Enron scandal
The Enron scandal was an accounting scandal sparked by American energy company Enron Corporation filing for bankruptcy after news of widespread internal fraud became public in October 2001, which led to the dissolution of its accounting firm, Arthur Andersen, previously one of the five largest in the world. The largest bankruptcy reorganization in U.S. history at that time, Enron was cited as the biggest audit failure.
Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, Lay developed a staff of executives that – by the use of accounting loopholes, the misuse of mark-to-market accounting, special purpose entities, and poor financial reporting – were able to hide billions of dollars in debt from failed deals and projects. Chief Financial Officer Andrew Fastow and other executives misled Enron's board of directors and audit committee on high-risk accounting practices and pressured Arthur Andersen to ignore the issues.
Shareholders filed a $40 billion lawsuit, for which they were eventually partially compensated $7.2 billion, after the company's stock price plummeted from a high of US$90.75 per share in mid-1990s to less than $1 by the end of November 2001.
The Securities and Exchange Commission began an investigation, and rival Houston competitor Dynegy offered to purchase the company at a very low price. The deal failed, and on December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until the WorldCom scandal the following year.
Many executives at Enron were indicted for a variety of charges and some were later sentenced to prison, including former CEO Jeffrey Skilling. Kenneth Lay, then the CEO and chairman, was indicted and convicted but died before being sentenced. Arthur Andersen LLC was found guilty of illegally destroying documents relevant to the SEC investigation, which voided its license to audit public companies and effectively closed the firm. By the time the ruling was overturned at the Supreme Court, Arthur Andersen had lost the majority of its customers and had ceased operating. Enron employees and shareholders received limited returns in lawsuits, and lost billions in pensions and stock prices.
As a consequence of the scandal, new regulations and legislation were enacted to expand the accuracy of financial reporting for public companies. One piece of legislation, the Sarbanes–Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders. The act also increased the accountability of auditing firms to remain unbiased and independent of their clients.
Rise of Enron
In 1985, Kenneth Lay merged the natural gas pipeline companies of Houston Natural Gas and InterNorth to form a multi-billion dollar company. Just a year later, they then changed the name to Enron. In the early 1990s, he helped to initiate the selling of electricity at market prices and soon after, Congress approved 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 asked for increased regulation, strong lobbying on the part of Enron and others prevented such regulation. Enron changed from being a natural gas producer and supplier to a trader of energy derivative contracts with the assistance of Jeffrey Skilling, who joined the company as a consultant before rising to the position of chief operating officer.As Enron became the largest seller of natural gas in North America by 1992, its trading of gas contracts earned $122 million, the second largest contributor to the company's net income. The November 1999 creation of the EnronOnline trading website allowed the company to manage its contracts trading business better.
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, paper plants, water plants, and broadband services across the globe. Enron also gained additional revenue by trading contracts for the same array of products and services it was involved.
This included setting up power generation plants in developing countries and emerging markets including the Philippines, Indonesia and India.
The bull market of the 1990s helped to fuel Enron’s ambitions and contributed to its rapid growth. Enron's stock increased from the start of the 1990s until year-end 1998 by 311%, only modestly higher than the average rate of growth in the Standard & Poor 500 index. However, the stock increased by 56% in 1999 and a further 87% in 2000, compared to a 20% increase and a 10% decrease for the index during the same years. By December 31, 2000, Enron's stock was priced at $83.13 and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market's high expectations about its prospects. In addition, Enron was rated the most innovative large company in America in Fortune's Most Admired Companies survey.
