Case Study

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’s financial 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. (http://www.youtube.com/watch?v=_xIO731MAO4)
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 its earnings 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 deregulated 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.”
The whistle was finally blown by an Enron insider. An Enron Vice President named Sherron
Watkins was given a list of asset accounts to manage when she moved into Fastow’s department. She
discovered Fastow’s intricate web of assets and “couldn’t believe Arthur Andersen signed off on it,” the
assets she was to manage were owned by banks at the time and were even guaranteed by Enron stock.
In an anonymous letter to Ken Lay Watkins disclosed her findings. The Wall Street Journal printed
findings detailing Fastow’s deception and the SEC launched an investigation as a result; I’ll resist
commenting further on a government agency failing to act until they see it in the Journal or on CNN.
Billions in mark to market profits should have actually been recorded as losses and new financial
statements were issued by Enron. By October 23, Enron’s stock price had fallen to $19/share. While Ken
Lay addressed the company in order to answer questions and reassure his employees, representatives
of Arthur Andersen were shredding documents a few blocks away. In one day they destroyed over one
ton on financial records. As the company was going under, Ken Lay still managed to sell $26 million of
personal stock while all other shareholders were frozen out of their accounts. The next day on October
24th Enron fired Andrew Fastow when they learned that his company LJM had siphoned off over $45
Million in profits from his various “raptor accounts.” When asked by the subcommittee how he could
conduct himself with such blatant dis-regard for personal or business ethics he plead the fifth
amendment and refused further statement. On December 3rd the stock price dropped to a scant
$0.40/share and the next day Enron declared bankruptcy.
The main contributing factor to the failure of Enron as a company was greed. It started from the
moment that Jeff Skilling incorporated mark to market accounting into Enron’s policies, and then that
system was immediately taken advantage of. The initial bonuses paid out to executives were based on
speculations in futures that were never realized. The company spent the next ten years trying to
generate new revenue streams in order to make their company as successful as they always said it was.
Often times these revenue streams were sustained through unethical or even illegal dealings on the part
of Enron and the companies they did business with. Greed and cutthroat attitudes were ingrained into
Enron’s corporate culture and at every turn employees were manipulating the system in order to make
bonuses, or mis-represent numbers from their department. When this is the corporate culture and your
corporation is one of the largest in the world, it is difficult for individuals within the company to stand up
for their own system of values. Whenever a problem arose it would be sent up the ladder and would
end with a “let me run it by Jeff”. Because Jeff Skilling was the infallible head of the corporation this was
sufficient to put the concerned party at ease. As I had mentioned before, Arthur Andersen and the Law
Firm Vincent and Elkins were both privy to Enron’s miss-dealings, but the appeal of over $50 million a
year in billable fees was too great a price for either firm to oust their client publicly. This culture of greed
was perpetrated by the executives to such an extent that shareholders were left with almost nothing in
the end.
Enron executives sold over $1 Billion in personal stock options in the two years leading up to the
collapse of the corporation. When the corporation went bankrupt 20,000 employees working directly
for Enron lost their jobs. The average severance pay was $4500 while the top executives collected final
bonuses totaling $55 Million. In 2001 employees of Enron Corporation lost $1.2 Billion in retirement
funds and retirees lost over $2 Billion in pension funds. Meanwhile executives sold $116 Million in stock
as the company was going under. Despite making remorseful statements about the employees of the
company, executives showed throughout the life of the company that there was no end to their
corporate greed. If you visit the Enron website now, it is a link to an investor relations site in which
former Enron shareholders are still engaged in a lawsuit with the former executives. Many of these
investors are former employees seeking some semblance of retribution for how they were treated and
for being lied to for so long. Another major outcome of the Enron scandal for line level employees was
the dissolution of Arthur Andersen. The Country’s oldest accounting firm voluntarily gave up their
license in the wake of handling Enron’s accounting audit function. Over 22,000 Arthur Andersen
employees lost their jobs over night and the company’s and therefore the employee’s reputations were
tarnished forever, whether they were involved with the Enron Audit or not. The intangibles such as
employees of Enron’s subsidiaries, other shareholders and countless other individuals were likely
negatively impacted by Enron’s greed and failure to accurately represent their company.
