest company in the world at the time, could not supply investors with basic financial statements. These statements as we learn in accounting are the fundamental tools through which we communicate a corporation’sfinancial position. So why was it that a corporation valued as much as $70 Billion at one time would have ever achieved such success without performing basic accounting functions? The CEO, Jeff Skilling’s caustic reply to the question foreshadowed the collapse of a company that had been built on lies and deceit. While the Enron scandal is one of the best known in the history of international business, the reasons for the collapse were built into the company from its very roots. I will begin with an overview of the company and the ensuing scandal, as well as touching on many of the events that led up to the collapse of the company. I will also touch on events that contributed to the company’s inflated stock prices and their unethical and often desperate business practices that undermined the foundation of their business.The aforementioned film, Enron: The Smartest Guys in The Room was an excellent resource as it was primarily historical footage and first-hand accounts from individuals involved with the scandal.(
Enron was founded as a result of a merger of gas companies in 1985. Founded by Kenneth Lay it originated in Omaha Nebraska. Despite promising to keep the headquarters in Omaha, Lay almost immediately moved the company to Houston Texas where they began consolidating much of their business into natural gas. Lay was Chairman and CEO of Enron Corporation and had a PhD in Economics. The first signs of trouble for Enron came early when Traders gambling with company assets in the oil market lost $90 million in a period of five days. The company reserves were gone and auditors from the company’s accounting firm Arthur Andersen saved the company by “bluffing the numbers” in other words mis-reporting the company’s net-worth. This often overlooked event spoke to the corporate culture that was beginning to develop at Enron. Company assets were being gambled in extremely risky investments in order to turn high profits. With company revenues hurting and a need for new life to be breathed into the company, Ken Lay hired an up and coming Harvard Business School graduate Jeff Skilling. Skilling had a big idea about trading energy, especially natural gas, as a commodity. His plan to trade natural gas as a valued asset was only one of his brilliant ideas; the other being adopting an accounting system that would ensure the success of Enron for the foreseeable future.
Skilling had a condition on which he would work for Enron, the corporation would have to adopt a new form of accounting called mark to market. Developed by traders in the 1980’s this new form of accounting allowed accounting for the fair value of an asset or liability to be based on the current market price, however this figure could also be obtained through any other objective process; in effect accountants could value assets and liabilities at any value they saw fit. Because the accounting system was a new and popular idea and so was the idea of trading natural gas as a commodity, Arthur Andersen, Enron’s accounting firm and the Securities and Exchange Commission both signed off on approval for Enron to adopt Mark to Market Accounting. Regardless of how much revenue Enron was earning, Enron could speculate natural gas futures and record them on their books as earned revenues. Amanda Martin Brock, an Enron Executive described the new system as “Very Subjective, and very, it left it open to manipulation”. When Mark to Market was approved the company immediately posted huge earnings and the Executives took the first of many large bonuses from these inflated earnings. The Enron executives literally threw a party when Mark to Market was approved; they immediately paid themselves bonuses based on un-earned revenue. This event was both the beginning, and the beginning of the end for Enron; Enron executives would spend the next 10 years trying to fill the financial void created by their accounting practices, eventually leading to the corporation’s demise.
Skilling was an innovator; he brought a corporate culture to Enron that was Darwinian to the point of near insanity. His survival of the fittest tactics were reflected in his PRC policies or Performance Review Committees. These committees would rate their peers on a 1-5 scale and the bottom 10% or so of employees would be systematically fired each year. Ken Lay described their culture by saying “Our culture is a tough culture, it’s a very uh, very aggressive culture.” This statement rang true as rumors of Enron’s reputation spread through the financial world. Enron traders wouldn’t do business with entities that defied them or disagreed with their speculations; they were the biggest bull in the market and Jeff Skilling’s macho culture fueled the cutthroat attitudes of his employees. Skilling encouraged risk taking and extreme behaviors. Corporate retreats were often spent engaging in extreme sports and the macho persona was reflected and rewarded in the company. The trading floor at Enron was staffed by individuals who would put in 12 hour days and then stay late to do more research, stepping on each other’s throats if it meant getting closer to their bonuses.
