ACLC College of Tacloban

Tacloban City, Leyte 6500, Philippines

Department of Business Management and Accountancy

The Fall of Enron Corporation:

A Case Study Report

Submitted to:
Mr. Jude M. Ubalde
Instructor

Submitted by:
Karyl Hingpes
Ivy Suzette Docil
Jasmine Joy Cabelin
Jonvic Ambal
 CHAPTER I
INTRODUCTION

Enron was named as “The Most Innovative” company in the United States by Fortune
Magazine for 6 consecutive years and Enron placed No. 18 overall on the list of the nation's
535 "Most Admired Companies" and ranked among the top five in "Quality of Management,"
"Quality of Products/Services" and "Employee Talent." The business kept constructing
power plants and running gas lines, but its distinctive trading enterprises helped it gain
greater recognition. In addition to purchasing and selling energy and gas futures, it gave rise
to entirely new markets for peculiar "commodities" like weather forecasting and broadcast
time for marketers’ futures as well as Internet capacity.

One of the biggest fraud scandals in the history of the globe is Enron Corporation.
The company was compelled to file for bankruptcy in December 2001 as a result of the fraud
investigations. Enron Corporation was "a provider of products and services in natural gas,
electricity and communication to wholesale and retail costumers". Omaha, Nebraska, is
home to Enron Corporation's founding. Huston, Texas-based Houston Natural Gas and Inter
North combined to form an energy firm in 1985. The business established the first pipeline
infrastructure for natural gas in the country. After learning that oil traders in New York had
overextended the company's accounts by nearly one billion dollars, Ken Lay, the former
CEO of Houston Natural Gas, was named chairman and chief executive officer of the new
energy company in 1986. The company worked out its loss to 142 million dollars in 1987.
Enron immediately reduces the risk of pricing fluctuations by creating new services as a
result of the loss. After a year, Enron Corporation established its first foreign office in
England. Senior officials were informed of the company's new strategy, which involved
pursuing unregulated markets through regulated pipeline operations. When Jeffry Skilling
joined Enron Corporation in 1989, he created Gas Bank, a program that allowed natural gas
buyers to lock in long-term supplies at set pricing. The company also began financing oil and
gas producers at the same time. In 1992, Enron Corporation began pushing for expansion in
South America by purchasing Transportadora de Gas del Sur. After a year, Enron's
Teesside power plant in England started up, marking the first achievements of the
company's global strategy. The company traded energy for the first time in 1994, and during
the following few years, it became one of Enron's main revenue streams. Enron joined the
European wholesalers’ market in 1995 as a subsidiary of Enron Europe, establishing a
trading facility in London. In India, work on the Dabhol power plant began in 1996. But the
project would be beset by political issues, and in 2001 Enron decided to put the project up
for sale. Enron acquired Portland General Electric Corporation, a utility serving Portland,
Oregon (USA), after a year. The utility would later be sold to Northwest Natural Gas Co. for
roughly 1.9 billion dollars in 2001. In the same year, Enron Energy Services was established
to offer energy management services to business and industrial clients. Enron persisted in
its strategy of purchasing businesses, and in 1998 it bought Wessex Water in the UK, which
served as the foundation for its water company Azurix. However, the company's issues
surfaced in 1999 when a third of Azurix sold to the public, causing the shares to plummet
drastically following an initial surge. Enron Online, the company's website for trading
commodities, launched that same year. Enron energy services turned its first profit in the last
quarter of the year. In 2000, Enron's yearly earnings surpassed one hundred billion dollars,
indicating the increasing significance of trading. But when Enron announced its plan to take
the subsidiary private, Rebecca Mark resigned as chairwoman of Azurix due to the
company's ongoing issues. Based on market capitalization, The Energy Financial Group
placed Enron as the sixth-largest energy firm in the world that same year. In April of 2001,
Enron revealed that it had acquired 570 million dollars from the bankrupt California utility
Pacific Gas & Electric Co. Even though the top executives were probably aware of the debt
and the unethical business activities, the deception was not made public until Enron
acknowledged in October 2001 that the company's true value had been estimated at 1.2
billion dollars less than previously stated. The Securities and Exchange Commission
launched an investigation in response to this issue, and the findings exposed numerous
degrees of dishonesty and unlawful activities carried out by senior Enron officials,
investment banking partners, and the company's accounting firm, Arthur Anderson. Enron's
stock closed at $8.63 per share at year-end, a decrease of 89% from the start of the year.
The scandal's pivotal dates are November 8, 2001, and October 16, 2001. Accounts of
Enron actually did not reflect the company's real level of debt at the time. (Seied Beniamin
Hosseini and Dr, 2016).
Upon receiving formal approval from the Securities and Exchange Commission,
where the Boards had applied, the firm subsequently opted to employ the mark-to-market
accounting approach. Income can be computed as an estimate of the present value of net
future cash flow according to this new Enron accounting methodology, which allows a
business to change the value of its balance-sheet assets from their historical value to the
current fair market value (FMV). Wherein the worth of the contract that has been signed by
Enron for years will be recorded in its book even there is no certainty that the unrealized gain
and realized gain would match which allowing them to create larger current earnings.

