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Enron: Questionable Accounting Leads to Collapse

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    Enron: Questionable Accounting Leads to Collapse

    The Enron Corporation was established by integrating two major gas pipelines in 1985. The Company provided products and services related to natural gas, electricity, and communications and it was one of the world’s leading organizations at these sectors with claimed revenues of nearly $101 billion in 2000. Throughout the 1990s, Chair Ken Lay, chief executive officer Jeffrey Skilling and chief financial official officer Andrew Fastow transformed Enron from an old style electricity and Gas company into a $150 billion energy company. However, after the bankruptcy of Enron, it was revealed that Enron used accounting loopholes, special purpose entities and poor financial reporting to hide billions of debts from failed deals and projects.

    And it was found that top executives of Enron were involved in this accounting fraud which led Enron to bankruptcy. In addition, Enron’s corporate culture also contributed to its demise. The following essay is a study of Enron’s case and an attempt to find out what went wrong for Enron. This essay would try to analyze the role of Enron’s culture, the role of its bankers, auditors and the role of chief financial officer Andrew Fastow to its bankruptcy.

    The Contribution of Enron’s Corporate Culture to Enron’s Bankruptcy: In general culture means the sum of social behaviors, beliefs, attitudes, human thoughts and creations. It affects every aspect of our lives—the way we look at things, the way we act and react and how we express our feelings (Wong). Corporate culture also indicates the same thing. Corporate culture or organizational culture has been defined as “the specific collection of values and norms that are shared by people and groups in an organization and that control the way they interact with each other and with stakeholders outside the organization.” (Charles & Gareth, 2001). Ethical and healthy competitive corporate culture can take a corporation to the peak of success; on the other hand, toxic corporate culture can lead a corporation to bankruptcy. Unfortunate to say that Enron’s corporate was not ethically healthy enough and it has contributed to push the company to bankruptcy. According to Enron Chairman Ken Lay, Enron’s ethics code was based on respect, integrity, communication, and excellence in short ‘RICE’.

    However, history does not say that moral sentiments like respect, integrity communication and excellence ever existed in Enron’s corporate culture. By criticizing Enron’s corporate culture Dembinski et al. defined ‘RICE’ as risk-taking, individualism, contempt and exploitation. William Thomas describes Enron as characterized by ‘individual and collective greed born in an atmosphere of market euphoria and arrogance’ (2002, p. 41). People usually describe Enron’s corporate culture by the word ‘arrogant’. Enron’s executives loved to believe that there is no competitor for Enron. They frequently used to quote that Enron’s people could handle increasing risk without danger. The reason behind the behavior of executives was that they might want to make their employees confident on their work. However, ‘confidence’ and ‘over confidence’ has very little difference. Overconfidence makes people to underestimate opponents’ strength.

    Enron’s executives became overconfident. According to Sherron Watkins, “Enron’s unspoken message was, ‘Make the numbers, make the numbers, make the numbers—if you steal, if you cheat, just don’t get caught. If you do, beg for a second chance, and you’ll get one.’” Enron’s corporate culture did little to promote the values of respect and integrity. Enron employed top MBA graduates from high ranked business schools of USA by offering rapid promotions and financial incentives. The ultimate goal of the corporation was made to maximize the stock price and these MBA graduates were very familiar with this. The ethic of short term stock price maximization was promulgated ruthlessly and at any cost. Those who contributed to this goal were prized, on other hand, managers who were unable unwilling to create or fabricated profitable deals did not last long (Dembinski et al.). Moreover, Enron introduced a performance monitoring system where employees were rated every six months. Those who raked in the bottom 20 percent were forced to quit. This ranking system did not boost up the performance of the employees; rather it created a fierce environment where employees competed against rivals not only outside the company but also at the next desk. Delivering bad news could result in the ‘death’ of the messenger, so problems in the trading operation, for example, were covered up rather than being communicated to management. Enron’s corporate culture failed to sustain the organization because it lacked any method of contractual enforcement. Enron’s ethic gave managers no rational justification for choosing ‘honor trust’ over ‘abuse trust’.

