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THE COLLASPE OF ENRON

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the EnronCorporation,an American energy company based in Houston, Texas, and the dissolution of ArthurAndersen, which was one of the five largest audit and accountancy partnerships in the world. Inaddition to being the largest bankruptcy reorganization in American history at that time, Enron

undoubtedly is the biggest audit failure. Enron was formed in 1985 by Kenneth Lay after mergingHouston Natural Gas and Inter North. Several years later, when Jeffrey Skilling was hired, hedeveloped a staff of executives that, through the use of accounting loopholes, special purposeentities, and poor financial reporting, were able to hide billions in debt from failed deals and projects.Chief Financial Officer Andrew Fastow and other executives were able to mislead Enron's board ofdirectors and audit committee of high-risk accounting issues as well as pressure Andersen to ignorethe issues.

Enron's stock price Enron's stock price, which hit a high of US$90 per share in mid-2000, causedshareholders to lose nearly $11 billion when it plummeted to less than $1 by the end of November2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and Dynegyoffered to purchase the company at a fire sale price. When the deal fell through, Enron filed forbankruptcy on December 2, 2001 under Chapter 11 of the United States Bankruptcy Code, and with

assets of $63.4 billion, it was the largest corporate bankruptcy in U.S. history until WorldCom's 2002bankruptcy. Many executives at Enron were indicted for a variety of charges and were later sentencedto prison. Enron's auditor, Arthur Andersen, was found guilty in a United States District Court, but bythe time the ruling was overturned at the U.S. Supreme Court, the firm had lost the majority of itscustomers and had shut down (see Arthur Andersen LLP v. United States). Employees andshareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices.As a consequence of the scandal, new regulations and legislation were enacted to expand thereliability of financial reporting for public companies. One piece of legislation, the Sarbanes-Oxley Act,expanded repercussions for destroying, altering, or fabricating records in federal investigations or forattempting to defraud shareholders. The act also increased the accountability of auditing firms toremain objective and independent of their clients.

The rise of Enron

Kenneth Lay founded Enron in 1985 through the merger of Houston Natural Gas and InterNorth, twonatural gas pipeline companies. In the early 1990s, he helped to initiate the selling of electricity atmarket prices and, soon after, the United States Congress passed legislation deregulating the sale ofnatural gas.The resulting markets made it possible for traders such as Enron to sell energy at higherprices, allowing them to thrive. After producers and local governments decried the resultant pricevolatility and pushed for increased regulation, strong lobbying on the part of Enron and others, wasable to keep the free market system in place. By 1992, Enron was the largest merchant of natural gasin North America, and the gas trading business became the second largest contributor to Enron's netincome, with earnings before interest and taxes of $122 million. The creation of the online tradingmodel, EnronOnline, in November 1999 enabled the company to further develop and extend itsabilities to negotiate and manage its trading business. In an attempt to achieve further growth, Enron

pursued a diversification strategy. By 2001, Enron had become a conglomerate that both owned andoperated gas pipelines, pulp and paper plants, broadband assets, electricity plants, and water plantsinternationally. The corporation also traded in financial marketsfor the same types of products andservices.

Causes of downfall

Enron's nontransparent financial statements did not clearly detail its operations and finances withshareholders and analysts. In addition, its complex business model stretched the limits ofaccounting, requiring that the company use accounting limitations to manage earnings and modify thebalance sheet to portray a favourable depiction of its performance. According to McLean and Elkid intheir book The Smartest Guys in the Room, "The Enron scandal grew out of a steady accumulation ofhabits and values and actions that began years before and finally spiraled out of control."[14] From

late 1997 until its collapse, the primary motivations for Enrons accounting and financial transactions

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seem to have been to keep reported income and reported cash flow up, asset values inflated, andliabilities off the books.

The combination of these issues later led to the bankruptcy of the company, and the majority ofthemwere perpetuated by the indirect knowledge or direct actions of Lay, Jeffrey Skilling, AndrewFastow, and other executives. Lay served as the chairman of the company 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, pushed for the use of mark-to-market accounting and pressured Enron executives to find new ways to hide its debt. Fastow andother executives, "...created off-balance-sheet vehicles, complex financing structures, and dealssobewildering that few people can understand them even now."

Lessons from Enron Scandal

Demonstrated the importance of old economy questions: How does the company actuallymake its money? Is it sustainable over the long haul? Is it legal!

Demonstrated the need for significant reform in accounting and corporate

governance in the U.S.

Does this necessarily mean government regulation can fix the problem

ACTS AND RULES INTRODUCED

1)

Sarbanes-Oxley Act (SOX) of 2002

Companies must list and track performanceof their material risks and associated controlprocedures. CEOs are required to vouch for the financialstatements of their companies. Boards of Directors must have Audit Committeeswhose members are independent of

company senior management. Companies can nolonger make loans to company directors.

SOX Act Essentially a response to one cause of the financial irregularities: failure byauditors, SEC, and other agencies to provide adequate oversight. Not clear how SOX Act will prevent misuse of offbalance- sheet activities that are difficultto trace. SOX Act also does not address other key causes:

misal igned incentives(e.g., shift from cash tostock option compensation)focus on s hort -run prof i tsrather than longerrun

profit performance.

2)

Getting Rid of SPE 3% Rule

SPE 3% Rule: Rule permitting Special Purpose Entities (SPEs) created by afirm to be treated as offbalance- sheet i.e., no required consolidation withfirms balance sheets as long as at least 3% of the total capital of the SPEwas owned independently of

the firm. Rule raised to 10% in 2003 following Enron scandal After more misuse of rule during Subprime Financial Crisis, Financial

Accounting Standards Board (FASB) replaced this rule in 2009 with stricterconsolidation standards on all asset reporting (FASB 166 & 167).

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Refrences

Chron.Com Special Report: The Fall of Enron, www.chron.com/news/specials/enron/ George Benston et al., Following the Money: The Enron Failure and

the State of Corporate Disclosure AEI-Brookings Joint Center forRegulatory Studies, Washington, D.C., 2003

www.aei-brookings.org/admin/authorpdfs/page.php?id=242 Wall Street Journal, Glossary of Questionable EnronDeals

http://online.wsj.com/public/resources/documents/info-enrongloss-0603.html

http://www.chron.com/news/specials/enron/http://www.chron.com/news/specials/enron/http://www.aei-brookings.org/admin/authorpdfs/page.php?id=242http://www.aei-brookings.org/admin/authorpdfs/page.php?id=242http://online.wsj.com/public/resources/documents/http://online.wsj.com/public/resources/documents/http://online.wsj.com/public/resources/documents/http://www.aei-brookings.org/admin/authorpdfs/page.php?id=242http://www.chron.com/news/specials/enron/