In addition, the company's troublesome operations were moved to companies known

as special purpose entities (SPEs), which are effectively limited partnerships established
with external parties. Despite the fact that many businesses gave assets to SPEs, Enron
took advantage of the arrangement by employing SPEs as repositories for its distressed
assets. By moving those assets to SPEs, Enron was able to keep them off its books and
downplay the severity of its losses. Furthermore, as management acquired the accounting
method of the off-balance sheet, the company did not limit its uses, resulting in showing
exaggerated assets and fewer liabilities, that banks will charge highly leveraged companies
more to borrow money since they are thought to be more prone to miss payments, and that
a healthier-looking balance sheet will probably draw in more investors. Enron then engaged
in derivative transactions with these organizations in order to protect volatile assets from
quarterly financial reports and manipulate the value of certain Enron properties.

With its poorly constructed compensation, the senior managers became increasingly
focused on rewards and began manipulating accounting standards to generate the
necessary profits to solidify their bonuses and stock options, which also led to inaccurate
financial reporting practices. The need for its independent auditor to give a reasonable
opinion about its financial reporting was defeated by fraud, for it was also rewarded by
money. Enron's expansion of business was also unrealistic, setting success without
considering the risk and length of the contract. Along with these issues, it was approved by
its higher-ups. Considering the earnings of the company, the boards and CEO did not do
anything, even if they were aware of the situation, which clearly shows poor corporate
governance. Consequently, business executives started to depend on questionable
accounting methods as a result of pressure from shareholders. According to Watkins, who
write for Fraud Magazine, there are warning signs at Enron that should have been alerted
but the company choose to ignore and these includes; state of risk management, tone at the
top, stock option overuse, diffusion of responsibility, exceptions to the rules allowed,
impeded internal communications and internal conflict of interest (Team, 2022).
 CHAPTER II
UNETHICAL ISSUES

Enron went to great lengths to enhance its financial statements, hide its fraudulent
activity, and report complex organizational structures to both confuse investors and conceal
facts. The causes of the Enron scandal include, but are not limited to, the factors below.

Enron’s Off-Balance Sheet Method

The off-balance-sheet arrangement was one of the primary violations of Generally
Accepted Accounting Principles (GAAP) that led to the Enron Corporation's collapse.
Furthermore, the specific purpose of the Enron Corporation (as cited in e.g., Anson 1999;
Evans, 1996) was to increase financial flexibility, lower the cost of borrowing from creditors,
reduce the tax portion, maximize profitability, and adequately improve the company's
financial health, as noted by (Angbazo, 1997; James, 1989; Shevlin, 1987). In addition,
Enron's actual financial aim in utilizing the off-balance sheet was to conceal losses and debt
from auditors, investors, financial analysts, and regulators.

On top of that, in November 2001, Enron Corporation announced plans to

consolidate the financial statements by restating $586 million in earnings prior to the period
using the accounting principles of obscuring losses and debt under the applicability of the
off-balance-sheet method, as mentioned in the research work of (Kahn, 2002; Henry, 2002).
As a result of Enron Corporation's inability to publicly disclose billions of dollars in debt held
by off-balance sheets (OBSEs), auditors required greater transparency in the financial
statements (Chandra, Ettredge, & Stone, 2006).