This aggressive corporate culture was backed by a huge media and PR campaign in order to further project the successful image that was Enron. Skilling wanted to bolster investor confidence so much that the price of Enron stock would never go down. Promising 10-15% returns annually, Skilling pushed into different markets and different types of energy in order to continually drive the price of their stock. The stock price drove the company and was prominently displayed as a constant reminder to employees what the company was worth. The employees themselves were encouraged to invest in Enron and many did, some of whom gambled their entire 401k’s and other personal investments. Because of their PR campaign and their public image campaigns, the company was in fact incurring losses while the stock price continued to grow. Enron built a natural gas power plant in India where other investors wouldn’t. The ego of skilling and the bullish culture of the company were beginning to affect major business decisions. The company lost over $1 Billion on the project when the local population could not afford the power the plant supplied. Meanwhile Enron executives had already paid themselves bonuses based on the potential earnings of the power plant. This loss encouraged Enron’s next big move, a merger with Portland General Electric, the electric company that controlled California and most of the Pacific Northwest. With a wealth of new employees to invest their retirements in the company Enron continued to cover the tracks of its accounting follies by expanding into new markets and creating new revenue streams, even if they were investments from their own employees.
Stock market analysts would use certified documents from Enron’s accounting firm in order to make buy and sell recommendations on Enron’s stock, the only problem was the company continually had a buy rating, thus driving the price higher. The first person to notice this otherwise unheard of financial anomaly was a Merrill Lynch analyst named John Olsen. When he raised questions about the companies reporting practices he was fired, it was said that in return Merrill Lynch was given two analyst jobs that paid $50 Million each; $100 Million in order to silence anyone who would raise suspicion about their company. Around this time Lou Pai, a sort of hidden Enron CEO became prevalent in the public eye. As CEO of Enron Energy Services, he netted around $120 Million for the company before leaving shortly thereafter following a scandal in his private life. He later was among the first executive to sell his stock to the tune of around $250 Million. Pai saw an opportunity to leave the company while it was still strong, or while it still appeared so to the public. As the PR campaign continued to advance Enron as a greater company than itsearnings reflected, CEO Skilling, in an attempt to continue the company’s growth, advanced new ideas into the market before the technology was even developed.
In the year 2000 Enron announced a plan to trade bandwidth; as it had developed a market for energy so it would with the tech revolution of the turn of the century. Enron formed a deal with Blockbuster to stream movies via the internet to customers using idle bandwidth, claiming to have developed the technology and instilling themselves as the new industry leader. Enron’s PR campaign was so effective at this point that the stock price rose to a new record high; despite the fact that the blockbuster deal fell through completely. It turns out that Enron had not in fact developed the technology to stream videos, and the idea of trading bandwidth was mostly smoke and mirrors. Despite not earning any revenue from the Blockbuster deal, Enron posted $53 Million in earnings based on projections from the deal. Executive bonuses were paid out based on this figure and despite the loss, the stock price continued to rise. In the wake of the failed Blockbuster deal, insiders, mostly Enron top executives started to sell off large quantities of their stock. The public image of the company continued to improve while the executives sold nearly $1 Billion in personal stock, Ken Lay and Jeff Skilling leading the charge selling around $300 Million and $200 Million of their own shares respectively. On August 23rd 2000, Enron announced that they would be speculating and trading weather reports in Enron’s newest scheme to expand into new markets. Enron stock was trading at $90/share, but this most recent ploy was a desperate almost comical move, despite this they were once again named the world’s most innovative company by Fortune Magazine.
Analyst Jim Chanos was among the first to see through the deception, he contacted Bethany Mclean, a writer for Fortune Magazine. Mclean was writing an article about Enron and at the behest of Chanos examined Enron’s financial statements more closely. In short Mclean couldn’t detect any fraud but somehow knew something was amiss. It was effectively unclear how Enron was actually making any money. When interviewing Jeff Skilling for the article she brought this up, only to be told that he wasn’t an accountant and did not have the answers she was looking for, he then bullied her out of the interview. At the threat of printing the article without their input, the next day Mclean and her editor met with Andrew Fastow and two other Enron executives in New York in order to get the answers Skilling could not or would not provide. Andy Fastow proceeded to lay out detailed accounts of the company’s business dealings over the next three hours, he even went so far as to include accounts of partnerships he was engaged in that existed solely to do business with Enron; Mclean didn’t mention these in her article thinking that the higher ups must surely know about these practices if they knew about the rest. At the end of the interview the Enron executives were leaving when Fastow turned and said to Mclean “I don’t care what you write about the company, just don’t make me look bad.”
