Enron Business Model and Mark-To-Market Accounting - Research Paper Example

Enron and number submitted Contents Background 3 Review of Enron business model 4 Mark-To-Market Accounting 5 Special purpose Entity (SPE) 5 Culture, legal and moral implication 5 Cultural implications 5 Moral Implications 6 Ethical Implications 7 Legal Implications 8 Compensation system 9 Legislative Changes due to the Collapse of Enron 9 Stock exchange regulation 10 Disclosure Requirements 11 Stock Options Accounting 11 Correlation between Enron and recent collapses 11 Key Players: Past, Present and Future 14 References 18 Background Enron was launched in the year 1985 after the acquisition of Houston Natural Gas by Inter North. It quickly became one of the largest commodity firms across America. Although the core areas of the business giant was power distribution and transmission, the quick rise was led by its various interests across related and unrelated sectors (Bartlett & Glin­ska, 2001). The firm diversified into many fields over next few decades, and some of the big non-energy sectors included risk management, internet bandwidth, weather derivatives, communications and natural gas, electricity and pulp and paper firms. The company regularly featured into the most innovative firms categories across America (McLean & Elkind, 2003).  The first investigations was of their complex and private networking with off-shore partners and then into their accounting practices. Enron bankruptcy is also known as largest audit failure in the history of America. The bankruptcy further led to the Arthur Andersen’s dissolution, which at that time were world’s fifth largest accountancy and audit partnerships. Before Enron bankrupted in the year 2001, its annual revenues increased from around 9 billion dollars in 1995 to more than 100 billion dollars in 2000. The audit after the investigation revealed that the company’s financial conditions were covered largely by systematic, institutionalized as well as creatively planned ethical and accounting fraud (Deli & Gillan, 2000). Thomas (2002a) examined the drop of the stock prices of the firm, which was less than 1 dollar per share by 2001 from 90 dollars per share, before the investigation. It was also found that Enron revised its annual financial statements over the past five years in order to cover its 586 million dollar losses. It was declared bankrupt on 2nd December, 2001 (Bartlett & Glin­ska, 2001). The current research paper will analyze the event’s details included conflicts in interests, management as well as accounting fraud. The analyzing will consist of both corporation’s perception and individual’s perception. The broader perspective of the research paper is to examine the scandal from multiple perspectives. The background of the paper has provided a summary of the scandal and situation of the company before and after the scandal. The paper will throw light on the business model that was implemented by Enron and culture, legal and moral implications of the business model that impacted the company in its later stages. Special light on the transformational and trait leadership in Enron will be analyzed while discussing the key players of Enron (McLean & Elkind, 2003). An analysis of the culture of Enron will help in identifying the two contrasting ethical systems of mixed deontology and egoism. The reason for the fall of the company will be discussed in detail, focusing on ethical and accounting fraud. The final section of the research paper will examine the various policy responses by the government after the scandal. The research paper will also examine the various correlations between Enron and recent collapses that occurred in the Wall Street. Finally the research paper will discuss the key players that were directly involved in the fraud, those who committed suicide and the fate of the convicted employees in the scandal. Review of Enron business model The business model of Enron was acquiring each markets physical capacity and then leveraging those investments by creating more flexible and bendable pricing structures for the different market participants and market shareholders. This was done by the use of pricing derivatives for risk management. The expertise and systems acquired by the company, especially in the field of gas trading was leveraged into new market acquisition. The company assumed a unique trading model which helped in continuous growth of the company during its diversification from pure-energy based firm to broad-based commodity and financial service provider (McLean & Elkind, 2003). After establishing itself as an energy giant, the company took over every aspect of their supply chain and integrated them into their decision making process. This included pipelines for natural gas, power marketing, allowance trading, coal mining and coal trading. As a result, the basic business models used for energy and coal trading was revamped with the entry of Enron. During its early stages, Enron was basically a combination of two sectors, energy supply and financial institution. The former was involved in purchase of electric power plants and pipelines for providing energy and the latter was into wholesale dealing as well as derivative transactions of financial derivatives and energy products. Having the crucial knowledge of wholesale dealing and order flow, the company had a competitive advantage over other big firms in these sectors (McLean & Elkind, 2003). Mark-To-Market Accounting Market-to-market accounting was incorporate