Enron’s Derivatives Manipulation

The Enron Corporation's second major violation of Generally Accepted Accounting
Principles (GAAP) was derivative manipulation, which escalated from $1.8 billion to $10.5
billion. Enron's management team used specialized financial tactics to conceal losses in the
derivatives section; likewise, investment and commercial banks alerted investors of Enron's
underwriting issues that arise. For example, some of the most important credit agencies,
Moody's, Standard & Poor's, and Fitch/IBC, failed to disclose Enron's financial difficulties
because Enron paid each credit agencies large sums of money by ignoring to notify Enron's
investors of such existing financial problems.

Consequently, the law firms that represented Enron profited significantly from
derivatives contracts (Albrecht, Albrecht, Dolan, & Malagueno, 2008). Derivatives are
financial contracts whose value is determined by the underlying asset, which can be
commodities, stocks, or bonds. Furthermore, the derivatives were controlled by investors in
the market, and the manipulation took place both internally and externally on Enron's
organizational environment by trading large amounts of income. For example, in 2000,
Enron recorded a gain of more than $16 billion via derivatives. Likewise, since 1997, Enron
traders planned to manipulate derivatives in the utility financial market industry with the
intention of concealing losses ("Derivatives," 2002).

The Role of Mark-to-Market Accounting

Enron Corporation relied heavily on the mark-to-market method as an accounting
fraud principle, which violated the Generally Accepted Accounting Principles. Mark-to-market
accounting is a method of evaluating a long-term contract using fair market value. At any
point, the long-term contract or asset could fluctuate in value; in this case, the reporting
company would simply "mark" its financial records up or down to reflect the prevailing market
value.

Additionally, the Enron Corporation was subject to external governance because

Enron had to report to organizations such as government regulators, private entities, audit
analysts in the equity sector, and some other agencies. Jeffrey Skilling and Andrew Fastow
were the pioneers in adopting the mark-to-market method in the Enron Corporation by
pumping up the stock price and covering major losses while continuing to attract major
capital investment, which was both illegal and immoral. Therefore, the U.S. Securities and
Exchange Commission (SEC) allowed Enron Corporation to use the mark-to-market
accounting method.

For Enron, mark-to-market accounting allowed the firm to recognize its multi-year
contracts upfront and report 100% of income in the year the agreement was signed, not
when the service would be provided or cash collected. Enron’s unrealized gains (as cited in
Thomas, 2002) were $1.41 billion reported as a pretax profit in 2000, and one-third was
reported as a pretax profit in 1999. Therefore, one of the major causes of Enron’s fall was
the U.S. Securities and Exchange Commission (SEC), allowing Enron Corporation to use, at
its best capacity, the mark-to-market accounting method (Li, 2010).

Special Purpose Vehicles

Enron created a complex organizational structure leveraging special-purpose
vehicles (or special-purpose entities). These entities would "transact" with Enron, allowing
the company to borrow money without showing it as debt on its balance sheet.

SPVs provide a legitimate strategy that allows companies to temporarily shield a

primary company by having a sponsoring company possess assets. Then, the sponsor
company can theoretically secure cheaper debt than the primary company (assuming the
primary company may have credit issues), as stated in Investopedia. This structure provides
legal and tax benefits. However, Enron crosses the line of illicit activity, breaching the U.S.
GAAP.
The main problem with Enron was a lack of transparency about its utilization of
SPVs. The corporation would transfer its stock to the SPV in exchange for cash or a note
receivable. The SPV would then use the stock to hedge an asset against Enron's balance
sheet. When the company's shares began to lose value, they no longer provided sufficient
collateral to be used by an SPV.

Inaccurate Financial Reporting Practices

Enron inaccurately depicted many contracts or relationships with customers. By
collaborating with external parties such as its auditing firm, it was able to record transactions
incorrectly, not only in accordance with GAAP but also not in accord with agreed-upon
contracts. For instance, Enron recorded one-time sales as recurring revenue. In addition, the
company would intentionally maintain an expired deal or contract through a specific period to
avoid recording a write-off during a given period.

