Thesis on "Enron's Misleading Accounting & Fraud Tactics"

Thesis 98 pages (27112 words) Sources: 20

[EXCERPT] . . . .

Enron was the seventh-largest corporation in the world. Enron Company was divided into five distinct parts including; Wholesale Services, Transportation and Distribution, Broadband Services, Retail Energy Services, and Corporate and Other. By the late 1990's, Enron had gone from a gas pipeline company to an energy trading company and then to a company based on trading gas, oil, water, forest products, minerals, broadband, and any other product that could be made into a commodity. Ultimately, the company began trading derivatives. Derivatives are useful because they provide a hedge against future business risks such as hikes in oil prices, changes in interest rates. When used legitimately derivatives can be beneficial to a company. The paper endeavored to explain the tactics that Enron used to evade detection and mislead investors. The company used a variety of tactics and resources to hide losses and mislead investors. In addition, to the use of derivatives, we found that the most popular method of hiding losses was the formation of Special Purpose Entities. The research suggests that a Special Purpose Entity is a corporation, limited partnership, or other legal vehicle designed to carry out specific activities as specified in its establishing legal document. Enron created more than 100 of these entities and used them to hide losses and debt. The discussion suggests that the SPE's of greatest concern were Chewco, LMJ1, LMJ2, and the Raptors. The research contends that each of these entities was created for hiding profits. Ultimately the company was forced to expose its wayward tactics and went into bankruptcy. As a result of this implosion, thousands of employees and investors lost a great deal of money. In addition, the Enron Company faced a class action lawsuit and many other legal actions.

Introduction

Once upon a time, there was an enterprise called Enron. It was a leading energy company headquartered in Texas with offices throughout the world. One fall morning in 2001 this large corporation, with thousands of employees and stockholders imploded after an exhaustive effort to hide the company's financial losses. No single collapse of a corporation has affected America and the world in the manner that the demise of Enron did. The demise of the company not only affected thousands of employees and stockholders but also jeopardized the retirement funds of many others. There are many reasons the company collapsed including deceitful accounting methods, to a select group of employees who refused to tell the truth about the company. In any case, many questions remain unanswered concerning the ability of the company to avoid detection for so long.

The purpose of this discussion is to explore how a company can look so good on paper but ultimately disintegrate. The paper will seek to explain the tactic that Enron used to evade detection and mislead investors. We will discuss with depth and brevity the financial dealings of the company and the actions that leading executives played in perpetuating such a facade. The discussion will also focus on the issue of business ethics and the thought processes that were employed in making these terrible decisions. We will also bring attention to the thousands of people that were effect by Enron's practices. Let us begin our discussion with some background information about Enron.

BACKGROUND

In 1985, Enron was formed with the merger of Houston Natural Gas, a Texas pipeline company headed by Ken Lay, and Internorth, a larger Nebraska-based pipeline group. Sam Segnar, CEO of Internorth, headed the new company until his resignation during a reorganization in 1986. Kenneth Lay then resided as the head of the newly created Enron. He held this top position until he resigned under pressure on January 23, 2002.

Ken Lay, who had a doctorate from the University of Houston, saw the potential of natural gas deregulation in the 1980s. However, during the late 1980s, Enron struggled as a pipeline company in a period of plummeting natural gas prices. According to an article in the Journal of Accountancy, this struggle was fueled by the fact that Enron incurred a large amount of debt as a result of the merger; in addition, deregulation meant that the company no longer had control over its pipeline (Thomas 2002). For these reasons, the company was on the verge of failing and was forced to create an innovative organizational strategy to generate cash flow and profits (Thomas 2002).

To combat this situation, Enron hired Jeffrey Skilling, in 1990. Skilling was working as an energy trader handling the Enron account for McKinsey and Company. Skilling, a Harvard business school graduate, had a vision of turning Enron into a fast-moving energy trading company with few hard assets such as natural gas fields, pipelines, and power plants. Together, Lay and Skilling started to transform Enron into one of the largest, most respected companies in the world.

Under Lay and Skilling, Enron grew quickly, constantly moving into new markets and businesses. Skilling was the leader in transforming the corporate culture into a highly aggressive, innovative, and creative place to work. Enron prided itself on hiring the "best people." A company-wide performance review system was designed to weed out the poorest performers. Each person was evaluated and ranked against other employees in similar positions. Bonuses and promotions were based on employees' ranking. According to Thomas (2002), this ranking system was one of the most stringent systems of evaluating employees in corporate America. The author explains that the ranking system was referred to as the "360-degree review" which had its foundation in the values of Enron -- respect, integrity, communication, and excellence (RICE) (Thomas 2002). Because of the structure of this ranking system, individual performance was important; teamwork was not. The goal was making money at any cost. The measuring stick of success was the ever-increasing stock price driven by continued growth, regardless of risk.

In addition to Skilling, another key player entered the company; his name was Andrew Fastow (Thomas 2002). Fastow was 29 and a Kellog MBA when he began working for the company (Thomas 2002). Prior to coming to Enron, he worked for Continental Illinois Bank in Chicago coordinating leveraged buyouts and other complex transactions (Thomas 2002). Thomas (2002) reports that "Fastow became Skilling's protege in the same way Skilling had become Lay's. Fastow moved swiftly through the ranks and was promoted to chief financial officer in 1998. As Skilling oversaw the building of the company's vast trading operation, Fastow oversaw its financing by ever more complicated means (Thomas 2002)."

Enron's 2000 annual report touted their 15-year history of growth by writing "we have stretched ourselves beyond our own expectations . . . metamorphos (ing) from an asset-based pipeline and power generating company to a marketing and logistics company whose biggest assets are its well-established business approach and its innovative people."

During the go-go dot.com stock market growth of the 1990's, Enron's reputation as a low-asset, idea-based company played very well with stock market investors who continued to bid up Enron stock. Reported earnings per share continued to increase, supporting Enron's ever-increasing stock price. Enron's 2000 annual report stated, "earnings per share have increased steadily since 1997 and were up 25% in 2000 (and) the 10-year return to Enron shareholders was 1415% compared with 383% for the S & P. 500."

By 2001, Enron was ranked the seventh largest company in the United States. They had changed from a gas pipeline company to an energy trading company and then to a company based on trading oil, gas, water, minerals, forest products, broadband, and anything else they could make a commodity. As Enron grew larger, the company had to generate more earnings to support its increasing stock price. At some point in the late 1990's, Enron began trading derivatives.

Derivatives allow investors to gamble with other investors on the future price of an underlying asset, such as oil, electricity, weather, etc. When properly used, derivatives provide an effective hedge against future business risks such as hikes in oil prices, changes in interest rates, weather caused increases in energy usage with accompanying higher energy prices, and any other variable that could affect the value of underlying contracts. Although derivatives can be used to reduce risk, they are very precarious and can greatly exaggerate market gains and losses. The unpredictable and risky nature of derivatives is described in this manner

"Derivatives can be risky for several reasons. The major reason is that investors can use derivatives to take larger risks than they could otherwise obtain by the use of the capital to directly purchase securities or other assets. Another reason is that derivatives, even when used to reduce or hedge risk, create new risks in the form of credit risk. Credit risk is the exposure to a counterparty's inability to fulfill the derivative contract. Yet another risk is that… READ MORE

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