What Is The Enron Scandal?
The Enron Scandal involves Enron duping the regulators by resorting to off-the-books accounting practices and incorporating fake holding. The company utilized special purpose vehicles to hide its toxic assets and large debts from the investors and creditors.
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The Enron corporation was formed to merge Houston’s natural gas company and inter-north incorporation. After the merger, it grew rapidly and was regarded as the most innovative company. However, it resorted to bad accounting practices. It was involved in the creation of special purpose vehicles, utilized to hide the rising debt of the Enron incorporation, which led to the business’s failure and downfall.
Table of contents
Enron Scandal Explained
The Enron corporation and its management resorted to an evil scheme and malpractice of the off-balance-sheetOff-balance-sheetOff-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet. However, they tend to impact the financials of the company indirectly.read more mechanism. It created a special economic vehicle to hide the massive debt from its external stakeholders, namely creditors and investors. The special purpose vehicle was utilized to conceal the realities of accounting rather than focus on the operating results.
The corporation transferred some portion of assets that had rising marketable value to the special economic vehicle, and in return, it took cash or notes. The special purpose vehicle then utilized such stock to hedge an asset present on its balance sheet of Enron. It ensured that a special purpose vehicle reduced the counterparty riskCounterparty RiskCounterparty risk refers to the risk of potential expected losses for one counterparty as a result of another counterparty defaulting on or before the maturity of the derivative contract.read more.
The formation of the special purpose vehicles cannot be termed illegal, but compared with the securitization techniques relating to debt, it could be termed as bad. Enron disclosed the existence of special purpose vehicles to the investors and the public, but few people understood the complexity of transactions done using the special purpose vehicles.
Enron assumed that the stock prices would continue to appreciate and that they would not deteriorate or fail as hedge funds. The primary threat was that the special economic entities were capitalized with only the corporation’s stock. If the corporation is compromised, then the special economic entities won’t be able to hedge the deteriorating market price of such stocks. Additionally, the Enron corporation had held significant conflicts of interest concerning the special purpose vehicles.
Causes
Though every step that the Enron Corporation took went against it, there were specific reasons that made it worse for the business.
Let us have a look at them:
- The creation of a special purpose vehicle for concealing financial losses and a pile of financial debt;
- Mark-to-market accounting as an accounting concept is an excellent method to value securities, but such a concept becomes a disaster when applied to the actual business.
- Lapse of corporate governanceCorporate GovernanceCorporate governance is a set of rules or practices through which an entity is directed and controlled to increase shareholders wealth by increasing the economic value and is concerned about its relations with various entity stakeholders.read more in Enron Corporation.
Mark To Market (MTM)Accounting in Enron Scandal
The CEO of Enron corporation Jeffrey Skilling transitioned the accounting practice of the Enron corporation from a historical cost accounting method to a mark to market accounting method. Mark to market accounting is a practice that reports the fair market value of the liabilities and assets for a given duration or financial period. The transition of the accounting practice received approval from the securities and exchange commission in 1992.
The mark to market gives insights into an institution and is regarded as a legitimate practice. The method, however, is also exposed to some form of manipulation. The Mark to market is based on fair value rather than taking up the actual value. It caused the business to fail miserably as they reported the expected profits as the actual profits.
Rise
The scandal began with Enron’s misdeeds in the video rental chains. The business collaborated with a blockbuster to penetrate the VOD market. After entering the market, the business overstated the earnings basis for the growth of the VOD market.
The business executed $350 billion in trades, but it did not last long as the dot com bubble came in. It spends a significant amount on broadband projects, but the business could not recover costs from the spending made. The company was exposed to massive exposures, and investors lost money as market capitalization deteriorated.
In 2000, the business started to crumble. CEO Jeffrey Skilling concealed all financial losses resulting from the trading business and broadband projects by applying the accounting concept of mark-to-market accountingMark-to-market AccountingMark to Market Accounting means recording the value of the balance sheet assets or liabilities at current market value to provide a fair appraisal of the company's financials. The reason for marking certain market securities is to give an accurate picture, and the value is more relevant than the historical value.read more. The company kept building assets. It reported profits that were yet to be earned. If the actual profit earned were less than the reported earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more, the loss was never reported. Additionally, the business transferred the asset to the off-the-books corporation. Like this, the corporation concealed its losses
To add to the agony, the chief financial officer of the business Andrew Fastow deliberately resorted to the plan that displayed that the business was in good financial shape even though its subsidiaries lost many investors’ money.
Summary With Timeline
The Enron corporation was regarded as a corporate giant. The corporation had massive debts in its name. It tried to conceal these with the help of special economic entities and special purpose vehicles. But after a good run, it failed miserably and ended up as a bankrupt business. The failure and bankruptcy of the Enron Corporation jolted Wall Street and put several employees on the verge of aThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more financial crisisFinancial CrisisThe term "financial crisis" refers to a situation in which the market's key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more. Enron traded at the highest market price of $90.75 on December 2, 2001. And when the accounting scandalAccounting ScandalAccounting Scandals refer to situations which demonstrate intentional falsification or misrepresentation of financial documents. Some of the most famous ones are by Enron, Freddie Mac, HealthSouth, & American Insurance Group etc. read more emerged, stock prices went down to a record low of $0.26 per share.
The summary along with the timelines is as follows:
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#1 – Business Background
The year was 1985, and Enron was incorporated as Houston Natural Gas company, and Internorth Ince merged. In 1995, the business was recognized as the most innovative business by Fortune, and it made a successful run for the next six years. In 1998, Andrew Fastow became the CFO of the business, and the CFO created SPVsSPVsA Special Purpose Vehicle (SPV) is a separate legal entity created by a company for a single, well-defined, and specific lawful purpose. It also serves as the main parent company's bankruptcy-remote and has its own assets and liabilities.read more to conceal the financial losses of Enron. During the period 2000, the shares of Enron traded at the price level of $90.56.
#2 – Initial Ripples
On February 12, 2001, Jeffrey Skilling came in place of Kenneth as a chief executing officer. On August 14, 2001, Skilling abruptly resigned, and Kenneth took over the role again. Same period, the broadband division of the business reported a massive loss of $137 million, and the market prices of stock fell to $39.05 per share. In October, the CFO’s legal counsel instructed auditorsAuditorsAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws.read more to destroy the files of Enron and asked to maintain only the utility or necessary information. The business reported a further loss of $618 million and a write-off of $1.2 billion. The price of the stock deteriorated to $33.84.
#3 – Fall of Giant
On October 22, the business got under a probe by the securities and exchange commission. With this news, the stock of Enron further deteriorated and was reported at $20.75. In November 2001, the business, for the first time, admitted and made the revelation that it had inflated its income levels by $586 million. Also that it has been doing so since 1997. On 2nd December 2001, the business filed for bankruptcy, and the stock prices ended up flat at $0.26 per share.
#4 – Criminal Probe
On January 9, 2002, the justice department ordered a criminal proceeding against the business. On January 15, 2002, the NYSE suspended Enron, and the accounting firm, along with Arthur Andersen, was convicted of obstruction of justice.
Importance
The Enron scandal is significant in learning perspectives for both new financial professionals and experienced professionals. The scandal tells us why strong corporate governance is the key to success for any business to sustain and drive profitable business. Additionally, it draws insights into how accounting policies should not be used and applied. Any misuse can have drastic results or impacts on the business’s health.
Due to the bankruptcy, employees lost several perks and pension benefits. Many came on the verge of a financial crisis. The crisis was so deep that the business shareholders lost an estimated value of $74 billion. Such corporate fraud should be taken as learning, and an understanding should be drawn as to why regulations and compliance are necessary.
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