by Enron during the mid 1990s for its energy trading branch. It was used in an unprecedented manner for the energy trading transactions. This rule, whenever Enron has derivative or energy related contract on its quarter ending financial balance sheet, it had the power to adjust the numbers to market value that was considered fair and this was done by booking unrealized losses or gains to that period’s income statement. While a major disadvantage of the policy it the risk in terms of the future of the long-term contracts, the rule helped Enron in developing valuation models on the basis of their own methods and assumptions (Deli & Gillan, 2000). Special purpose Entity (SPE) The assets accumulated by the firm were majorly financed though debt structures and as a result, it lead to a debt-to-equity ratio and that particularly high. Enron was able to hide this high ratio from its investors through unique partnerships called SPE (special purpose entities). As a result, the investor’s sentiments for the firm were positive even after the company was in a high debt situation. A SPE is a trust set up by a firm with the objective of holding some assets of the firm. The company implemented SPE arranged by Citigroup for assessing capital and hedging risks. The limited partnerships helped Enron to increase its leverage and ROA (return on assets) without reporting debt. The account principles were pushed to new heights and the company used hard liabilities and assets as well as complex financial derivatives and other financial instruments for capitalizing the risks (Niskanen, 2005). Culture, legal and moral implication Cultural implications The internal culture of Enron was described as arrogant and making employees believe that greater risks could be taken without any dangerous encounter. The overall corporate culture of the company was almost negligent towards promotion of integrity respect and similar values (Leeds, 2003). Enron highly emphasized on decentralization and its compensation and performance appraisal programs were complex and showcased its cultural and ethical inconsistency. The business units and divisions of Enron were separate and distinct from each other and interaction was very little (Niskanen, 2005). As a result, internal communication was minimal and the top management controlled all aspects of decision making and business strategies. Information and communication process was top-down approach without any suggestion from the middle and lower management. The financial and operational control was insufficient where a handful of top management consisting of chairman, board of directors and chief operations, financial and executive officers controlled the entire operations and financials (Leeds, 2003). The audit committees, lawyers and accountants were incapable of any control. The performance appraisal process was also threatening and rigorous and used peer evaluation for punishing the underperformers and even firing them. As a result, employees intentionally ranked their colleagues lower so that their position is secured in the firm (Harvard Business Review, 2013). Moral Implications Lack of trust: As discussed above, the moral implications which resulted in the loss of trustfulness originated from the lack of transparency from the Enron management. The major motive of the senior executives at Enron was to protect its reputation as well as compensation system and as a result evade full disclosure (Harvard Business Review, 2013). The selling of the stocks was told to the employees at the very last minute and even there was no evidence of the company’s sudden turnaround days or weeks before the notice. Only after the start of the investigation the stakeholders came to know about the sell-off of the stocks by the CEO of the company (Leeds, 2003). This shows a lack of transparency both inside the organization as well as with the external investors. Conflict of interest: According to critics, lack of a critical and independent oversight and numerous conflicts in terms of personal and organizational interests led to the collapse of the firm. It has also been suggested that the compensation policies gave rise to a narrow-minded view of the stock price and earnings growth (Gillan & Martin, 2007). The role of Arthur Anderson can be explained as the biggest example in terms of conflict of interest in the firm. While Arthur’s role was that of an external audition, his relationship with the top management also made him an important external consultant to the firm. As a result, while Arthur gained substantial compensation as an external consultant to Enron, most of the audits were largely ignored. It also threw light on the influential role of reputation of a recognized auditor on the market prices of its clients. The management of Enron, especially the CEO knew that Anderson’s audit would have a high influence on Enron’s share price and market value and as a result he started establishing powerful but unethical relationship with the external auditor (Nelson, Price & Rountree, 2008). The reputation of Andersen was further damaged by the revelation that most of the correspondence and documents related to Enron were destroyed by the firm employees. As a result, not only Enron, the four biggest clients of Andersen faced negative market reaction (Mekay, 2003). Apart from the above, conflicts of interests were also found between two important internal members of Enron. These members were Rebecca Mark and Jeffrey Skilling, both having vastly different leadership