Table of Contents
The Enron scandal came to the limelight in October 2001, ultimately leading to Enron Corporation’s bankruptcy and collapse (Bratton, 2002). Enron Corporation is an American energy corporation located in Houston, Texas. The bankruptcy that resulted from the scandal remains a memorable event in the American history. The company was established by Kenneth Lay in 1985 following a merger between Houston Natural Gas and InterNorth. Many years later under the leadership of Jeffrey Skilling the executive staff, via the utilization of accounting loopholes, poor financial reporting and special purpose entities, were capable of hiding several billions of debt coming as the consequences from certain failed projects and deals (Bratton, 2002). Andrew Fastow, the Chief Financial Officer, together with other executives misled the board of directors of Enron, as well as the audit committee, regarding high-risk accounting practices and put pressure on Andersen to disregard the issues.
Enron’s shareholders lost almost $11 billion as the the company’s stock prices fell to less than $1 in November 2001, from the cost of $ 90 per share in 2000 (mid-year) (Benston, 2003). The American Security and Exchange Commission launched an investigation; Dynergy, at the same time, offered to buy the company. However, the deal backfired and, on 2nd December, 2001, the company filed for bankruptcy as stipulated under the 11th Chapter of the US Bankruptcy Code. Enron’s bankruptcy became the biggest example of bankruptcy in the history of the USA till it was followed by WorldCom’s bankruptcy in 2002 (Benston, 2003). Consequently, several executives at Enron Corporation were accused of various charges and violations and later sentenced to prison. Arthur Andersen, Enron’s auditor, was found culpable in the US District Court, although, by the time the ruling reached the US Supreme Court, the corporation had lost most of its clients leading to its shutting down. In spite of losing billions of dollars in stock prices and pensions, the company’s shareholders and employees got very limited proceeds in lawsuits. As a result of the scandal, new regulations, as well as legislation, were passed to expand the precision of public companies’ financial reporting. This paper looks into how the Enron scandal was committed, how the fraudsters were eventually revealed, and it also investigates the steps that were taken to prevent the recurrence of such incidents in the future.
How the Fraud Was Committed
According to Raver (2006), Enron Corporation had shown certain signs of cracks in its walls from the very beginning: it retained large amounts of debts in its foundation, due to the deregulation of the gas pipelines. In an attempt to find a solution to the company’s revenue and credit issues, Kenneth Lay, the company’s CEO, enlisted the assistance of Jeff Skilling, a sharp and young finance and banking consultant. Eventually, Lay got impressed for being able to persuade Skilling to join the company that grew to become a leading market middleman of energy, eventually dominating in trading energy contracts. In addition, Skilling hired the most astute and sharp business people he was able to persuade to join his new team. As a result, Skilling got Enron Company involved in buying and selling electrical futures; the company also began to deal with web-based commodities. That was a move that seemed to have brought an overnight success to the company. This was especially evidenced by the company’s stock value which skyrocketed (Raver, 2006). Following several years of what seemed to have been a huge success, more cracks started to appear within the company’s structure. Due to a thorough analysis, it was found out that a conspiracy amongst Lay, Skilling, and other executives resulted in the collapse of Enron because of fraud, shoddy accounting practices, false revenue reports as well as an overall disregard for business ethics.
What turned the company’s case into a major financial scandal was the way the company responded to its problems. As opposed to disclosing its accurate financial condition to the public investors according to the law’s requirements, Enron misrepresented its accounts. The company assigned business losses to special purpose entities and unconsolidated partnerships. In simple terms, the Enron’s public accounting statements pretended that there were no losses taking place. Additionally, Enron appeared to have masked loans from banks as energy derivatives trades in order to conceal the level of its indebtedness. These accounting fictions were hidden for almost eighteen months but, when they were finally revealed, and the right accounting statements issued, more than 80% of the earnings reported in 2000 had vanished. Thus, Enron quickly collapsed. The unexpected fall of such a huge company, as well as the corresponding losses in jobs, market confidence and investor wealth, were an indication of how serious the flaws in the American securities regulatory system (based on the accurate and full disclosure of financial information, which market participants require to make knowledgeable investment decisions) were.
The accounting of Enron was considered to be fairly straightforward until Skilling joined the company and began to demand an adoption of the mark-to-market accounting which, according to him, would help reflect the company’s true economic value. Consequently, Enron became the initial non-financial firm to utilize such a method for accounting its complicated long-term contracts. The adoption of this accounting method was seen as a major contributor to the Enron scandal. According to mark-to-market accounting, once a long-standing contract has been signed, the estimation of income is performed according to the current value of the net future cash flows. According to Healy and Krishna (2003), the viability of the contracts and their associated costs were often found to be hard to judge. Because of the huge inconsistencies arising from trying to match the cash and profits, investors were usually given misleading reports. The method enabled the company to record incomes from projects, even if they had not received the money. This consequently inflated the financial profits on the books. Nonetheless, in the future years, earnings could not be included; therefore, additional and new income had to be incorporated from additional projects in order to develop further growth in order to appease the investors (Healy & Krishna, 2003). In spite of the probable pitfalls, the American Securities Exchange Commission endorsed Enron’s accounting method in January 1992, in the trading of natural gas futures contracts. The company later expanded the use of its accounting method to other areas.