Poorly Constructed Compensation Agreements

Many of Enron's financial incentive agreements with employees were driven by short-
term sales and quantities of deals closed (without consideration for the long-term validity of
the deal). In addition, many incentives did not factor in the actual cash flow from the sale.
Employees also received compensation tied to the success of the company's stock price,
while upper management often received large bonuses tied to success in financial markets.
 Part of this issue was the rapid rise of Enron's equity success. On Dec. 31, 1999, the
stock closed at $44.38. Just three months later, it closed on March 31, 2000 at $74.88. With
the stock hitting $90 by the end of 2000, the massive profits some employees received only
fueled further interest in obtaining equity positions in the company.

Lack of Independent Oversight

Many external parties learned about Enron's fraudulent practices, but their financial
involvement with the company likely caused them not to intervene. Enron's accounting firm,
Arthur Andersen, received many jobs and financial compensation in return for their services.
Investment bankers collected fees from Enron's financial deals. Buy-side analysts were often
compensated to promote specific ratings in exchange for stronger relationships between
Enron and those institutions.

Unrealistic Market Expectations

Both Enron Energy Services and Enron Broadband were poised to be successful due
to the emergence of the internet and heightened retail demand. However, Enron's over-
optimism resulted in the company over-promising online services and timelines that were
simply unrealistic.

Poor Corporate Governance

The ultimate downfall of Enron was the result of overall poor corporate leadership
and corporate governance. Former Vice President of Corporate Development Sherron
Watkins is noted for speaking out about various financial treatments as they were occurring.
However, top management and executives intentionally disregarded and ignored concerns.
This tone from the top set the precedent across accounting, finance, sales, and operations.
In the early 1990s, Enron was the largest seller of natural gas in North America. Ten years
later, the company no longer existed due to its accounting scandal.
 CHAPTER III
SOLUTION

1. The Sarbanes-Oxley Act of 2002 was enacted after several financial scandals occurred,
including the Enron scandal. To prevent the misuse of Special Purpose Vehicles (SPVs) for
fraudulent activities, the Sarbanes-Oxley Act of 2002 was implemented to enhance
corporate governance and financial disclosure of companies. Section 401 of SOX requires
the entity's financial statements to be accurate and reflect any off-balance liabilities,
transactions, or obligations of the company to refrain deceptive accounting practices.
Additionally, section 409 mandates companies to disclose significant changes in their
financial position or operations, such as acquisitions, divestments, and major personnel
departures, in clear and unambiguous terms. Through this act, investors are better
safeguarded from fraudulent organizations like Enron Corporation.

2. To mitigate inaccurate financial reporting practices, section 404 of the Sarbanes-Oxley Act
mandates companies to include in their annual reports a management assessment report on
the effectiveness of the company's internal controls for financial reporting. External auditors
are also required to attest to and report on the effectiveness of these internal controls. This
external audit provides independent verification and assurance to users of financial
information regarding the accuracy and reliability of the company's financial reporting
processes.

3. Mark-to-market accounting is a valuation method that assesses assets and liabilities at

their current market value rather than their historical cost. Although common in the financial
industry, proper utilization of this method is essential, unlike the misapplication by Enron
Corporation. Firstly, identify the assets and liabilities requiring valuation using mark-to-
market accounting, such as securities, loans, and other financial instruments. Then, gather
necessary market data, including current market prices, interest rates, and other influencing
factors to determine the fair value of these assets and liabilities. Utilize the collected market
data to calculate the fair value by applying current market prices and essential data
accurately. Subsequently, update the financial statements to reflect the fair value, potentially
recognizing gains or losses in the income statement and adjusting the balance sheet
accordingly. Lastly, ensure disclosure in the financial statements regarding the use of mark-
to-market accounting, the valuation methods employed, and any significant impacts on the
company's financial position. Regular monitoring and updating of asset and liability
valuations using mark-to-market accounting are crucial to ensure that the financial
statements reflect the most current market values accurately and are not overstated.