styles. While Skilling focused on taking risks by acquiring huge assets and hiding the debts from external investors, Mark believed in developing assets in areas such as telecommunications, water and energy. As a result, while Mark with her employees was fully compensated for overseas projects, these projects were failing one after the other indebting the firm. Analysts have argued that Enron’s failure in America could be anticipated from its results overseas (Mekay, 2003). Ethical Implications Various ethical implications can be discussed which occurred due to the fraudulent activities by Enron’s top executives. The investigations and subsequent proven allegations proved that the top executives of Enron not only ignored the integrity, respect, excellence and communication that were integrated in Enron’s ethics code, they also manipulated the policies and ethical stances for personal gains. During the initial investigation into the inconsistency and incomprehensiveness of the company’s financial statements, the then-CEO Skilling was called to provide details and clarification. Instead, the CEO became agitated and questioning the authenticity of the investigator itself (Harvard Business Review, 2013). The unethical activities of the firm were not related to internal transactions only, but also included unethical activities outside the firm. This was done by influencing the rating agencies and auditors for maintaining a positive image in the market and keeping the investor sentiments high for Enron. The company established a special entity Enron and used it to increase the equity of shareholders. While this would result in decrease in almost 1.2 billion dollars of shareholder’s equity, Skilling ultimately forced the auditor, Anderson to remove the accounts from the balance sheet (Harvard Business Review, 2013). This resulted in a substantial decrease in the net worth of Enron’s shareholders. Two of the top management leaders Fastow and Skilling, were engaged in grave unethical activities. Fastow himself challenged the foundations and values of the firm. As trading companies are known to be volatile and highly rewarded, Fastow concealed its extensive deal with these trading firms. As high valuation in market was the only reason for Enron’s success in the market, all volatile earnings were off the book and the shareholders and investors money were put at high risk. Fastow was also responsible for operating as well as setting up partnerships with related parties and carry business with the company (Leeds, 2003). As a result, Fastow was exempted form the entire ethics code of the company and was allowed to use any means to gain short-term profits, risking the long term future of the company. Legal Implications Being a public company, Enron was exposed to various government sources. For creating a consistent profitable situation and keep investor’s confidence at maximum, the traders for Enron were forced to forecast low rate of discount and high cash flows on every long-term contract or bond with the firm. While profits were calculated on the basis of future profits, these profits were highly risky and the project long term income was overly inflated and optimistic (Sims, 2000). Using SPE (special purpose equity), Enron borrowed huge amount of money. These amounts were then used for balancing the overvalued contracts of Enron. As a result, the high valued loans as well as debt –obligated assets of Enron were changed into income. Also, the company kept transferring more and more stocks to its special equity partnerships. At the same time, these assets and debts purchased by special equities were shown in the financial reports of Enron. As a result, shareholders were misled about the healthy business environment of Enron, when in real the revenues were decreasing and debt was increasing. Some of the major SPE which led to the insolvency and bankruptcy of Enron are as follows; Chewco Investments  A special purpose equity named was established in the year 1997 so that CaIPERS, the California Pension fund, could join another investment portfolio of Enron, without having to leave the joint venture investment made in the year 1993. Through this SPE, Enron was able to guarantee its debt and keeping the losses off the company’s balance sheet. This was one of the major implications of the unethical and manipulation business transactions by Skilling. This arrangement between CaIPERS and Enron was discovered in the 2001 and the previous joint venture model between the above two was cancelled. As a result of this, the company’s reported earnings decreased by 405 million dollars and the indebtedness of the company rose by 628 million dollars. Whitewing Another SPE (special purpose entity) was used by Enron in its financial manipulation. Whitewing was found from funding of 500 million dollars from an outside investor and 579 million dollars from Enron. After two years, the arrangement of the entity was changed so that the figures are not counted under the balance sheet of Enron. This find from the entity was used for purchasing assets such as shares in power companies, stocks, pipelines and other financial investments. While these transactions were essentially loans, they were treated as assets which rose to 2 billion dollars by the end of 2000 (Klein, 2002). Compensation system While the objective of the performance management and compensation system of Enron was designed for retaining and rewarding its valuable employees, it turned the corporate culture dysfunctional which