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The Enron Scandal

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Aditya Matam

on 10 June 2014

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Transcript of The Enron Scandal

The Enron Scandal
History
Kenneth Lay,
the CEO of Houston Natural Gas
Was formed from the merging of two companies in July 1985 (8)
InterNorth
+
Houston
Natural Gas
=
Enron
became chairman and CEO of Enron (8)
About Enron
Enron started out selling natural gas to consumers
After government deregulation, they decided to move on to sell futures (8)
The government reduces the restrictions on that industry (8)
Before Deregulation
After Deregulation
Government controlled energy industry
Businesses could open plants and compete for customers
From here, they became the 7th largest company in the U.S. to include over 21,000 workers in over 40 countries(8) and worth $70 billion (7)
What they did wrong
They wanted their company to look financially better so they created various SPEs to hide the debt
It did this by making Enron look like it did not have a debt when it really did
Special Purpose Entities
These are seperate business entities that a business creates in order to borrow more (16)
By selling these SPEs some assets belonging to the company, the SPE can take larger loans at a lower rate than the business itself could because the SPEs do not have any previous debts or owe any money (16)
HOWEVER
If Special Purpose Entities are used properly, the business will not have to record any debts taken on by their SPE on the business financial statements (16)
How they did it
Enron did a number of things to successfully "offload" their debt to the SPEs...
A business deal was made,
Enron sold the stake in the deal to one of their SPEs
The SPE would use this as a security to get investments
Investments that Enron would use for their business
Since this "asset" was sold to the SPE, Enron would not have to include it in their balance sheet
BUT
If the deal went sour, and resulted in money loss, then Enron would not have to include it on their balance sheet either
Thus hiding debt
...at least temporarily
Who was to blame
Andrew Fastow
Became Chief Financial Officer of Enron in 1990
.
Was the person behind the setting up of the different SPEs (7)
.
Fired from Enron in 2001 after Enron's first losses were reported (7)
.
Agreed to a plea bargain that reduced his sentence to 10 years in prison and while agreeing to repay 23 million dollars (7)
.
Kenneth Lay
Became chairman and CEO (Chief Executive Officer of Enron after the merger between Houston Natural Gas and InterNorth (8)
.
Was the CEO of Enron during the years when it was suspected of illegal accounting practices
.
Was convicted of fraud and conspiracy in 2006 (17)
.
Died of a heart condition shortly after his appeal (10)
.
David Duncan
Employed by Arthur Anderson (an accounting firm), he was the chief Enron auditor (9)
.
Was responsible for ordering the destruction of over a tonne of documents related to Enron (7)
.
How it negatively impacted Enron
Enron over-estimated the potential revenue for the deal using a technique called
mark-to-market accounting
Mark-to-Market accounting is when a business records its assets at the current market value (5)
Since Enron was expanding into newly deregulated markets, the real market value was not easy to determine
As a result, Enron could vastly overestimate the revenue of deals even though they were highly unlikely to make that much money
Originally plead guilty to obstruction of justice, he withdrew this plea when Anderson's conviction was overturned and was not convicted (10)
.
Jeffrey Skilling
Was originally the Chief Operating Officer, and president of Enron (9)
.
Became the CEO of Enron in 2001 (9)
.
Resigned later that year, resulting in suspicion about Enron (7,9)
.
Convicted of conspiracy, fraud, and insider trading, and sentenced to 24 years in prison (10)
.
GAAP Violations
Enron guaranteed its SPEs with its stock
A guarantee is a promise to pay the debt that the SPE owed (16)
This way, if the SPE was unable to pay the debt, the guarantor would give the SPE the resources to do so (16)
This meant that as long as Enron's stock continued to stay high, the SPEs would be able to pay their debts
But if Enron's stock fell, then the SPEs would require more from Enron to be able to repay the debts
This meant that as long as Enron's stock fell, Enron would have to pay the SPEs more for them to repay the debt
How they got caught
An executive at the company, Sherron Watkins, saw that the company could implode and sent a letter to Ken Lay (9)
This letter was used as evidence later when the trials started (9)
This would in turn lead to money flowing away from Enron, and lower stock prices
Shortly afterwards, in the wake of the dot com bust in 2001, Enron's stock started to fall
Enron saw the rising internet markets as an opportunity to make more money
This rush to the internet led to a huge bubble that collapsed, leading to many bankrupt companies
Due to the nature of the SPE partnerships in Enron, this led to huge losses
Source: BBC
Soon, Enron realized the scale of the problem
This led them to bring some of their SPEs into their main account (8)
Because of this, they started to show massive losses, the kind that they had been hiding all along (8)