Special Purpose Entities
The use of special purpose entities was another cause of the scandal. Special purpose entities are limited companies or partnerships that are created to accomplish a specific purpose. Enron chose to use these entities to fund risks associated with particular assets. The company chose to reveal minimal details regarding its utilization of these entities. The firms were financed by debt financing and independent equity investors; but they were formed by a sponsor. The use of the entities involved more than simply circumvent accounting meetings. On account of one violation, the balance sheet of Enron understated its liabilities while, at the same time, overstating its equity and earnings. Examples of such entities include LJM, Chewco, JEDI etc. (Healy & Krishna, 2003).
How the People Involved in the Enron Scandal were Eventually Caught
Following investigations into the Enron scandal, conducted by financial auditors in conjunction with the law enforcement agencies, several executives of the company were indicted. Jeffrey Skilling, who was the company’s ex-CEO, was convicted of twenty eight counts of conspiracy, fraud, insider trading as well as speaking lies to auditors regarding his attempt to fool investors into thinking that Enron Company was doing well financially. Consequently, the court sentenced him to twenty four years and four months of imprisonment.
Another person involved in the scandal was Ken Lay, the founder and former chairman of Enron. He was charged with eleven counts of criminal offenses, such as conspiracy and fraud among others. He did not plead guilty to all of the charges, claiming that he was ignorant of the fraud schemes and blaming his junior managers, as well as other colleagues, for misleading him. Lay mostly blamed Fastow, Enron’s former chief of finance, for the company’s fall. Lay was convicted of six counts of wire and securities fraud. He was sentenced to forty-five years in prison. Nevertheless, prior to the commencement of the sentence, Lay passed away following a heart attack in July, 2006. Lay’s death happened when SEC was demanding over $90 million from him, in addition to civil fines.
Fastow, together with his wife, also pleaded guilty to the numerous charges against them. Fastow was originally charged with ninety eight counts of crimes including fraud, insider trading, conspiracy, and money laundering among others. He pleaded guilty to two conspiracy charges, which led to his imprisonment for ten years. Lea, Fastow’s wife, on the other hand, was indicted with six counts of felony, although the judges later dropped all of them in support of one misdemeanor tax charge. The result was one year sentence for assisting her husband conceal revenues from the government.
The Enron scandal cannot be discussed completely without mentioning how Arthur Andersen, the firm’s accountant, was involved in the scandal and the consequent crash of the company. According to Cable News Network (2002), the officers working under Andersen, when asked if they were accountable for the scandal, maintained that the company’s fall resulted from the direct effect of its faulty business models, as opposed to its poor accounting practices. However, Raver (2006) maintained that a closer assessment of facts revealed otherwise, following an investigation of the company’s scandal by law enforcement agencies and auditors. As Cable News Network (2002) stated, the courts found Andersen guilty of negligence, deleting company files and emails, obstructing justice, conspiring to create false financial reports, thus hiding large amounts of debts as well as artificially increasing stock prices past the limit. An investigation regarding Andersen also revealed that he was responsible for tearing up numerous documents, which stated the correct extent of the Enron’s financial problems, thus making it possible for the fraud to continue. However, the American Supreme Court later overturned Andersen’s conviction, owing to the jury not being appropriately instructed regarding the charge against him. Accordingly, Andersen was set free to resume his operations, though his reputation was already tarnished too much. In the end, the Enron scandal brought about the scrutiny of the entire US accounting system.
Steps Taken To Ensure such an Incident Does Not Recur
The accounting and financial scandal that took place in the Enron company in 2001 had far-reaching impacts on the company and American citizens in general. Something had to be done to prevent a recurrence of a similar incident in the future. Consequently, the American Congress passed the Sarbanes-Oxley Act of 2002, which contained extensive amendments to the securities laws. The Act included the following provisions:
- The act provided for the creation of a new oversight board to control public traded companies’ independent auditors.
- It increased auditor independence by banning auditors from offering some consulting services to their customers and necessitating pre-approval by the board of directors of the client for non-audit services (Jickling, 2003).
- The Act also necessitated leading audit and corporate management committees to be more involved in making sure that financial statements were accurate (Jickling, 2003).
- It also improved the disclosure requirements of some transactions, such as stock sales, conducted by corporate insiders as well as transactions involving unconsolidated subsidiaries.
- The Act directed SEC to implement rules in order to avert conflict of interest, which impacts on the stock analysts’ objectivity (Jickling, 2003).
- It permitted $776 million for SEC during the 2003 financial year and required the commission to have more frequent assessments of corporate financial reports.
- The Act also increased the punishment for various offenses linked to securities fraud like destruction of records, wire and mail fraud and misleading auditors among others (Jickling, 2003).
Enron Corporation, an American energy corporation located in Houston, Texas, was established by Kenneth Lay in 1985 following a merger between Houston Natural Gas and InterNorth. The company experienced a scandal that came to the limelight in October 2001, resulting in its bankruptcy and subsequent collapse. The scandal impacted the lives of not only the company’s stakeholders, but everyone in the United States. It compelled people to look at themselves and realize the effects of their breakage of laws and reckless greed. The Enron scandal should be a wake-up call to all Americans to be vigilant and not to let a similar occurrence affect the lives of more people in the future.