Economic Concepts of the Enron Scandal - Essay Example

? The Enron Scandal This paper highlights various economic concepts in view of the scandal that tarnished the US corporate image – Enron Corporation. This brief paper examines economic concepts including supply and demand, incentives and unemployment, market failure, property and ownership and cost analysis. The Enron Scandal Enron ranked seventh among world’s leading American energy companies before it went bankrupted due to its poor management strategies and financial reporting (Miller & Fusaro, 2002). Enron and its audit firm - Arthur Andersen, which was one of the five largest audit and accountancy partnership in the world, got bankrupted (Benston, 2003). There have been several causes suggested by various experts and analysts that actually caused the failure of the company. Experts have indicated Enron as the biggest audit failure in the American history. The biggest energy company in the world rapidly collapsed which drew attention on its several economical and commercial aspects (Wilkinson, 2005). For the purpose, this paper shall analyze the case study of Enron scandal. Several management and strategic decisions and policies contributed to the major fall in the US corporate history. The paper shall further analyze the causes of the failure from economic perspectives. Background Enron was established in 1985, and it was one of the leading seven American energy companies. It was one of the world’s leading natural gas, electricity, and communication companies. The annual revenues of the company rose from $9 billion to more than $100 billion in just 5 years after 1995 (Salter, 2008). According to reports and published financials, in 2000 the company’s stock price stood at $90; however, at the end of 2001, the stock price of Enron felt to less than $1. Furthermore, the last published financial statements of Enron depicted that the company made a loss of $586 million (Sterling, 2002). This caused the company to financially fail and by the end of December 2001, the company went bankrupt. As a result of this, billions of dollars were wiped out from the US capital markets and investors across the globe lost their trust in the US financial and corporate sectors, which were not efficient enough to build strong checks and balances on businesses like Enron. The case of Enron opened up investigations into several other unethical practices of other organizations, and the ripple effect shook up the entire US corporate sector. Supply and demand During 1990’s, the population of California raised by thirteen percent, whereas, the government did not make any enough investments in building power plants to cope with the rising requirements of electricity. The government expanded the existing energy plants’ capacity by 30% during 1990-2001. Furthermore, in 1991 the drought in the northwest states caused the supply of hydroelectric from Pacific Northwest of Oregon and Washington to decline (Barreveld, 2002). Both drought and energy shortages created a supply gap in the country, and the government faced several issues to cope with the energy demand in the region (Swartz & Watkins, 2004). With the rapid increase in the population and the breakdown in California’s electricity generating capacity created a situation of less supply as compared to the energy demand. The industrial sector was highly affected as the supply of energy remained very low during the peak working hours. Furthermore, the private industries were using privately owned power generating plants as energy reserves of California were not sufficient to meet the demand. On the other hand, the state owned energy plants were deliberately shut down in order to manipulate energy prices (Swartz & Watkins, 2004). The gap between supply and demand of energy was deliberate in order to raise prices of the electricity generated by private generators (Miller & Fusaro, 2002). Enron secretly exercised with the government to create a gap between the energy produced and its requirement in the country. This permitted the private power generating units to charge very high rates to both domestic and industrial consumers (Miller & Fusaro, 2002). The gap in the energy supply and demand in California created an opportunity for the energy companies to demand high energy prices. The rates were semi-regularized by the government which were increased to create a hike in the market. Furthermore, the energy companies in California took an advantage of the infrastructure weaknesses in California (Barreveld, 2002). The government made no effort to enhance the energy supply in the region which further created gap in the energy supply and demand (Barreveld, 2002). According to a study by the International Energy Agency, if the supply of energy was lowered than 50 percent of the demand then it would result in 50 percent reduction during peak hours of the Californian crisis (Miller & Fusaro, 2002). The government and energy companies manipulated energy supply in the country; this created an opportunity for Enron to take advantage and therefore, the company took actions to overcome the energy gap and offered high energy prices to public. Incentives and unemployment The collapse of Enron highly affected the American economy as Enron was one of the largest companies employing more than 4,500 employee and contributing heavy turnovers to the American economy (Sterling, 2002). The strong financial position of the company attracted heavy foreign investment and generated great employment opportunities (Swartz & Watkins, 2004). These are certain factors that contributed to the growth of the American economy. The collapse of Enron imposed several economic challenges for both foreign and domestic investors (Swartz & Watkins, 2004). One of the major factors that caused the failure of the company was overseeing phenomenal incentives to its workers. The salaries and incentives paid to auditors and workers were high; whereas, their output was relatively inefficient (Swartz & Watkins, 2004). The team of auditors hired by the company overlooked several aspects that caused major losses to the company (Wilkinson, 2005). The actual performance of the company was falsely anticipated with the profit projections from future company’s projects (Miller & Fusaro, 2002). Therefore, financials of the company reflected false operating profits and performance of Enron. The management of Enron believed that incentives should be given according to the performance of the company and due to the false reporting the actual performance was overlooked by the management and high incentives were paid out. When the company got bankrupted, it made 4,500 workers unemployed across the country (Barreveld, 2002). Therefore, it could be stated that the false reporting of the company caused the management to fail in determining the actual performance of their employees. Furthermore, the management of the company placed huge amounts allocated to employees in the company’s stock (Sterling, 2002). The strategy of the company was to show these incentives as a part of stock investment in the company (Wilkinson, 2005). Analyzing this situation from macroeconomic perspectives of a company, incentives are tools used by an organization to boost the performance level of its employees (Swartz & Watkins, 2004). The purpose is to provide