only focused on short-term earnings for maximizing bonus (Sims, 2000). Quality of profits or cash-flows was often disregarded, for a better performance review. Stock options were largely used as a compensation system. Extravagant spending were also common in the company as Skilling believed that employees worried about their pay and compensation would not be able to perform well. Legislative Changes due to the Collapse of Enron The fraud and subsequent collapse of Enron was a big blow to the energy and financial services market as Enron had become a market leader in both sectors. As a result, the company because substantially influential and used its powers to gain massive profits over inflated future profits and non-existent revenues. Due to the lack of a firm legislative and corporate policy, Enron was able to make extremely complex financial derivatives and securities portfolio; most of them were extremely difficult for analysts and auditors to decipher. Furthermore, Enron also manipulated its financial accounts by establishing new rules and policies in energy sector and financial markets, some of them being completely focused on providing high gains to the firm and compromising on the investor’s interests (The Library of Congress, 2003). After the scandal became a major public and financial issue, the housing, financial services, banking and urban affairs senate committee held multiple meetings from 2001 to 2002, searching for solutions for investor protection and minimizing accounting scandals (The Library of Congress, 2003). The corporate scandals led by Enron and similar other firms during that time led to the formulation and passage of Sarbanes-Oxley Act in the year 2002 (The Library of Congress, 2003). The act was called as Enron’s mirror image where the corporate governance failure of the firm was virtually acted in the fundamental provisions. Few of the major provisions from the act were establishing a public company with an oversight board for closely monitoring the activities of companies, developing standards in terms of audit report preparation, restricting firms from giving any non-auditing service while auditing, establishing more freedom and independence in terms of members of audit committee, mandatory signing on the financial reports by the executives, disclosure of the benefits and bonuses provided to the senior executives, more transparent financial disclosure in terms of company’s internal and external partnerships or any other unsolicited relationships Stock exchange regulation As a result of the increasing accounting violations as well as corporate malfeasances, the regulatory bodies at the stock exchange was changed and upgraded, recommended by SEC. New governance policies were announced in the year 2002 and were approved by SEC at the end of 2003 (The Library of Congress, 2003). Few of the important provisions were as follows; Independent directors should be majority in all companies All independent directors should comply with all criteria and definition provided by the policy The nomination committee, compensation committee as well as the audit committee must consist of a certain number of independent directors All members of the audit committee should fulfill the educational and literacy criteria set by the new guidelines. Apart from that, at minimum one audit committee member should pose financial management or accounting related expertise. Apart from having regular sessions, company boards should also conduct additional sessions and some of them without the management. Disclosure Requirements Various other provisions were added for strengthening the disclosure requirements on public firms. The new policy stated that all SPEs or off-balance sheet financial transactions should be disclosed in the quarterly and annual financial reports (Klein, 2002). Also, if a firm uses any form of financial derivatives to calculate the future profits based on expected revenues and sales, the firm must disclose financial statements on the basis of general accounting principles. Although insider trading is generally considered illegal, any legal trading by the firm directors or officers should be reported within two days (Bumgardner, 2003). Stock Options Accounting Stock options accounting is a controversial policy according to which stock options provided to employees and executives are in general not counter under company compensation expenditure. Enron utilized this loophole in the accounting policy and the employees and other executive members were hugely compensation with bonuses and benefits in the form of stock options, even though the company was going under huge debts (Bumgardner, 2003). In order to control this misuse of stock options accounting, the board for financial accounting proposed options expensing and disclosure of the stock options provided to the executives and employees. Also, a three year review was established where various proposals were made in order to control and regulate the stock options given to the executives and employees. Correlation between Enron and recent collapses The fall of Enron can be considered the beginning of the subsequent collapses occurring in Wall Street as well as other overseas markets. However, most of these bigger companies went bankrupt and were charged with fraud and market manipulation for almost similar reasons. A similar scandal occurred at WorldCom. The company was charged with fraud, account manipulation, business conspiracy and securities fraud. Similar to Enron, the CEO of