Financial Scandal

Enron was an American energy company located in the city of Houston in the state of Texas that was started in 1985 by Kenneth Lay and became a bankrupt in 2001 following the revelations of its involvement in one of the biggest financial scandals of the recent times. The company had begun as a seller of natural gas, quickly becoming the biggest firm specializing in this field by 1992. In the 1990s, it had diversified into other businesses, such as paper and electric power plants, as well as the setting up of broadband services across the world. With these, it had its profits and revenue go up, and soon it was ranked the most innovative company in America by Fortune (Cruner, 2002).

Enron’s downfall began in 2001, when a journalist called Bethany McClean wrote in the magazine Fortune  that the stock of the company was overpriced. She based this assertion on the fact that the shares were trading at a very high value exceeding almost fifty times the earnings of the company (Jacobius, 2001). Following the publication of this article, another financial analyst suggested that upon going through the company’s 10-K report, he had found out that the Enron had huge debts, as well as other worrying and confusing financial details. As this information started streaming out, the CEO of the firm named Skilling started becoming abusive, when asked to explain some unclear points.

Most of these practices that started being questioned had been used for quite a long time, but the 1990’s had seen Enron experience such a very high growth rate with high profits, revenues and stock trading that a few dared to question about its accounting practices. The suspicions that something might be wrong with Enron continued growing, especially after Skilling, the CEO, had suddenly resigned his post for personal reasons, soon citing Enron’s shaky share prices at the markets (Driscoll & Hoffman, 2000).

A whistle blower in the company, Shawn Watkins, was soon silenced, when she raised issues to Lay, a new CEO, that the company’s accounting practices were illegal and that they risked being caught soon. In spite of her protests, the company’s law firm, Vinson & Etkins, was tasked with investigating her claims, and as expected the firm was given a clean bill of health (Fusaro & Miller, 2002).

All these suspicions had their toll on the confidence of investors. To shore up the latter, a new chairman was named. With reports that the Securities and Exchange Commission was likely to start investigating the company’s accounting violations, Enron announced that it was going to carry out the restatement of its financial records to correct the previous accounting mistakes. When it had been finally done, the company showed a dramatic reduction in its equity and revenues and an increase in its liabilities in the period from 1997 to 2000. However, soon the SEC announced that it was going to investigate the accounting principles of the company. This news immediately led to the tumbling of stock prices at the markets.

Apart from the issues connected with the company’s accounting practices, questions were also asked about the level of cash that Enron had. The CEO tried to assure investors buying back their commercial papers of the liquidity health of the firm. It unfortunately caused the depletion of its line of credit. However, Enron continued being plagued by liquidity problems and had to borrow from banks to the tune of approximately $2 billion (Elliot & Schroth, 2002). Bad news continued spreading, as Moody lowered its credit ratings. It meant that borrowing the company was going to be more difficult. This announcement was quickly followed by the stumbling of its share prices. As problems mounted, Enron was forced to fire its Chief Financial Officer, who had been pushing for more openness in the financial accounting sector.

With the possibility of bankruptcy in mind, the company started looking for a buyer. Dynegy, a neighbouring energy company, agreed to buy it for $8 billion (Elliot & Schroth, 2002). Meanwhile, the further restatement of accounts revealed that the enterprise did not make any profits in 1997. Bad news came, when its credit rating was further lowered by Moody, and the information that the top management, including the CEO, had sold a significant amount of shares greatly angered tense investors. The final nail in the coffin was the withdrawal of Dynegy from the buyout plan unilaterally and the announcement of the SEC that it had filed a civil fraud lawsuit against Andersen. These news were quickly followed by the tumbling of the company’s shares to worthless $0.5. With all options closed, it was forced to file for bankruptcy (Cruver, 2002). No factor can be singled out as a cause of the scandal. A large number of causes contributed to this unfortunate occurrence. Among these, there was the unconventional recording in accounting books of what the company perceived to be a revenue.

Enron got its profits from constructing and maintaining power plants and buildings, wholesale trading, among other business activities. Companies engaged in such kind of business conventionally record trading fees as their revenue only. However, Enron usually recorded the value of the whole trade rather than just trading fees. The result of this was revenue inflation, creating a picture of having huge profits, when in reality they were much lower. Due to this, the company recorded a phenomenal revenue increase by 750% between 1996 and 2000.

Another factor contributing to the collapse of the company was the market-to-market accounting practice it used. By means of this method, Enron usually recorded the present value of cash it hoped to receive on some future date as its income. Since the values of contracts could not be clearly estimated, huge discrepancies resulted, when attempts were made to match profits and cash, due to incomes were recorded without any cash received. As a result, the company resorted to giving investors false financial reports (Cruner, 2002).

