The Business Model of Enron - Essay Example

Finance and Accounting Business model of Enron The business strategy followed by Enron in 1990s was to exploit new risk management forms in the energy supply chain. It started business in mid-1980, after merging with two utility companies. For the next ten years, Enron had good margins of profit, given that it had exploited all opportunities that arrived from energy markets of US. It had a natural gas and electricity transmission business as well as retail business dealing with energy users, besides ownership of several inter-state pipelines of gas. After 1985, Enron started trading gas and offered various types of derivates to customers for the same, when the business of gas pipelines had stopped (Dell’Ariccia, Igan and Laeven, 2009). When the derivatives were distributed, it created an opportunity of basic training and helped in exploiting the difference in prices in future and spot markets. The gas trading of Enron had allowed it to be a market maker and acted as counterparty by trading on both sides and made profits as spreads between the offer and the bid price. Enron was under residual risk after it accessed both the markets and was able to overcome the same by entering into swaps and other such arrangements with dealers. As Enron owned physical plants and took charge of operating those, it had a comparative advantage over the competitors. The company was also able to protect itself from the market price movements for the same reason. Being an industry insider, it also had advantages of acquiring information needed for forecasting shocks related to particular region or sector. Therefore, besides being a market maker, Enron was also a creator of new products. The business strategy used by Enron, in 1990s, was asset light and vertical integration, after it became too leveraged due to the merger. The asset light approach indicates combination of the development of sophisticated risk management techniques with the least amount of ownership and operation of plants. Virtual integration system helps to maintain the reliability of a product with less capital investment. Exploitation of advantage of deregulation Enron took advantages of deregulation of the US energy markets, as later on, it can be noticed that they enjoyed the experience of steadily rising profit from merger of two utility based companies. Additionally, besides owning several gas pipelines, it also ran a natural gas as well as electricity transmission business. After 1985, Enron even started trading in gas and offered various types of derivates to interested customers, when the gas pipelines business met an end. When the derivatives were distributed, it was able to create opportunity of basic training as well as to exploit the difference in prices in the future and the spot markets. It grew into a market maker and creator, given that it owned and operated plants by itself. Enron brought in asset light and virtual integration approaches in business process, after getting filled with leverages. Therefore, all these points suggest how the company had taken advantage of the deregulation. Preconditions for success of "asset light" Enron, during the period of 1990s, was heavily burdened with loans taken for the purpose of merger. There were a lot of fixed costs that the company had to deal with, related to power stations, reservoirs and pipelines, which led to outflow and drainage of the company’s profitability as well as guarded the needed capacity to manage debts. Trading on derivatives was also not quite fruitful. Asset light is the combination of ownership and operation of plant, which is necessary for market presence with the development of techniques related to risk management (Llewellyn, 2008). The preconditions of the company to adapt asset light are the following: 1) The company needs to have access to liquid capital, if it wants to serve the obligations towards both suppliers as well as sellers in the supply chain. 2) The company must have a flawless reputation with the credit rating agencies and banks from which it gets the liquid capital that it requires. 3) The company needs to maintain physical presence in those sectors, where it operates in the form of a trader. For this purpose, as a market maker, the company needs to maintain an information advantage, which can be compared. Enron was able to follow all the preconditions for maintaining a competitive position till 2001. Reasons for bankruptcy The bankruptcy of the company had taken place, when it was unable to maintain any of the preconditions as laid down by asset light. The decision to provide derivative contracts, such as, broadband, was not only highly volatile, but the company also had no specialized knowledge and physical existence so as to achieve comparative advantage. The fall down of support and non-existence of working credit were few reasons for unravelling of the devices of accounts, which were used for the purpose of shifting volatile assets present in the Balance sheet. These were least acceptable aspects for following the asset light approach. So, all these had led to bankruptcy of the company (Mian and Sufi, 2008). Setting up Special Purpose Entities (SPE) SPEs are corporate vehicles or entities with special purpose used to manage assets in the Balance Sheet. According to US rules, a company can set such corporate vehicles for managing the assets. It helps to spread the risk of the company. The Return on Asset (ROA) can be maximized and the risk can be minimized, if the assets are transferred to the SPE account, which aids repayment of debt taken from the vendor, at some point of time. Enron had used SPE to replace the liabilities with the assets and made certain illegal usage of the same in the future (Tricker, 2012). Contravene or breach of accounting report During 1990s, Enron had set up several companies, which were not consolidated, following the SPE rules. Thus, equity accounting did not cover subsidiaries of the company and accounts of the subsidiaries were also not consolidated with the company. Enron replaced the liabilities with earnings and assets, by using the equity accounting technique. In practice, it did not show any problem, until on the same, the company made a series of transaction for which there was no genuine investors. There was a SPE, named Chewco, where investment was made as a bank loan, which was guaranteed by Enron. The company soon made attempts to represent the loan as an equity holding, but was not successful as the bank, which was in question, did put up any sorts of risk capital; as a result, the deal was a deceit (Nankervis, 2005). The SPEs of Raptor and LJM entities were again capitalized through bank loans and common stock of Enron. They were utilized to make volatile investments, like, purchasing of shares in a dotcom based company. The company made a clever attempt of representing those shares as asset of the company in the Balance Sheet. This pointed towards a risk in the credit rating of the company. All misrepresentations were presented in Annual Report of company, but in an unclear and difficult manner. Hence, these were the accounting reports to which Enron had contravened (Hoflich, 2011). Conflicts of interest Conflicts of interest had taken place between the Board of Directors and managers. The directors were unable to monitor activities of the management; as a result of which conflicts of interest were seen to occur among them. This is the root cause, which was considered for