In my last blog I talked about fair value accounting and today I am going to talk about how the largest accounting scandal and business fraud in the history of the United States occurred as a result of fair value accounting abuse.
The Enron scandal changed the business and accounting world. Enron was the largest corporate bankruptcy at the time and the fraud committed by the executives cost shareholders and employees millions of dollars. The result of the scandal created an environment filled with laws and regulations to protect the shareholders of public companies. These laws expanded the roles of public accounting and created more jobs in the profession.
History
Enron was founded in 1985 by Ken Lay when Houston Natural Gas and InterNorth merged. Enron was the wholesaler of electricity and natural gas owning and operating many different plants and gas pipelines worldwide. In 1992, they became the largest seller of natural gas in North America. Along with being a wholesaler of energy, Enron also traded energy and other commodities.
Enron was the seventh largest company on the Fortune 500 and the sixth largest energy company in the world valued at nearly $70 billion. In fifteen years, it went from a $10 billion in assets to 65 billion. It employed approximately 20,000 people and claimed to have revenues of nearly $101 billion dollars. Enron was awarded the most innovative company for six consecutive years by Fortune magazine.
As a result of these great accolades, Enron was considered to be a blue chip stock by many analysts. Its stock price increased by $311 percent from 1990-1998 and another 56% in 1999 and 87% in 2000. During the same years, the S&P increased by only 20% and decreased by 10% in 2000. The company’s stock priced peaked at 90$ with its market capitalization exceeding $60 billion. Enron’s stock drastically outperformed the market.
Mark-to-Market Accounting (Fair Value)
Jeff Skilling was Enron’s CEO and under his guidance, Enron entered the energy trading market. He developed the idea of using energy as financial instruments like stocks and bonds, which can be traded over an active market. He predicted huge profits for Enron from this idea. In order for Enron to be successful as energy traders, they needed to be able to use mark to market accounting to account for the trades. Arthur Andersen and the SEC approved the use of mark to market accounting.
It allowed Enron to book future profits on energy contracts and deals. Enron would predict what the future cash flows would be from the contracts and discount them to record profits in the current period. As a result of mark to market accounting, Enron’s profits could be whatever they wanted them to be. Mark to market accounting allowed Enron to record billions in profits from many of their projects. Many times these projects were failures and resulted in huge losses. But in an attempt to keep its stock price high, Enron continued to record profits from these failed projects even though there was never any cash that materialized. These projects include the power plant in Dabhol, India and the bandwidth partnership deal with Blockbuster.
Special Purpose Entities (SPE’s)
Enron was losing cash as a result of these failed projects. Andrew Fastow was Enron’s CFO and was in charge of covering up these losses and keeping the stock price up. Fastow created multiple special purpose entities (SPE) to hide Enron’s debt. These SPE’s were owned by Andrew Fastow and financed by some of the major banks in the United States such as Merrill Lynch. The SPE’s strictly did business with Enron and Fastow controlled every single transaction, personally profiting $49 million by taking a little bit from every transaction.
The SPE’s would remove Enron’s debt from its balance sheet and be placed on the SPE’s. This allowed Enron’s balance sheet to appear debt free. The use of SPE’s by Enron was legal and approved by Arthur Andersen. All the information required to be reported was disclosed by Enron. Even though the use of SPE’s was legal, Enron fraudulently used accounting techniques to hide about $30 billion dollars of debt from its balance sheet.
Bankruptcy
December 2, 2001. Its stock price fell to less than a dollar and over 20,000 employees lost their jobs. It was the largest corporate bankruptcy at the time. Before the bankruptcy, the top executives and other insiders sold off a billion dollars’ worth of Enron stock. While the average severance pay for the employees was $4,500, top executives were paid bonuses totaling 55 million dollars. In 2001, employees lost $1.2 billion in retirement funds and retirees lost $2 billion in pension funds, Enron’s top executives cashed in $116 million in stock.
In the summer of 2001, Enron’s stock price began to decline. On August 14, 2001, Skilling announced his resignation as CEO of Enron. But before he left, he sold off $66 million worth of stock. Unable to sustain its stock price, Enron declared bankruptcy on December 2, 2001. Its stock price fell to less than a dollar and over 20,000 employees lost their jobs. It was the largest corporate bankruptcy at the time.
The Enron scandal was one of the largest corporate frauds committed in the history of the United States. Many of the top executives including Skilling, Fastow, and Ken Lay were convicted of criminal charges for their roles in the fraud. Jeff Skilling was indicted in 2004 on 35 counts of fraud, insider trading and other crimes. On October 23, 2006, he was sentenced to 24 years and four months in prison and fined $45 million. Andrew Fastow who made more than $45 million through his LJM partnership took a plea bargain with prosecutors and agreed to testify against the other executives in order to get a reduced sentence. He pled guilty to conspiracy to commit wire fraud, forfeited $23 million in assets, and was sentenced to ten years in prison. Ken Lay was convicted of six counts of securities and wire fraud and was looking to face up to 45 years in prison. He died of a heart attack prior to sentencing.
For their involvement in Enron, Arthur Andersen was charged with obstructing justice. They were forced to give up their CPA license and were no longer able to practice in public accounting. Although this charge was later overturned, it was too late for Arthur Anderson. Their reputation was tarnished. They went from being one of the largest, oldest, and respected accounting firms in the world to a firm no one wanted to do business with. With their reputation ruined, the firm was ultimately destroyed losing all of its clients.
Results of Scandal
The Enron scandal resulted in major changes to the world of business and accounting. In an effort to prevent future corporate scandals, the United States government created the Sarbanes-Oxley Act of 2002 to protect investors and shareholders from corporate greed. Along with more government regulations, the New York Stock Exchange issued a new Governance Proposal. In order to be listed on the exchange, the proposal required companies to have a majority of independent directors, all audit committee members should be financially literate, and at least one member of the audit committee is required to have accounting or related financial management expertise. In addition, the board should hold additional sessions without management and the compensation committee, nominating committee, and audit committee shall consist of independent directors.
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Image Credit to Enron
Accounting, Finance, and Business 