    The Contribution of Enron’s bankers, auditors, and attorneys to Enron’s demise: ‘High risk accounting, inappropriate conflicts of interest, extensive undisclosed off-the-books activity, and excessive compensation’ these are some of the headings of the report prepared by the U.S. Senate’s Permanent Subcommittee on Investigations titled “The Role of the Board of Directors in Enron’s Collapse.” (Permanent Subcommittee on Investigations,2002). Enron continuously used partnerships, called ‘special-purpose entities’ (SPEs) with the help of its bankers and auditors to move assets and debts off its balance sheet and to increase cash flow by showing that funds were flowing through its books when it sold assets. Most SPEs were fabricated entities. Enron created them from their own money maintained control over them.

    If any entity failed to meet the obligations, Enron covered them from their own stock. So long Enron’s stock price was high, this accountancy practice worked. However, as the stock price fell, cash was needed to meet shortfall, and gradually this type of accountancy directed Enron to bankruptcy (Ferrell et al. pp. 421) The US security and Exchange commission found that the bankers of Citigroup and J.P Morgan helped Enron Corporation to manipulate its financial statements. Each institution helped Enron mislead its investors by characterizing what were essentially loan proceeds as cash from operating activities (US Securities and Exchange Commission). The voluminous third interim bankruptcy report in the Enron bankruptcy, by court-appointed examiner Neal Batson, is explicit in detailing the bankers’ role in Enron’s fraud, replete with names, internal memos, phone conversations, faxes, sworn testimony, and e-mails. In addition, the final report of Neal Batson revealed that bankers from Barclays, Canadian Imperial Bank of Commerce, Deutsche Bank, and Merrill Lynch also knew about and participated in Enron’s schemes. The conclusion of the story is that Enron was failing terribly. The company needed a path to get cash to maintain its investment grade credit rating. It owed banks like Citigroup and J.P. Morgan, billions of dollars. Hence, the banks needed Enron on race.

    The ultimate result is ‘Off-balance-sheet special-purpose entities (SPE)’, some masterpieces from sophisticated financial engineering–and highly aggressive accounting to understate debt and overstate cash flow (Levinsohn, 2003). Enron’s auditor, Arthur Andersen was responsible for ensuring the accuracy of Enron’s financial statements and internal bookkeeping. Anderson’s reports were used by potential investors to judge Enron’s financial soundness and future potential before they decided whether to invest and by current investors to decide if their funds should remains invested there. These investors would expect that Anderson’s certification were independent and without any conflict of interest. However, Anderson was found guilty of obstruction of justice in March 2002 for destroying Enron-related auditing documents during an SEC investigation of Enron. The reason behind why Anderson auditors failed to ask Enron to better explain why its complex partnerships before certifying Enron’s financial statements was that Anderson was unduly influenced by the large consulting fees Enron paid it. Enron’s attorneys did a crime by approving illegal transactions. Kenneth Lay, the Chairman and the CEO of the company said that he believed that the transactions were legal because they were approved by attorneys and accounts.

    The role of CFO, Andrew Fastow, in creating Enron’s financial problems: Enron practiced controversial accounting to cover losses from appearing on its statements. And the chief financial officer, Andrew Fastow, was the brain behind the accounting duplicity. To hide the true financial condition of Enron Corporation, Andrew Fastow utilized his position in creating unconsolidated partnerships and ‘special purpose entities’, which later became popularly known as the LIM partnership. Taking advantage from the SPEs’s main purpose, which provided the companies with a mechanism to raise money for various needs without having to report the debt in their balance sheets, Enron’s CFO directly ran these partnerships and designed them to purchase the underperforming assets (such as Enron’s poorly performing stocks and stakes). ).