incentives in order to enhance the performance level and output of the organization (Barreveld, 2002). In managerial economics, incentives are efficient tool to enhance the competitiveness of the organization in the employment sector. Therefore, the management should carefully determine basis for assessing performance of its employees and providing them incentives. The false anticipation of Enron’s future led the management to make wrong use of incentives (Wilkinson, 2005). Enron offered high level incentives to its employees and auditors without considering their performances. Enron’s management considered that the top management’s interests should be aligned with the success and welfare for their employees (Swartz & Watkins, 2004). The management considered that employees expect aristocratic privileges with the progress of the company (Paull, 2003). This was misperceived by the management as auditors and accountants of the company secretly exercised false reporting to hide the actual performance of the organization (Salter, 2008). Market failure After the merger of Houston Natural gas and InterNorth, Enron hired an accountant who used accounting loopholes to hide poor progress and performance of the company (Miller &Fusaro, 2002). This allowed the organization to hide several billions in debts that were resulted from poor investment decisions of the company (Sterling, 2002). Furthermore, Chief Financial Officer and Chief Executive Officer of the company were able to manipulate information provided to the board of directors and auditors of the company. This allowed the company to hide its poor financial performance and high risks that were accountable to the organization (Wilkinson, 2005). The internal control mechanism allowed the organization to suppress the governance failure (Miller & Fusaro, 2002). The false reporting caused stock prices to rise. The market was misled by the false reporting of the organization. Financial appearance of Enron reflected high creditworthiness and financial stability (Barreveld, 2002) when the company was facing high financial and leverage risks. From analyzing Enron’s case, it can be determined that the market exercised the way it was supposed to do. The abrupt disruption caused the market to function accordingly and responded negatively (Wilkinson, 2005). The investors made the right decision to invest in Enron on the basis of the company’s financials (Swartz & Watkins, 2004). The market is not to be held responsible for investors’ decision to invest in the company (Swartz & Watkins, 2004). Therefore, it can be stated that the market failure of the company was mainly caused by the lack of internal control within the organization and involvement of the management and those responsible for keeping checks and balances in the fraud (Barreveld, 2002). The complex structure of Enron allowed auditors of the company to take advantage of the structure and overlook false financials (Wilkinson, 2005). From the analysis of Enron’s case, it can be stated that the market failure was due to the fraud within the company. The high price of Enron’s stock was false and not in line with the actual performance of the company. This caused the market to be misled and high investments were made in Enron’s stock which eventually lost all their value. Property and ownership Enron had a complex ownership structure as it consisted of about 1,300 foreign entities. The information reveals that a majority of Enron’s operations i.e. 80 percent was operated as foreign entities. These entities were inactive shells and were not engaged in ongoing business and were therefore, irrelevant for the tax purposes (Miller & Fusaro, 2002). The remaining 20 percent of the Enron’s operations was considered as ongoing business and it was subject to taxation (Miller & Fusaro, 2002). The inactive entities of Enron were showed in the financial statements of the company, however, they were not engaged in any business activities (Miller & Fusaro, 2002). Apparently, the structure of the company was shown as a strong multinational company, but the real functioning was very weak (Barreveld, 2002). The information further reveals that Enron created several fake entities and there was no tax imposed on such entities (Paull, 2003). The company basically used these entities for hiding taxes. Therefore, Enron used its complex structure as a source to hide its losses from investors and public (Benston, 2003). Cost analysis Enron used cost analysis to make financial decisions. The executives and directors of the organization were highly influenced by money making opportunities (Giles, 2012). The management used cost-benefit analysis to anticipate outcomes from a particular investment decision. Enron used cost benefit analysis to enhance profitability and returns of the company (Rosenfield, 2006). However, every organization uses cost analysis to make major financial decision but its use should not be for manipulating the reality (Miller & Fusaro, 2002). Enron used various methods to hide its costs and losses. According to various reports, executives of Enron had hidden their losses by investing employees’ funds in the company’s stock (Miller & Fusaro, 2002). Furthermore, the company’s executives used cost analysis methods to hide debts, taxes, and losses of the company by overstating profits of the company (Rosenfield, 2006). Analyzing the Enron scandal, it can be determined that the Enron is one of the major frauds done in the US corporate history. The fraud which involved executives and auditors of the company was based on false financial reporting. This caused the company’s financial reports to reflect the false performance of the company. The economic analysis of Enron depicts that executives, directors, and auditors of the company took advantage of several reporting and management aspects. The management used economic tools to hide facts about the company. The complex structure of the organization and the involvement of the auditor in the fraud allowed the management to commit fraud to the public at large. Reference List Barreveld, D. J. (2002). The Enron Collapse: Creative Accounting, Wrong Economics Or Criminal Acts? : a Look Into the Root Causes of the Largest Bankruptcy in U.S. History. Lincoln: iUniverse. Benston, G. J. (2003). Following the Money: The Enron Failure and the State of Corporate Disclosure. Virginia: Brookings Institution Press. Giles, S. (2012). Managing Fraud Risk: A Practical Guide for Directors and Managers. Chichester: John wiley. Miller, R. M., & Fusaro, P. C. (2002). What Went Wrong at Enron: Everyone's Guide to the Largest Bankruptcy in U.S. History. NewJersey: John Wiley & Sons. Paull, L. L. (2003). Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues, Etc., Volume I: Report. Washington DC: DIANE publishing. Rosenfield, P. (2006). Contemporary Issues in Financial Reporting: A User-Oriented Approach. New York: Routledge. Salter, M. S. (2008). Innovation Corrupted: The Origins and Legacy of Enron's Collapse. Havard: Havard Uiversity Press. Sterling, T. F. (2002). The Enron Scandal. New York: Nova Publishers. Swartz, M., & Watkins, S. (2004). Power Failure: The Inside Story of the Collapse of Enron. New York: Currency Doubleday. Wilkinson, N. (2005). Managerial Economics: A Problem-solving Approach. Canbridge: Cambridge University Press. Read More