As CFO Fastow’s responsibility was to report the company’s earnings, or rather in this case, to fabricate the company’s earnings and cover the tracks of the failing company. There are some who feel Fastow was set up as the fall guy in this situation, as someone who “lacked a strong moral compass” he would be the perfect point man to make all of Enron’s problems disappear. Fastow was young and ambitious but posting gains year after year when Enron was in fact losing money landed them $30 Billion in debt. Fastow began layering liability’s in order to post gains for Enron. While this is normally common business practice, the layers that Fastow was creating were in fact shadow companies used to siphon off Enron’s debt. In this way the liabilities of the shadow companies grew exponentially while Enron was able to continually post gains quarter after quarter. Eventually Fastow’s idea culminated in the founding of LJM, a shadow company started by Fastow in order to sell Enron’s assets to major banks. By temporarily removing certain assets from the books Fastow could continue to make Enron’s numbers look good. As partner in LJM Fastow secured significant profits and bonuses for himself, he sold the idea to major banks by insuring the assets with Enron stock. It was effectively a guaranteed money maker, backed by stock options so the legality of the plan was overlooked by 96 of the world’s major banks who invested as much as $25 Million each in the project. At this point the major banks of the world knew that Enron was engaging in unethical and even illegal accounting practices, but like so many others they wanted to take their share of the profits before exposing the scandal. The banks jumped ship as soon as the scandal broke, mostly claiming ignorance.
As Fastow’s desperate plans to keep the company afloat in the public eye began to unravel, we can consider all of the parties that have not brought the situation to light at this point. The extreme corruption and deception on the part of Enron Corporation was now being shared by 96 of the world’s leading banks. All of whom knew that some things were too good to be true. Enron’s accounting firm Arthur Andersen was collecting nearly $1 Million in fees every week for their part in the deception, and it is reported that their attorneys at Vincent and Elkins were collecting similar fees. This is not to mention the Enron executives or even the top level employees that did not blow the whistle when they realized the deception. Motivated by many things, among them greed, literally dozens if not hundreds of people could have spoken up at any time and decreased the magnitude of the failure of Enron, instead they lined their pockets while they watched the company sink into oblivion.
At his wits end, Skilling began to be visibly concerned with the condition of the company. In 2001 he was quoted as saying “I don’t know what the hell I’m going to do” meanwhile chairman Lay was buying a new corporate jet. Facing $500 Million in losses, executive Tom White had a final desperate plan to make his numbers work and that plan was California; the de-regulation of the energy market in California allowed Enron to run said market as they saw fit, or in other words in a way that would make them the most money. Enron would shut down power plants causing rolling blackouts throughout California in order to make a profit. Driving the price of energy upward they began trading energy surpluses across the Western states, increasing the price even further. The problem with all this is California had more than enough power generation capacity to meet their demand, so there should never have been the blackouts that drove the price up. Public outrage and an energy crisis in California eventually caused the governor to declare a state of emergency, thus regaining control of the de-regulated energy market. The year-long energy battle would cost the state of California over $30 Billion. Ken Lay met with Arnold Schwarzenegger and other California politicians secretly in order to continue to promote de-regulation of the energy market in California. Governor Davis was recalled based on the state of California’s economy and Schwarzenegger won the Governor’s ballot. Meanwhile Ken Lay became energy secretary under President George W. Bush, from this position all he had to do was make sure that the federal government stayed out of state matters and thus perpetuated the energy crisis in California in order to bolster Enron’s numbers once again. It wasn’t until elections gave democrats a majority in the senate that the Federal Energy Regulation Commission stepped in to end the stand-off.
By now investor confidence was weakening after the public outrage over energy in California, Jeff Skilling was losing control of his traders as the cutthroat culture he had helped foster were managing to trade the company out from under him. In a hearing with a congressional sub-committee Skilling stated “On The day I left, on August 14, 2001 I believe that the company was in strong financial condition”, two days later the price of Enron stock dropped to $36.85. Skilling was a rat jumping from a ship that he knew was sinking. He resigned without a PR campaign or a plan on August 14th; Ken Lay returned as CEO and stated that “The Business is Doing Great.”