Soon afterwards, the SEC (Securities and Exchange Commision) announced that it had started to investigate Enron (8)
This is how they did it:
This led to Enron expanding their business into the internet
Although SPEs were legal, the way Enron used them were unethical, as it led investors to believe Enron was performing better than it was
Enron did many things wrong as a company
Among these were their violations of the GAAPs (Generally Accepted Accounting Principles)
The Cost Principle
This states that the accounting entries must be made at the cost price to the purchaser
BUT
Using Mark-to-Market accounting, Enron made up bogus revenue numbers
Enron would also book deals as profit, even though in reality, they hadn't made a penny in revenue (like the Blockbuster deal) (15)
Enron made a deal with the movie company Blockbuster in 2000
This deal was aimed at providing customers with an opportunity to stream movies to their television (15)
This deal ultimately failed, reaching a peak with only a few thousand viewers who were not paying any money (15)
This didn't stop Enron from claiming $110.9 million in profits (15)
The Materiality Principle
States that the business must disclose any information that is important in determining the finances of the company
This means that the business cannot hide any information that would prevent people from seeing the net income, or the financial position of the company
BUT
Enron did exactly this, as the SPEs that they used were specifically designed to hide debt and cover losses
When they merged some of their SPEs with the business when Enron started to fail, the financial statements looked drastically different
They went from showing hundreds of millions in profit to showing $618 million in debt (8)
The Principle of Conservatism
This rule says that accountants must be fair and reasonable, not overstating profits to make the company look good
BUT
Enron used Mark-to-Market accounting to vastly overstate the value of deals
This goes against the principle as Enron was making deals look more profitable than they actually were
In the Enron scandal, the person behind the setting up of the various SPEs was Andrew Fastow, the CFO (7)
After news of the scandal broke
Enron's stock had already been reduced from almost $100 a share to $33 a share (8)
But news of the investigation removed any chance that the shares might rise again (8)
As more and more investors left the company, Enron could no longer pay its debts and declared Chapter 11 bankruptcy in 2001, with stock worth less than a dollar per share (8)
There are different types of bankruptcy
Since Enron is an American company, it follows American bankruptcy laws
In Chapter 11 Bankruptcy, the company gets a temporary shelter from creditors, and is given time to restructure in order to be able to pay them off later
How executives made money off of it
By using these unethical accounting practices, Enron's stock became very high
The executives, who received millions in stock options, cashed it in while the stock was high (7)
This led to the people at the top of Enron walking away with hundreds of millions of dollars (7)
How others fared
Due to the 401k pension plan, employees lost all of their pensions
This was a pension plan that involved the employees tying their pension to the company's stock (1)
This way, if the stock went up, the employees' pensions would increase as well
But in the case with Enron, if the company ends up collapsing, Employees can lose all of their pensions
In addition, due to the Enron bankruptcy, 20,000 employees lost their jobs (7)
About $3.2 billion in pensions and retirement funds was lost (7)
Because of this, there were many convictions of Enron executives (7)
Investors lost billions of dollars as well
Enron today
Laws since Enron
Due to Enron's collapse, there were some policy changes in the U.S.
401k Plan was capped (1)
This was done because Enron's employees lost all of their pensions upon its collapse
This was to protect employees from losing all of their pensions in the future
.
.
Power granted to supervising bodies increased (3)
Agencies like the FERC (Federal Energy Regulatory Commission) gained more power to fine, and supervise companies (3)
.
This was done so that in the futute, companies could be more effectively monitored so they didn't end up like Enron
.
This led to public disgust
Due to the scandal, more people believe that large corporations are dishonest about their dealings (2)
Enron still exists today
Though it does not do any business
The few workers who remain are employed solely to liquidate as much of the company as possible to repay creditors
Source: BBC (8)
The End
New legislation limited the amount of money that employees could invest in the plan
.
An accounting firm, it was responsible for auditing Enron
It was considered to be one of the top 5 accounting firms
Enron received approval for their shady practices from Anderson
One of their top partners, David Duncan, shredded a tonne of material related to Enron
They were found guilty of obstructing justice, and were almost destroyed by the conviction
A judge later overturned the conviction, and although it didn't make things much better for the firm, their employees could at least declare innocence
Full transcript