Enron’s name and operations came to the limelight with the merger of Houston Natural Gas and InterNorth back in 1985. The company was engaged in the business of interstate pipeline services, which expanded rapidly. It was in 1999 when the company initiated its online commodity trading services under the name “Enron Online”. The success of that online commodity trading service was such that it accounted for around 90 percent of its total earnings. With continuous and remarkable growth, Enron established its goodwill and status amongst its large customers and investors base. However, in December 2001, the company was declared as the biggest bankruptcy case in the history of the United States (Bierman).
During the “dot com” boom, Enron realized a future with infinite possibilities and entered the market at peak time. With a progressive mindset, Enron’s management was inclined at borrowing more to enable the company to capitalize in the market by trading more. However, with the sudden downfall in the market in 2000, inflows of the company shrunk and liabilities kept on piling up. These situations are normally experienced by big multinationals whenever market conditions fluctuate unfavorably. But, Enron’s case was different from others, not only due to market conditions but also due to accounting fiction. With the continuous fall in its revenues from online commodity trading operations, the company’s management decided to present the financial position of the firm in a falsified manner. Enron’s management was less inclined in disclosing the true and fair financial position of the company and therefore it raised SPEs (Special Purpose Entities) and shifted losses suffered by the company to these SPEs. In this way, Enron’s stakeholders were told that the losses incurred were belonging to those independent entities, which were not under the control of the company’s management. Moreover, the management also concealed the nature of its non-current liabilities by way of presenting them as energy derivatives rather than borrowings from banks (McLean and Elkind; Bierman).
These practices continued for about one and a half years and when uncovered, the company went into liquidation. The news of Enron’s collapse was shocking not only because of the downfall of a market leader but also because Arthur Andersen, a highly rated accounting and auditing firm, which was responsible for Enron’s external audit, could not report on the misrepresentation of financial information by the company. Investigations revealed that the auditors were accomplices in Enron’s fraud as they helped Enron’s management in presenting falsified financial statements. Arthur Andersen was later charged due to their conflicting relations with the client. The firm made a total of $ 52 million for its auditing and consulting services in the year 2000. Enron paid this amount to Arthur Andersen for overlooking the credit risks relating to the SPEs and accounting practices of the company’s management (Kammerer; Dharan and Bufkins).
Apart from a collision with its auditing firm, Enron engaged several professional accountants to work on finding loops within the financial reporting framework presented under GAAP (Dharan and Bufkins). As narrated by McLean and Elkind in their book, one of many professional accountants who worked for the company stated, “We tried to aggressively use the literature [GAAP] to our advantage. All the rules create all these opportunities. We got to where we did because we exploited that weakness” (McLean and Elkind, p. 127).
While reviewing the case of Enron’s failure, it is established that the root cause of the downfall dates back to the ’90s, when the company started using “mark to market accounting” to appraise its assets in the energy business (Thomas). In the energy sector, if companies have due energy contracts on their financial statements at the end of an accounting period and they are using “mark to market accounting”, then such companies are required to make adjustments for such contracts based on their fair market values and the resulting gains or losses have to be recorded accordingly. However, in the absence of fair market values or quotations, which is a common case in long-term agreements for gas, business entities are at liberty to set their fair market values by making use of certain assumptions and models. This is what Enron did through the exercise of these discretionary powers and recorded enormous unrealized gains; thus, making Enron’s financial position stronger than ever and with the use of such accounting methods, the company was able to report gains that could not be recovered in the upcoming years (Thomas).
After the fall of Enron and Arthur Andersen, it was expected that regulators would come up with something to prevent the occurrence of such instances in the future. These expectations turned into reality with the introduction of the Sarbanes Oxley Act 2002. With the promulgation of the Sarbanes Oxley Act 2002, PCAOB (Public Company Accounting Oversight Board) was also formed, which presented new regulations for public accounting firms (Kammerer).
References
Bierman, Harold. Accounting / Finance Lessons of Enron: A case study. Singapore: World Scientific Publishing Co. Ltd, 2008.
Dharan, Bala G and William R Bufkins. “Red Flags in Enron’s Reporting of Revenues and Key Financial Measures.” Rapoport, Nancy G and Bala G Dharan. Enron: Corporate Fiascos and Their Implications . New York: Foundation Press, 2004. 97-112.
Kammerer, Matthias. Creative Accounting, the Enron case and its impact on Corporate Governance. Seminar Paper. Norderstedt: GRIN, 2005.
McLean, Bethany and Peter Elkind. The Smartest Guys in the Room. New York: Penguin Group, 2004.
Thomas, C Williams. “The Rise and Fall of Enron.” Journal of Accountancy (2002).