WorldCom, Bernard Ebbers was largely held responsible for the fraud and pleaded guilty. The company filed for bankruptcy in 2002 July. Another communications firm, Quest was held for fraud and criminal activities in the year 2003. The sales director of Quest, was accused of establishing secret deals with the objective of increasing the overall revenues of the company. These deals were essentially illegal and were manipulated into the financial accounts. Also, the chief financial and executive VP (vice president) paid 250 million dollars to SEC in settlement (Public Affairs Television, 2014). The Tyco accounting scandal can be highly correlated to the Enron scandal. Tyco was a security systems firm based in New Jersey. The CFO (Chief financial officer) and CEO (chief executive officer) stole 150 million dollars from the company and inflated the income of Tyco by 500 million dollars. The money was siphoned through fraudulent sales of stock and unapproved loans. The money was also swiped out as executive benefits or bonuses. Manhattan D.A and SEC investigations revealed the questionable and illegal accounting practices. While the CEO and CFO were sentenced up to 25 years imprisonment, Tyco had to pay 2.92 billion dollars to its investors (Public Affairs Television, 2014). Adelphia Communications was a Pennsylvania based firm that was among five biggest cable firms across the US. However, the company went bankrupt in the year 2002 because of internal corruption. The founders of the company violated the securities policies and manipulated the financial accounts. Timothy and John Rigas were imprisoned for about 20 years and other directors were indicated. A complicated cash management and illegal system was made by the Rigases and funds were directed towards their private family-owned businesses (Public Affairs Television, 2014). Lehman Brothers was one of the biggest financial services company across the globe, controlling a substantial amount of financial assets and had a major influence on the financial markets across the US as well as other continents. The company disguised 50 billion dollars of loans as sales in order to show the good financial health of the firm (Thomas, 2002b). However, the fraud came into the eyes of regulatory bodied only after it went bankrupt, which is termed as the biggest bankruptcy in the history of the US. A very similar relation between Lehman and Enron was the power they had over other dependable companies and the top executives of the company were directly involved with the fraud. Another similarity is that both Enron and Lehman were rated high in terms of admired and innovative companies by well known rating agencies (Public Affairs Television, 2014). Bear sterns can be considered as the largest government bailout of a US company, which was essentially to avoid the rupture of the financial markets at that time. The company was charged with fraud, lying to the investors about the degrading financial strength and huge debts. The top executives were also charged with manipulating the financial market by influencing big companies and many big rating and auditing agencies. The company became almost bankrupt and was sold to JP Morgan Chase for 240 million dollars (Public Affairs Television, 2014). Changes to energy policy or prices that resulted from collapse While in power, Enron had an influential impact on the energy sector of the US. With big acquisitions and mergers, the overall composition of major energy firms across drastically, to a meager 10 in the year 2000 from 19 in the year 1990. This clearly indicated the impact of these firms on the energy prices or other policies across the US. One such situation occurring due to the collapse of Enron was electricity crisis in California. This electricity crisis was substantial and continued for almost two years, from 2000 to 2001. During this electricity crisis, entire California suffered from huge electricity supply shortage (Tracin­ski, 2002). This shortage was majorly due to illegal pipeline shutdowns and market manipulations by Enron as well as capping on the electricity prices. Large-scale and multiple blackouts occurred in the state after the collapse of the largest electricity firm and also impacted the economy of the state during that time (Tonge, Greer & Law­ton, 2003). Approval delays in the construction of new energy and power plants, drought as well as market manipulation resulted on significant decrease in the supply. As the power companies across California became bankrupt, the average wholesale prices of energy in terms of electricity increased to 800 percent in 9 months just before the announcement of Enron’s bankruptcy. Also, after the collapse of Enron, many associated and dependent businesses suffered huge losses due to continues rolling blackouts. This also caused a huge gap in demand and supply of local commodities (Thomas, 2002b). Before its collapse, Enron used to trade energy derivatives that were specifically exempted from most of the trading commission’s regulations. After the fallout of the largest energy firm, measures were taken in order to monitor and control the energy companies so that they do not mis-utilize the facilities and resources provided to them (Tracin­ski, 2002; Soxlaw, 2014). For instance, most of the companies were required to oversight, disclose and comply with the regulatory energy policies and regulations. Also, large oil companies were required to embed greater transparency in terms of their transactions, business with local and