Causes of downfall
Enron's complex financial statements were confusing to shareholders and analysts. When speculative business ventures proved disastrous, it used unethical practices to use accounting limitations to misrepresent earnings and modify the balance sheet to indicate favorable performance.The combination of these issues later resulted in the bankruptcy of Enron, and the majority of them were perpetuated by the indirect knowledge or direct actions of Lay, Skilling, Andrew Fastow, and other executives such as Rebecca Mark. Lay served as the chairman of Enron in its last few years, and approved of the actions of Skilling and Fastow, although he did not always inquire about the details. Skilling constantly focused on meeting Wall Street expectations, advocated the use of mark-to-market accounting, accounting based on market value, which was then inflated, and pressured Enron executives to find new ways to hide its debt. Fastow and other executives "created off-balance-sheet vehicles, complex financing structures, and deals so bewildering that few people could understand them."
Revenue recognition
Enron earned profits by providing services such as wholesale trading and risk management in addition to building and maintaining electric power plants, natural gas pipelines, storage, and processing facilities. When accepting the risk of buying and selling products, merchants are allowed to report the selling price as revenues and the products' costs as the cost of goods sold. In contrast, an "agent" provides a service to the customer, but does not take the same risks as merchants for buying and selling. Service providers, when classified as agents, may report trading and brokerage fees as revenue, although not for the full value of the transaction.Although trading companies such as Goldman Sachs and Merrill Lynch used the conventional "agent model" for reporting revenue, Enron instead elected to report the entire value of each of its trades as revenue. This "merchant model" was considered much more aggressive in the accounting interpretation than the agent model. Enron's method of reporting inflated trading revenue was later adopted by other companies in the energy trading industry in an attempt to stay competitive with the company's large increase in revenue. Other energy companies such as Duke Energy, Reliant Energy, and Dynegy joined Enron in the largest 50 of the revenue-based Fortune 500 owing mainly to their adoption of the same trading revenue accounting as Enron.
Between 1996 and 2000, Enron's revenues increased by more than 750%, rising from $13.3 billion in 1996 to $100.7 billion in 2000. This expansion of 65% per year was extraordinary 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, placing the company at the sixth position on the Fortune Global 500.
Enron also used creative accounting tricks and purposefully misclassified loan transactions as sales close to quarterly reporting deadlines, similar to the Lehman Brothers Repo 105 scheme in the 2008 financial crisis, or the currency swap concealment of Greek debt by Goldman Sachs. In Enron's case, Merrill Lynch bought Nigerian barges with an alleged buyback guarantee by Enron shortly before the earnings deadline. According to the government, Enron misreported a bridge loan as a true sale, then bought back the barges a few months later. Merrill Lynch executives were tried and in November 2004 convicted for aiding Enron in fraudulent accounting activities. These charges were thrown out on appeal in 2006, after the Merrill Lynch executives had spent nearly a year in prison, with the 5th U.S. Circuit Court of Appeals in New Orleans calling the conspiracy and wire fraud charges "flawed". Expert observers said that the reversal was highly unusual for the 5th Circuit, commenting that the conviction must have had serious issues in order to be overturned. The Justice Department decided not to retry the case after the reversal of the verdict.
Mark-to-market accounting
In Enron's natural gas business, the accounting had previously been fairly straightforward: in each period, the company listed the actual costs of supplying the gas and actual revenues received from selling it. However, when Skilling joined Enron, he demanded that the trading business adopt mark-to-market accounting, claiming that it would represent "true economic value". Enron became the first nonfinancial company to use the method to account for its complex long-term contracts. Mark-to-market accounting requires that once a long-term contract has been signed, income is estimated as the present value of net future cash flow. Often, the viability of these contracts and their related costs were difficult to estimate. Owing to the large discrepancies between reported profits and cash, investors were typically given false or misleading reports. Under this method, income from projects could be recorded, although the firm might never have received the money, with this income increasing financial earnings on the books. However, because in future years the profits could not be included, new and additional income had to be included from more projects to develop additional growth to appease investors. As one Enron competitor stated, "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 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's end. After several pilot projects, Enron claimed estimated profits of more than $110 million from the deal, even though analysts questioned the technical viability and market demand for the service. The parties withdrew from the contract in March 2001, but Enron continued to claim future profits, even though the deal resulted in a loss.