While I think the right people were brought to trial to answer for their crimes I would have
further investigated other executives who left the company even before Jeff Skilling, such as Lou Pai and
Rebecca Mark-Jusbasche, former CEO of Enron International. Both parties escaped criminal charges and
cashed in large amounts of company stock in the years leading up to the collapse. I also don’t feel that
the punishment fit the crime. According to the article in Financial News “The Enron Cast: Where are they
now?” Jeff Skilling former CEO and COO paid attorneys a $23 Million retainer to defend his innocent
plea. He was found guilty of fraud and insider trading; he is currently serving a 24 year prison sentence
that his lawyers are still fighting at every level of court and on every ground for appeal available to
them. If he were to serve those 24 years in a proper federal penitentiary that might be sufficient
recourse for his actions. Ken Lay was convicted of 10 counts of fraud and 2 cases of conspiracy; he faced
up to 165 years in prison but died of a heart attack before he could ever be processed. Fittingly he died
on a ski vacation in Colorado, likely paid for with the money he effectively stole from Enron investors.
CFO Andrew Fastow served just over 5 years in exchange for cooperation with prosecutors and
testimony against other Enron executives. Barely a slap on the wrist, Fastow should be spending the
same 25 years in prison that Skilling is, and again in a proper federal penitentiary. Our justice system
rewards rats and Fastow is just another sociopath trying to save his own skin. Fastow along with Lou Pai
and Rebecca Mark-Jusbasche paid significant sums of money in civil suits from former shareholders;
however none of these figures were anything close to the amount of money they had made off of Enron
and the sale if it’s stock. Other employees including Mark-Jusbasche went on to other successful
careers, many of which for other energy companies. Sherron Watkins, the VP who blew the whistle in
the end started her own consulting firm and speaks publicly about corporate social responsibility. In a
tragic but fitting end, Cliff Baxter, Enron’s top salesman and Chief Strategy Officer committed suicide on
January 25th 2002, just weeks after Enron declared bankruptcy. In his suicide note he referenced his
dealings with Enron, “Where there was once great pride, now it’s gone.”
The Sarbanes Oxley Act of 2002 was signed into law in order to encourage trust in publicly
traded companies. In the wake of the Enron scandal more concise accounting and reporting practices
are now required. According to the SEC website “The Act mandated a number of reforms to enhance
corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and
created the “Public Company Accounting Oversight Board,” also known as the PCAOB, to oversee the
activities of the auditing profession.” The creation of PCAOB would hopefully prevent another Arthur
Andersen situation from occurring in the future. While some argue that the cost of implementing the
higher standards of Sarbanes Oxley is too expensive for small businesses, the overall effect of the
legislation could be considered effective. Investor confidence was temporarily restored, until security
speculation much like commodity speculation in the Enron case sent the U.S. financial system spiraling
once again in 2008. The resulting policies do require more accurate accounting principles, and greater
regulation of oversight companies providing accounting audits for that company. (www.sec.gov)
In conclusion, Greed and a lack of fundamental ethical values drove a potentially successful
company into the ground. Had the executives of the corporation instilled values into their corporate
culture that reflected dealings with them and others in a value driven and ethical light; Enron might
have never collapsed and tens of thousands of lives wouldn’t have been ruined. In this day and age
people are hopefully running out of ways to defraud investors out of billions of dollars, but we prove
every few years that there is no end to the potential for human greed. Working toward degrees in both
the college of business and the college of health I am shocked to see the difference between the two
curriculums. While some argue that different types of people are attracted to different majors, business
majors have a bad reputation for being cold, unethical, greedy, cutthroats. And knowing a few of them,
especially in the master’s program, I would tend to agree with this stereotype. Frankly I pity people that
subscribe to this ideal, history has shown time and time again that the most successful businesses in the
long term are those that are honest and deal fairly with customers and employees. I am sickened by the
millions Enron executives skimmed off for themselves while simultaneously running their own
corporation into the ground. And on top of it all they lied about it. By defrauding the American public,
their investors and their employees, a few people made untold fortunes from the Enron Empire; the
cost of which was calculated in many lives and billions of dollars but in reality cost more than we will
ever know. It is my hope that my fellow students and I will see the merit of ethical dealings in business in
order to further the ideals of business ethics and corporate social responsibility. By holding one another
accountable we might be able to see problems like Enron become less common in the future.
References
Enron: The Smartest Guys in the Room
Jigsaw Productions (Producers), Alex Gibney (Director), Peter Elkind (Writer), Bethany Mclean (Writer),
2005. Enron: The Smartest Guys in the Room [Motion Picture]. USA: Magnolia Pictures.
The Enron Cast: Where are they now?
Partington, Richard (2011, December). The Enron Cast: Where are they now?. Financial News Retrieved
March 20, 2012 from http://www.efinancialnews.com/story/2011-12-01/enron-ten-years-on-wherethey-are-now
Sarbanes Oxley Act
U.S. Securities and Exchange Commission. (Modified 2/15/2012). The Laws that Govern the Securities
Industry. Retrieved March 18, 2012, from http://www.sec.gov/about/laws.shtml#sox2002