failure of the company (Davies and Green, 2008). Approach to performance appraisal The approach of Enron towards performance appraisal was based on ranking given to employees, on the basis of their performance. The employees with low rankings were subject to getting fired. This was rather a ruthless approach followed by the company (Dell’Ariccia, Igan and Laeven, 2009). Charges against the Board The Directors of Enron had failed to make proper assessment of the risks that it was exposed to. These directors were all involved in the gamble and played it with the right amount of intelligence. The strategy related to asset light was uncertain and dependent on circumstances that were contingent. It also faced increasing competition from newcomers. The other factors leading to downfall of Enron, for which the Board of directors should be blamed, were inability of the Board to monitor work of the managers as well as conflicts of interest that took place between them. Besides various frauds and conflicts of interest, there were also other reasons, which can be considered for the collapse of the company. It was greatly affected by the existence of corporate risk. The systematic failure of the company had occurred due to its business plans and accounting policies. The company’s managers had even tried to use strategies for minimizing the fixed costs, which in turn could boost the price of their shares. Finally, in order to lower costs, the company took steps ranging from being asset light to employing SPEs for misrepresenting earnings’ as well as reducing debt burden. Enron even fired employees at lower ranks and treated them as assets, which can be easily disposed off at their own will and conditions. This had led to the failure, in terms of accountability and information, which turned out to be catastrophic. It happened in the autumn of 2001 and as a result, any further monitoring by the Board could not bring in fruitful results. Hence, these were the charges made against the Board (Soloman, 2010). Failure to recognize risk As already stated earlier, Enron was affected by the existence of corporate risk and failure to recognize it. The failure of the company took place because of its business plans and accounting policies, which were not systematic. The company’s managers tried to use illegal strategies to minimize fixed costs and boost the price of shares. At last to diminish the costs, it took steps ranging from being asset light to using SPEs to manipulate earnings and reduce the debt burden. Therefore, information given above describes reasons responsible for the company’s inability to recognize risk (Callioni, 2008). Victims of Enrons collapse The victims of Enron’s collapse are the shareholders, stakeholders, employees and the society as a whole. The shareholders had lost all their money that they had invested in the company on a positive note. They had anticipated the right amount of dividend in return; but, instead, they lost all their valuable stakes with downfall of the company. Similarities and differences between Enron and other institutions There were many companies in other sectors besides Enron, who were also involved in the accounting forgeries. In past also there were similar cases of fraudulency in the company’s other than Enron. Some of these companies’ fraudulent acts are presented in a detailed manner below: Companies Activities The Maxwell affair (1991) Bank of Commerce & Credit International (1991) R. Maxwell kept his company afloat and boosted its share price by taking money from pension schemes. The structure of the company was complex. The company was liable to Goldman Sachs for 2 loans at the end of October, 1991, and started selling MCC shares; even the Lehmans asked for the repayment of their financing. It lost the support of the bankers because it needed to reveal true state of affairs. The company finally collapsed in Nov, 1991 after Maxwell’s death. The company was into monetary losses because of several scandals that ranged from $10b to £17b. It was involved in doubtful lending, fake record keeping, and fraudulent trading. It also violated regulations related to bank ownership and did a lot of money laundering. The senior management of the company was involved in the manipulation of gapping the risk structure of the bank. Even the bank failed to make any profit for the last 19 years and issued unsecured loans with no documentation. The bad debts of the company were allegedly covered up with new deposits for which no records were maintained. Therefore, there were also many companies who were involved in the shams like Enron. These were Polly Peck, WorldCom, Barings Bank, Parmalat, and Olympus. All these companies were also involved in fraudulent acts besides Enron. Development made by the regulators The following developments were made by the regulators for curbing the financial crisis that had affected the economy worldwide. The Cadbury report was prepared to make the corporate governance of U.K. clearer. They highlighted on three areas of the existing system which needed to be improved. These were: Auditing The Board of directors The shareholders This report extensively stressed the importance of the institutional shareholders and considered them the as the most influential group of shareholders. It also stated the importance of the public companies to declare whether they were following all the aspects of the Code as needed. The Greenbury report stated the importance of the identification of the legal practices at the time of determining the remuneration of the Director, as well as the preparation of Code of practice that should be followed by the PLC’s of UK. This report encouraged the institutional investors who are also the owners, to take their own responsibilities for any form of corporate immoderations and decrease in accountability and to influence any sort of decision making of the company. Therefore, the investors were asked to be more active in influencing the decision making process of the company and voice their opinion for any fraudulent act of the company. There were also other reports developed by regulators like the Hampel and Turnbull reports. Hence, these were the developments made by the regulators as per the reports. Reference List BBC Business, 2007. Northern Rock Ups Sub-Prime Rate. [online] Available at: [Accessed 24 February 2014]. Callioni, P., 2008. Compliance and regulation in the international financial service industry. London: Global Professional Publishing. Davies, H. and Green, D., 2008.Global financial regulation. Cambridge: Polity Press. Dell’Ariccia, G., Igan, D. and Laeven, L., 2009. Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market. [pdf] International Monetary Fund. Available at: [Accessed 24 February 2014]. Hoflich, P., 2011. Banks at risk: Global best practices in an age of turbulence. Singapore: John Wiley & Sons (Asia) Ltd. Llewellyn, D.T., 2008. The Northern Rock crisis: a multi-dimensional problem waiting to happen. Journal of Financial Regulation and Compliance, 16(1), pp. 35-58. Mian, A. and Sufi, A., 2008. The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis. [pdf] International Monetary Fund. Available at: [Accessed 24 February 2014]. Nankervis, A., 2005. Managing services. New York: Cambridge University Press. Soloman, J., 2010. Corporate governance and accountability. Chichester: John Wiley & Sons. Tricker, R., 2012. Corporate governance: Principles, policies and practices. Oxford: Oxford University Press. Read More