ENRON CASE

ENRON

The collapse of Enron is probably the most famous example of a company failure due to fraudulent accounting.

Enron was one of the top 10 American companies in 2001. It filed for bankruptcy in December 2001 as a result of accounting scandals that rendered the financial statements worthless.

THE ACCOUNTING SCANDAL

Enron was an energy company based in Houston, Texas, formed by bringing together two other operations and was run by the chairman, Kenneth Lay. He was highly regarded as a businessman as Enron had performed so well.

Enron provided energy and also started to look at new ways of making money by developing energy derivatives such as options and futures. The problem was that Enron needed to borrow a lot of money to continue to finance its operations. It was aware that high levels of debt made the company’s financial position look weaker so instead of borrowing the money in the Enron companies it set up special purpose entities (SPEs), who borrowed the money on Enron’s behalf and then channelled the funds in to Enron.

At the time, American accounting standards were set up in such a way that if these SPEs were set up carefully enough, the liabilities would not appear in the Enron accounts. This is called ‘off-balance sheet’ financing as the debts belong to Enron but are not shown in that company’s balance sheet/statement of financial position.

Many of the hidden debts were backed by the Enron share price. If the share price continued to rise, the debts did not need to be repaid. However, if the share price fell, the debts had to be settled. This had an adverse impact on cash flow, which then had a negative effect on the share price thus requiring more debts to be settled and so on.

Enron had massively under reported just how debt they had. The financial statements showed profits when in reality the company was hiding huge debts and losses in the SPEs. When the Enron share price reached its highest level in August 2001, Enron senior executives started to sell their own shares, whilst still encouraging investors to buy shares in Enron. As large numbers of shares were offloaded by Enron executives who knew the true financial position of the company, the share price started to fall. By the end of November 2001, the news of the financial losses and mounting debts was made public and the company filed for bankruptcy in December 2001. The share price had dropped from a high of US$90 to being worthless.

WHAT WENT WRONG?

There were a number of problems at Enron. Whilst some of the accounting was strictly within the American rules, some of it contravened accounting standards. Far too much information and control was in the hands of a very small number of dominant individuals who were too involved in the day to day running of the business.

There was a lack of internal control and poor risk management. Whilst Enron did have non-executive directors they did not appear to understand what was happening and clearly did not question the executive directors sufficiently.

There was a serious failure in the audit function as the auditors, Arthur Andersen, were aware of what Enron was doing. The role of the auditor is to report to the shareholders on the accuracy of the financial statements and yet Andersen was so close to the directors that they were not fulfilling their obligations. There are allegations that they assisted Enron in committing some of the illegal accounting. Arthur Andersen collapsed as a result of this scandal.

Andersen earned a large audit fee as well as a huge amount of fees for non-audit work. There has always been an opinion in the accountancy profession that if the auditors perform many other services in addition to the external audit it could compromise their opinion about the accuracy of the financial statements, as they do not want to upset the directors and risk losing the (usually) more lucrative non-audit work.

As a result of Enron’s bankruptcy, the American government responded by issuing the Sarbanes-Oxley Act in July 2002. This was American corporate governance backed by law. It is a very tough piece of legislation with strict rules about the director’s responsibility for the financial statements, auditor independence and internal control. It aims to ensure that such public accounting scandals cannot happen again.