    Although being recorded as related third parties, these partnerships were never consolidated so that debt could be getting off its balance sheet and the company itself could boost and have not had to show the real numbers to stockholders. Andrew Fastow was using SPEs to conceal some $1 billion in Enron debt and this led directly to Enron’s bankruptcy. Overall, according to Enron, Fastow made about $30 million from LJM by using these partnerships to get kickbacks which were disguised as gifts from family members who invested in them and enriching himself. His manipulation of the off-balance-sheet partnerships to take on debts, hide losses and kick off inflated revenues while banning employees’ stock sales was one of the reasons triggered the collapse of the company and its bankruptcy. “Fastow entered his plea in a federal court in Houston and agreed to serve a 10-year prison sentence and to cooperate with authorities. He had been facing a 98-count indictment and an April trial date.

    He also agreed to surrender $23.8 million as part of the arrangement, most of which has already been frozen in various accounts.” (CNN Money). It is also proved in the investigation that Andrew Fastow helped committing accounting fraud by the use of off the books partnerships to hide billions of dollars in debt and artificially boost the company’s profits. The crucial challenge for Enron was to enter burgeoning deregulated energy markets without sacrificing its credit rating by carrying too much debt on the books. Hence, Fastow used his creative but conning brain. He increased his staffs to 3 times by employing many bankers and giving them the task of selling and buying capital risk. “They were all young kids, 28 to 32, with great pedigrees, and they started coming up with these fancy derivatives,” says Houston lawyer Tom Bilek, who interviewed dozens of former Fastow associates before suing Enron’s management. “But Fastow was the boy genius setting all these SPEs up.” (Saporito, 2002). Conclusion:

    Enron is a sad example of how an arrogant culture that rewards high performance and gets rid of ‘weak links’ can back fire. Enron spread a culture where employees competed against outside as well as with their colleagues. This created a culture where ethics and loyalty cast aside in exchange for high performance. The Enron Code of Ethics and its foundational values of respect, integrity, communication, and excellence obviously did little to help create an ethical environment at the company. However, all the explanation of Enron’s ethical collapse is still to have a concluding opinion as legal proceedings continuing. Fourteen top level Enron employees were found guilty to various charges; 12 of them were awaiting sentencing, while the other two, one of whom is Andrew Fastow’s spouse, have received prison sentences of at least one year. In conclusion, it is obviously proved that Enron’s toxic corporate culture inspire top level executives to practice illegal accountancy to hide losses of the corporation which eventually led Enron to bankruptcy. References:

    Charles W. L. Hill, and Gareth R. Jones, (2001) Strategic Management. Houghton Mifflin. CNN Money, ‘Fastow and his wife plead guilty ‘, viewed 23 January, 2012, Dembinski P, Lager C, Cornford A & Bonvin J, “Enron and World Finance A Case Study in Ethics”, Palgrave Mcmillan, viewed 21 January, 2012 Ferrell O.C., Fraedrich J, Ferrell L, ‘Business Ethics: Ethical Decision Making and Cases’, 8th Ed., South Western Cengage Learning, pp. 419-428 Final Interim Report of Neal Batson, 2003, viewed 22 January, 2012, Levinsohn, 2003, ‘Bankers’ complicity in Enron’s fraud’, Money Library, viewed 23 January, 2012, Saporito B, 2002, ‘How Fastow Helped Enron Fall’, Time Business, viewed 23 January, 2012, Third Interim Report of Neal Batson, 2003, viewed 22 January, 2012 Thomas, W. C. (2002) ‘The Rise and Fall of Enron’, Journal of Accountancy (April), pp. 41–8. US Securities and Exchange Commission, ‘SEC Settles Enforcement Proceedings against J.P. Morgan Chase and Citigroup’, viewed 22 January, 2012 < http://www.sec.gov/news/press/2003-87.htm> Wong, P, “Lessons from the Enron Debacle: Corporate Culture Matters!”, International Network on Personal Meaning, viewed 20 January, 2012

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