Kovaleva Mary Assignment 3. Enron scandal Rise of the company Enron was an American energy company based in Houston, Texas. It was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth.
In 1985, Kenneth Lay merged the natural gas pipeline companies of Houston Natural Gas and InterNorth to form Enron. In the early 1990s, he helped to initiate the selling of electricity at market prices and, soon after, the United States Congress passed legislation deregulating the sale of natural gas.The resulting markets made it possible for traders such as Enron to sell energy at higher prices, thereby significantly increasing its revenue. After producers and local governments decried the resultant price volatility and pushed for increased regulation, strong lobbying on the part of Enron and others was able to keep the free market system in place. In just 15 years, Enron grew from nowhere to be America’s seventh largest company, employing 21,000 staff in more than 40 countries. In an attempt to achieve further growth, Enron pursued a diversification strategy.The company owned and operated a variety of assets including gas pipelines, electricity plants, pulp and paper plants, water plants, and broadband services across the globe. The corporation also gained additional revenue by trading contracts for the same array of products and services it was involved in.
As a result, Enron’s stock rose from the start of the 1990s until year-end 1998 by 311% percent. By December 31, 2000, Enron’s stock was priced at $83. 13 and its market capitalization exceeded $60 billion. Demise of the companyBut the firm’s success turned out to have involved an elaborate scam. Enron lied about its profits and stands accused of a range of shady dealings, including concealing debts so they didn’t show up in the company’s accounts. As the depth of the deception unfolded, investors and creditors retreated, forcing the firm into Chapter 11 bankruptcy in December. The problems started when Jeffrey Skilling was hired. He developed a staff of executives that, through the use of accounting loopholes, special purpose entities, and poor financial reporting, were able to hide billions in debt from failed eals and projects.
Chief Financial Officer Andrew Fastow and other executives not only misled Enron’s board of directors and audit committee on high-risk accounting practices, but also pressured Andersen (the auditor) to ignore the issues. The main CEOs involved in the scandal Kenneth Lee “Ken” Lay was an American businessman, best known for his role in the widely reported corruption scandal that led to the downfall of Enron Corporation. Lay and Enron became synonymous with corporate abuse and accounting fraud when the scandal broke in 2001.Lay was the CEO and chairman of Enron from 1985 until his resignation on January 23, 2002. He took a regional natural gas pipeline business and turned it into a energy conglomerate with a market capitalization of $70 billion, betting the future on unregulated energy markets. Jeffrey Skilling was hired by Lay in 1990 as chairman and chief executive officer of Enron Finance Corp. In 1991, he became the chairman of Enron Gas Services Co. , which was a result of the merger of Enron Gas Marketing and Enron Finance Corp.
Skilling was named CEO and managing director of Enron Capital & Trade Resources, which was the subsidiary responsible for energy trading and marketing. Andrew Fastow was one of the key figures behind the complex web of off-balance-sheet special purpose entities (limited partnerships which Enron controlled) used to conceal their massive losses. The causes of the downfall As already been said, Enron scandal was caused by financial misconducts, unethical practices, misrepresenting information and so on. Finally it spiraled out of control and ended up with the bankruptcy of the company.No I suggest going deep into details of Enron’s fraudulence. 1. Wrong revenue recognition. Besides its main activity, which involved building and maintaining electric power plants, natural gas pipelines, storage, and processing facilities, Enron, as other energy suppliers, earned profits by providing services such as wholesale trading and risk management.
Enron instead of using the conventional “agent model” for reporting revenue (where only the trading or brokerage fee would be reported as revenue), elected to report the entire value of each of its trades as revenue.This “merchant model” approach was considered much more aggressive in the accounting interpretation than the agent model and enabled Enron to increase its revenue by more than 750%, rising from $13. 3 billion in 1996 to $100. 8 billion in 2000. This extensive expansion of 65% per year was unprecedented in any industry, including the energy industry which typically considered growth of 2–3% per year to be respectable. For just the first nine months of 2001, Enron reported $138.
7 billion in revenues, which placed the company at the sixth position on the Fortune Global 500. . Mark-to-market accounting. In Enron’s natural gas business, the accounting had been fairly straightforward: in each time period, the company listed actual costs of supplying the gas and actual revenues received from selling it.
However, when Skilling joined the company, he demanded that the trading business adopt mark-to-market accounting, citing that it would reflect “… true economic value. ” Enron became the first non-financial company to use the method to account for its complex long-term contracts.Mark-to-market accounting requires that once a long-term contract was signed, income was estimated as the present value of net future cash flows. Often, the viability of these contracts and their related costs were difficult to judge. Due to the large discrepancies of attempting to match profits and cash, investors were typically given false or misleading reports.
While using the method, income from projects could be recorded, although they might not have ever received the money, and in turn increasing financial earnings on the books.However, in future years, the profits could not be included, so new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor pointed out, “If you accelerate your income, then you have to keep doing more and more deals to show the same or rising income. ” Despite potential pitfalls, the U. S. Securities and Exchange Commission (SEC) approved the accounting method for Enron in its trading of natural gas futures contracts on January 30, 1992.
However, Enron later expanded its use to other areas in the company to help it meet Wall Street projections. For one contract, in July 2000, Enron and Blockbuster Video signed a 20-year agreement to introduce on-demand entertainment to various U. S. cities by year-end. After several pilot projects, Enron recognized estimated profits of more than $110 million from the deal, even though analysts questioned the technical viability and market demand of the service. When the network failed to work, Blockbuster pulled out of the contract.
Enron continued to recognize future profits, even though the deal resulted in a loss. 3. Using “Special purpose entities” Andrew Fastow, who was already mentioned as one of the Enron’s CEOs, designed a complex web of companies that solely did business with Enron, with the dual purpose of raising money for the company, and also hiding its massive losses in their quarterly balance sheets.
This effectively allowed Enron’s audited balance sheet to appear debt free, while in reality it owed more than 30 billion dollars at the height of its debt.While presented to the outside world as being independent entities, the funds Fastow created were to take write-downs off Enron’s books and guaranteed not to lose money. Enron used special purpose entities—limited partnerships or companies created to fulfill a temporary or specific purpose—to fund or manage risks associated with specific assets. These shell firms were created by a sponsor, but funded by independent equity investors and debt financing. In total, by 2001, Enron had used hundreds of special purpose entities to hide its debt.Mainly SPEs was created for the purpose of buying Enron’s poorly performing stocks and stakes to improve its financial statements, and was funded not by sponsor (Enron), but equity investment and debt financing so that Enron could get extra money from nothing. Enron made a habit of booking costs of cancelled projects as assets, with the rationale that no official letter had stated that the project was cancelled.
This method was known as “the snowball”, and although it was initially dictated that snowballs stay under $90 million, it was later extended to $200 million. 62] In 1998, when analysts were given a tour of the Enron Energy Services office, they were impressed with how the employees were working so vigorously. In reality, Skilling had moved other employees to the office from other departments (instructing them to pretend to work hard) to create the appearance that the division was bigger than it was.
 This ruse was used several times to fool analysts about the progress of different areas of Enron to help improve the stock price.