4. The Fair Labor Standards Act is a pivotal federal law in the United States that plays a
crucial role in safeguarding employees from unfair compensation practices by establishing
minimum wage standards, overtime pay requirements, and other protections to ensure fair
compensation for their work. This act sets the federal minimum wage required to be paid to
covered non-exempt employees, guaranteeing fair remuneration. Additionally, the FLSA
necessitates covered non-exempt employees to receive overtime pay at a rate of at least
one and a half times their regular rate of pay for hours worked beyond 40 in a workweek,
ensuring fair compensation for extra work hours. Moreover, the FLSA mandates employers
to maintain accurate records of employees' working hours, wages, and other pertinent
information to ensure compliance with wage and hour laws.
5. The Securities and Exchange Commission (SEC) plays a critical role in detecting,
investigating, and addressing fraudulent activities that lead to unrealistic market
expectations. To assess the extent of fraudulent activities causing unrealistic market
expectations, the SEC conducts thorough investigations to gather evidence, which includes
reviewing entity financial statements, trading patterns, and other relevant information. Upon
finding sufficient evidence of fraudulent activities, the SEC may take enforcement actions
against individuals or companies involved. These actions encompass civil enforcement
actions, administrative proceedings, or criminal charges, depending on the severity of the
violations. The SEC also possesses the authority to impose sanctions and penalties on
those found guilty of fraudulent schemes, such as fines, disgorgement of ill-gotten gains,
injunctions, and other corrective measures. Via these actions, the SEC aims to preserve
market integrity, protect investors, and uphold trust and confidence in the financial markets.

6. To enhance corporate governance, the transformation must commence within the

company. The company must ensure that the board of directors is independent, diverse, and
actively engaged in overseeing the company's operations. It is crucial to establish clear
responsibilities, roles, and governance structures for the board to effectively monitor
management and make strategic decisions. Additionally, transparency should be improved
by enhancing the disclosure of financial information, executive compensation, and
governance practices to provide users of financial information with accurate and timely
information about the company's performance and governance practices. Furthermore, the
company should develop and enforce a code of conduct and ethical standards to guide the
behavior of employees, executives, and board members that will promote a culture of
integrity, honesty, and ethical decision-making throughout the company.
 CHAPTER IV
CONCLUSION

Enron Corporation was once hailed as the most innovative company in the US.
Enron’s rise was fueled by unique trading practices and expansion strategies, from
constructing power plants to trading energy globally. However, the company’s downfall was
marked by massive fraud that led to the biggest accounting scandal and the company’s
eventual bankruptcy.

Enron’s operations were at their peak with the help of Jeffrey Skilling, who was
Enron’s CEO at the time. Under Skilling’s leadership, Enron Corporation became a trader in
energy derivative contracts, acting as an intermediary between natural gas producers and
their customers. With the agreements, producers could reduce the risk of energy price
fluctuations by fixing the selling prices of their products with Enron’s fee agreement. As a
result of these activities, Enron dominated the market for natural gas contracts and the
company began to generate large profits from its transactions.

As Enron’s competition in the energy business increased, the company’s profits

declined rapidly. This forced the company’s management to rely on questionable accounting
practices, including “mark-to-market accounting”, to hide the problems. Mark-to-market
accounting allowed the company to write off unrealized future profits on some trading
contracts to the income statement, giving the illusion of higher current profits.

In addition, Enron’s use of special purpose vehicles (SPVs), some of which were
owned by its CFO, Fastow, allowed Enron to transfer its distressed assets to these SPVs to
keep them on its books and in his presentation. Significantly lower number of losses; and the
use of these special purpose vehicles also allowed Enron to borrow money without showing
it as debt on the balance sheet, leading to illegal activity that violated US GAAP.

The gravity of the situation began to emerge. The SEC and many analysts delve into
Enron’s activities, revealing the biggest accounting scandal of all time. The Enron scandal
involved fraudulent accounting practices, off-balance sheet transactions, manipulation of
derivatives, and unrealistic market expectations. Enron used inaccurate financial reporting
practices, inaccurately described contracts, and kept outdated contracts in place to avoid
spoilage.

Enron’s unethical practices highlighted mismanagement, lack of oversight, and

misleading financial statements. To address such problems, the Sarbanes-Oxley Act of 2002
was introduced to improve corporate governance and financial disclosure to prevent financial
scandals such as the Enron accounting scandal.
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