Enron Scandal: Nitty- Gritty, Aftermath

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Introduction

Investors’ confidence in American business was greatly shaken by the Enron Scandal. Enron Corporation was a company rated as one of the most ambitious and fast rising company, so much so, that Fortune magazine once rated this company as ‘the most innovative company’ before the scandal broke down in December 2001. Enron was energy manufacturing and trading company. Enron was the largest marketer of electricity, and natural gas in Northern America, and U.K.; but Enron scandal broke down all of financial, administrative, commercial, and statutory parameters. The company investors suffered so much from the scandalous management that their Enron holdings became worthless. Some say that basic cause of debacle was the non- happening of miracle that Enron shown to its investors. Enron promised them results miles ahead of other energy companies and in the process company’s borrowing increased and resulted in a great corporate financial debacle of decades.

Nitty- gritty of Enron Scandal

Company declared false profits for a number of years, as its accounting systems failed utterly in observing the ‘Generally Accepted Accounting Principles’ (GAAP)
Big-wigs of management who were responsible for the disaster escaped either under the game plan of retirements or they sold their stakes in Enron prior to eruption of scandal.
Controls, both internal and external, of the company proved so ineffective that for years declaration of false profits went on unchecked as if controls were ploy in hands of manipulators.
Those at the helm of affairs, like board of directors and audit committees, were made so ineffective in over viewing the actual facts, or probably were part of scandalous operations.
Outside auditors overlooked the happening for years and that questioned the working of hitherto unblemished accounting profession.
It is said that million of dollars spent in top US politicians election campaigns at different levels was the real cause of emptying the Enron coffers and then covering those with fraudulent financial and accounting manipulations.

Scandalous Schemes

Special Purpose entities (SPEs)

As per GAAP operating income is calculated from ordinary course of activities that are carried on as main business of the entity. Assets sales were never the main business of activity for Enron. In one of the so called innovative way adopted by Enron to hide the losses was to transfer assets those were creating losses for the company to partnerships called SPEs. Once such assets are transferred to partnerships, and then those transfers were shown as sales revenue and considered for the purposes of calculating earnings from operational or ordinary course of activities.

Enron took great advantage of its political linkage. The company formed a complex web of 2800 subsidiaries (so called Special Purpose Entities). Out of these 874 were located at overseas locations like Cayman Islands where they enjoyed tax exemptions and very relaxed banking regulations. Enron made sale of loss creating assets to these SPE s and showed those as revenue receipts. Whereas, sale of assets is in fact capital receipt, and as per GAAP profit or loss on sale of assets is treated and shown separate from earning from operational activities in Income statements. Sale of assets is an extraordinary activity in the income statement. Such activities are out of the purview of calculation of income from ordinary course of activities, but Enron deliberately treated those as revenue receipt and inflated the earnings unnecessarily.

Later on emergence of scam Enron had to suffer huge charge against this grossly fraudulent accounting treatment of sale of assets.

For years Enron audit committees never bothered about such gross accounting negligence. Even its external auditors Arthur Andersen, LLP never pointed out such basic accounting mistakes those were being used to inflate profits to impress innocent investors.

Prepay Schemes

Enron entered into agreements with many offshore companies to supply gas in future. Those companies were setup by banks providing finance to Enron. There were never any intentions on part of Enron to supply gas to those companies. It was only a ploy to procure loans from banks and on the basis of those agreements Enron could book profits. In the ploy employed those companies later sold gas back to Enron so that loans could be repaid.

Corrupt management

Less than 150 members of top management were paid millions of dollars as compensation on their (planned) retirement and also as sale of stocks held by those top employees. The value given to them for sale of their stock was ruling price of Enron stock which was based on highly inflated earnings. The money was siphoned by those at the helm of affairs.

Whereas, ordinary employees were cheated as their stock holdings could not be sold before they turned 50 years of age and when the price of stock nosedived, such employees found their stock as valueless.

Recurring losses treated ‘non recurring’

As per GAAP losses, those occur during the course of main operation of business and are of recurring nature, reduce the operational income or increase the operational losses of the business. In connivance with its external auditors, Arthur Andersen, Enron treated those losses as ‘non- recurring’ so that an artificial profitability is created to boost the market price of its share. Naturally when some transaction has approval of auditors, normally every member or shareholders of the company believe it to be true, and that is what happened as Arthur Andersen actively collided with Enron in keeping those losses out of reckoning for operational loss calculations. Not only auditors helped Enron in creating false profits, but tried to cover up such transactions by removing or shredding the documents evidencing the crime. In fact those who work to investigate and verify the affairs on behalf of investors became the real culprit not only to perpetuate the crime but in making frantic efforts to cover the crime. Arthur Andersen, the external auditors of Enron, who were supposed to guard the interests of investors, was held responsible for ordering shredding of documents proving the crime.