international clients as well as financial accounts. Also, the Supreme Court of the US ruled that the regulatory bodies in the energy sector had that power to negate any bilateral contract if they find that terms, prices or any condition in those contracts are unreasonable or unjust (Tonge, Greer & Law­ton, 2003). Key Players: Past, Present and Future Several key executives were sent to prison after the exposure of Enron fraud. They were charged for manipulating the stock prices and company’s earnings as well as lying to the employees and investors regarding the financial health of the firm. Some of them died, others committed suicide. Few have started a new journey while few are still serving their jail sentences. A review of the involvement, charges and present status of the key players directly involved with the company is given below; Jeff Skilling, CEO of Enron (February 2001- August 2001) Before taking over as chief executive officer, he was the COO (chief operating officer) and president of Enron. Skilling has been charged with insider trading and fraud and is currently serving a jail term of 24 years. While the former CEO is still fighting for innocence, his case been met with only failure so far. Another blow in his life came when his 20 year old son, John Taylor died in 2011 and Skilling could not attend the funeral (Financial News, 2011). Ken Lay Key lay was the chairman and chief executive of Enron from 1987 to February 2001 and was again made the CEO from August 2001 to January 2002. He was charged with 10 conspiracy and fraud counts in two different cases. Accordingly, he faced 165 years imprisonment. His sentence was due on 23rd October 2006 but in July 2006, he died due to a heart attack while skiing in Colorado. After his death, the court vacated his convictions (Financial News, 2011). Andrew Fastow Fastow was the CFO (Chief Financial Officer) of Enron from 1988 to 2001. He faced imprisonment of 10 years on charges of fraud, insider trading lying to employees. However, his imprisonment was reduced to six years because he cooperated with prosecutors. After his release, Fastow was on probation for two years. At present, Fastow is working as a full-time document-review clerk with the Houston-based Law firm that defended the former CFO in civil affairs during his sentence (Financial News, 2011). J. Clifford Baxter Baxter was the CSO (chief strategy officer) of Enron from 1992 to May 2001. In the year 2002, Baxter committed suicide after he was consistently subpoenaed by investigating committees. Sheron Watkins, the whistleblower, had named Baxter in the letter as a key executive who knew and complained regarding the unethical transactions occurring in the Enron accounts. He committed suicide just before he was about to provide crucial evidence against the company (Financial News, 2011). Lou Pai Pai served as the chief executive (CEO) of Enron Energy Services from 1997 to May 2001. While he resigned from his post before Enron went bankrupt, he had to pay 31-5 million dollars in disgorged profits and fined to SEC. This also included 6 million dollars which was forfeited previously for Enron shareholders benefit. After that, he founded a renewable energy firm called Element Markets which is currently the home to many former senior employees of Enron (Financial News, 2011; Business Insider, 2011). Rick Causey Causey was the COO (chief accounting officer) of Enron from 1999 to April 2002. He was charged with conspiracy and wiring fraud and was pleaded guilty. He went to prison in the year 2007 and was later released in the year 2011 after testifying against Skilling and Lay. At present, he is promoting himself as an independent and freelancer accounting professional (Financial News, 2011). Sherron Watkins Watkins was the vice president (VP) - corporate development of Enron from 1993 to November 2002. One of the key players and the person who blew the whistle on Enron, she has also warned Lay in a letter which said that the company might implode because of its increasing pile of accounting scandals. The letter resulted in an investigation by Vinson & Elkins, a law firm. Currently she is working as a consultant and public speaker and has opened an advisory firm known as Sherron Watkins & Company (Financial News, 2011; Business Insider, 2011). Arthur Anderson The auditor that was in charge of auditing and rating Enron was Arthur Anderson. The auditing firm was found guilty and was charged for obstructing justice as well as shredding substantial number of documents, deleting company files and e-mails which indicated the lower rating and degrading financial health of the firm. While only handful members from Arthur Anderson were involved in the scandal with Enron, the scandal put the firm effectively out of their business, as the security and exchange company does not accepts audits done by convicted felons. As a result, the firm had to surrender its license and more than 80000 members of the auditing firm lost their employment. Although a lack of proper charges eventually freed Andersen and allowed to resume its operations, the damage from the scandal was substantially large and till now the auditing agency has not been able to recover in terms of clients and revenues (Financial News, 2011). References Bartlett, C. A. & Glin­ska, M. (2001). Enron’s Trans­for­ma­tion: From Gas Pipeline to New Econ­omy Pow­er­house. 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Enron Retrieved from http://www.capitalismagazine.com/2002/january/rwt.enron.htm. Read More