In addition, the company used special entities to manage risks. Due to this, it could hide its debts. Thus, Enron’s accounting books showed that its liabilities were low, while in fact they were high. It also showed that its earnings and equity were high, while in reality they were much lower. The information that the company gave to its investors was that it had hedged its downside risks using special entities with illiquid investments, while these actually financed hedges with Enron’s financial guarantees and stocks. The result is that the firm was not well protected from downside risks as it claimed (Fusimo & Miller, 2002).

The Enron’s policy of awarding employees with huge bonuses created a company culture, whereby workers were so focussed on receiving these fees that they were ready to disregard business ethics and the fiscal health of the company in their incessant deal making in order to increase their profits and stock options. This dangerous path was also followed by the top executives, who also received very huge pays exceeding almost twice the ones of other same-level executives in other companies of roughly the same size (Elliot & Scroth, 2002).

Lastly, Arthur and Andersen, Enron’s auditing company contributed greatly to the creation of the scandal. It would never be known perhaps whether it was because of incompetence or the conflict of interests. However, what was certain was that the company did a shoddy job. The allegation of the conflict of interests result from the fact that Andersen earned a lot from the company as a consultant and an auditor. For example, in 2000, it earned $27 million of consultation fees, $2 million more than the amount of money received through auditing fees. There was the possibility that the company always did its work in a hurry with their goal solely focussed on these huge fees. The proof of the firm’s involvement in the scandal was the fact that all its records pointed out to the case, when the scandal broke out shredded, and thousands of emails and computer files were deleted. These facts sparked allegations of covering up some information and were widely seen as desperate efforts taken by Andersen to get itself out of the scandal (Driscoll & Hoffman, 2000).

Alternatively, perhaps, the company was incompetent and lacked the expertise required to recognise and understand Enron’s special entities, revenue and other accounting practices. The company did not disclose to be pressurized by the latter not to reveal its charges for special entities, when credit risks started being known. If Anderson had done so, these fees would have been included in Enron’s losses increasing them. The latter also used other accounting methods that were deeply disturbing. For example, cancelled projects were entered in accounting books as assets. While this method was at first used for small projects only, it later expanded to larger ones as well with dire consequences for the company.

The scandal was so huge that Enron collapsed due to it. Thus, all its employees became jobless all of a sudden. The top officials of the company, including its former CEO Skilling and founder Kay, were put to trial and convicted. However, Lay escaped justice when he soon died from a heart attack. Following the occurrence of this huge scandal, the financial committee of both Houses of Congress held hearings, which led to the passing of the Sarbanes-Oxley Act in 2002. It sought to seal loopholes in financial laws that had allowed the scandal to occur. One of the provisions of this Act was the setting up of the Public Company Accounting Oversight Board, which would be tasked with the coming up with the standards of audit report preparation. In addition, it was also supposed to ensure that public companies would be restricted from providing non-auditing services and would expand their financial disclosures of unconsolidated entities that they entered into relationships with.

Apart from the Congress, the Securities and Exchange Commission together with the New York Stock Exchange also stepped in to seal some of these loopholes. The recommendations they made that were meant to change the stock market regulations included the provision that all companies had a majority of independent directors, who apart from having other responsibilities should be part of important committees, like the audit committee, the nominating committee and the compensation committee (Fusimo & Miller, 2002). Additionally, the changes required the audit committee to be composed of members, who were financially literate with a minimum of one member having training or experience in financial management.

The scandal had huge negative financial implications not only on the company’s shareholders, but also on its creditors and employees. For example, it was estimated that $50 billion out of $74 billion that investors lost during the four years preceding the company’s bankruptcy were due to this fraud. It showed how big this scandal was (Elliot & Scroth, 2002). Shareholders went away empty-handed after the collapse of the company, while all its assets, including art and logo signs, had to be auctioned in order to pay creditors.

In addition, it paid out huge amounts of money to its employees and investors as a result of lawsuits. For example, the total of $85 million was paid to more than 20,000 workers, who had their pensions worth almost $2 billion. On the other hand, investors received approximately $4.5 billion in 2005, while other shareholders got $7.2 billion three years later in similar settlements (Furimo & Miller, 2002). One of the reason why managers of companies engage in such unethical and illegal activities as the ones performed by Enron’s executives is the belief that perhaps there is no deterrent punishment that is effective in the system and acceptance of an illegal activity as something rationale (Albright & Searcy, 2001). Thus, more stringent and effective laws need to be put in place to combat such malpractices.

The owners of companies should also play a bigger role, especially in the monitoring of the activities of top managers, and should know exactly how their firm is making money. If the Enron’s stakeholders had been keener in monitoring the activities of the company, the scandal would not have occurred at all. The Securities and Exchange Commission also needs to come up with a better accounting system that can disclose as much financial information as possible. It will prevent the reoccurrence of the market-to-market system used by Jeffrey Skilling in the company, accepted by the SEC and only later found out to be illegal.

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