“Andersen’s Chicago- based lawyer Nancy Temple, who, according to legalese, played the ‘corrupt persuader’ who led other astray. Knowing the Security and Exchange Commission was starting to scrutinize Enron’s books, Temple told David Duncan, who supervised the accounts, to remove her name from a file memo that disagreed with Enron’s characterization of a $1 billion loss as ‘non- recurring’(Cathey Booth Thomas).

Bankers Role

Enron never tried to declare its actual financial position to investors only because of unperturbed help provided by its bankers like Citigroup and JPMorgan. In initial years of Enron, these banks saved Enron a number of times from takeovers. The banks were instrumental in providing finance to Enron’s structured schemes like pre pay schemes described earlier in this write up. These banks made a number of deals involving structured financing and earned huge sum of money from Enron over such deals. But perhaps banks were aware that lending Enron was not very good investments; and that is why they got every financing deal with Enron hedged from insurers and others in order to mitigate losses when those occur.

Fake Trading Floor

It is interesting to note that analyst employed by investment bankers always maintained a positive view about Enron. In fact Enron did a lot of maneuvering to outsmart those analysts. It has been reported that Enron maintained a trading floor at the company’s Houston office, where analysts were tricked to believe the booming environment of company’s business. Click2Houston.com² reported on February 22, 2002 quoting Carol Elkin, Enron’s energy analysts that “It was an elaborate Hollywood production that we went through every year when analysts were going to be there to be impress them to make our stock go up.” Efforts on such big scale used to be made to present rosy picture of Enron and persuade the analysts in bringing out the company at financially best as compared to others. Lavish parties were thrown for analysts to believe that energy sector, perhaps Enron is the biggest entity.

Wastage of Liquidity as bribery and for non- business purposes

There were numerous instances when Enron wasted its liquidity by virtually throwing money in investments without even bothering about worth of those investments. In all those illegal wastage of funds Enron’s top level of executives were involved. Following one example will through the light on how liquid funds were wasted under the grab of investments. “Enron bought the shares of National Westminster Bank (NatWest) in a limited partnership with Credit Suisse First Boston. Enron paid $20 million, but only $1 million went to NatWest. The remainder of money went to several executives and their families, as well to three NatWest employees who were on the deal.” (National Legal News)

Such wastage of liquidity on bribery and illegal activity was bound to bring the house down one day. It is disgrace on part of those members of management of Enron who were bent upon ruining the hard earned money of shareholders and investors. It appears that business acumanship was almost missing with corrupt management personnel.

Aftermath

Economic and political repercussions

It is noticed that a large number of companies are restating their financial statements.

This will have a depressing effect on stock market. Perhaps one of the reasons for the recent depression on stock exchanges is the repercussion of aftermath effect of Enron. The companies have to be very careful about their political connections. Enron’s political donations did not help it during trouble. In fact political parties back lashed at it; and this has a telling effect on other companies. Regulatory agencies were also at receiving end and made earnest effort in introducing legislations like Sarbanes- Oxley.

Accounting profession held irresponsible

It is believed that shareholders’ loss in this scandal was around 60 billions of dollars. It might be possible that luck few cover up losses in their good days to come,; but what about the accounting profession that has lost its very image of independence as auditor. The profession lost the faith of investors and such loss of image is almost irrecoverable. Cathey Booth Thomas¹in the article ‘Called to Account’ in TIME has stated that “in holding the accountant responsible the jury in essence sanctioned the entire bean- counting industry for its failure to police rogue corporations.”

Major changes in finance industry

Enron has shaken the society’s faith in big iconic institutions. Normal business is not happening after Enron debacle. Analyst, accountants, and regulators have been taken to task. If we study the Enron scandal properly, we will find that there was no check and balance system in American corporations. Corporations were self regulating themselves. But Enron debacle has revealed the weaknesses of self regulations of business.

Sarbanes Oxley act, emerging after the debacle, seeks direct reporting about the affairs of the corporations from those who are at helm of affairs. They will be held responsible for failures and not their advisors.

It has been proved that auditors were not independent in forming opinion on financial statements. The accounting profession needs introspection to cleanse its shame suffered in the process.

Enron employees suffered huge losses because of their 401(k) retirement plans were stuffed with Enron’s stocks. Now workers of corporate sector will have to make planning of 401(k) holdings more sensibly. In fact replacing this with pension plans would be a better idea.

References

Cathey Booth Thomas, Called to Account, Times, 2002. Web.

Click2 Houston.com, Enron Designed Fake Trading Floor, Houston News, Web.

National Legal News, Southamption, 2008. Web.

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