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Annika Kay B.

Chan
Legal Accounting

KEEPING SKELETONS IN THE CLOSET: ENRON’S FINANCIAL SUCCESS AND


DOWNFALL

Background
Enron Corporation was an American energy company based in Houston, Texas.1 It was
the first big accounting scandal to have ever hit the American market. It is interesting to note
that the officers were able to hide the losses so well that prior to the scandal, Enron was dubbed
as “America’s Most Innovative Company,” by Fortune magazine between 1996 and 2000.2
Enron was formed in 1985 following a merger between Houston Natural Gas Company
and Omaha-based InterNorth Incorporated.3 With regard to its officers, Kenneth Lay (CEO of
Houston Natural Gas), became the CEO and chairman, and he quickly rebranded Enron into an
energy trader and supplier.4 Deregulation of the energy markets allowed companies to speculate,
and as a result, Lay created the Enron Finance Corporation, and subsequently appointed Jeffrey
Skilling as the head of the new corporation.5 The era’s lack of regulatory prowess allowed Enron
to flourish, at least on the outside, as stocks were being overvalued at absurd levels.6

Accounting Method Transition: Mark-to-Market (MTM)


Its success can be attributed to the accounting transition adopted: from a traditional
historical cost accounting to mark-to-market (MTM) method, which was approved by SEC in
1992.7 Mark-to-market is an accounting tool used to record the value of an asset with respect to
its current market price.8 It can change the value on either side of a balance sheet, depending

1
Rachel Smith, The Enron Scandal, available at http://large.stanford.edu/courses/2018/ph240/smith1/
(last accessed Dec. 16, 2019).
2
Id.
3
Troy Segal, Enron Scandal: The Fall of a Wall Street Darling, available at
https://www.investopedia.com/updates/enron-scandal-summary/ (last accessed Dec. 16, 2019).
4
Id.
5
Id.
6
Id.
7
Id.
8
The Economic Times, Definition of ‘Mark To Market’, available at
https://economictimes.indiatimes.com/definition/mark-to-market (last accessed Dec. 16, 2019).
on the conditions of the market.9 An example would be when stocks that an individual holds in
his/her demat account are marked to market everyday; and so at the time of the closing of the
market, the price assigned to each stock is the price that buyers and sellers decide at the end of
the day.10 The challenge with this method is that the value of the assets may vary every second
due to changing market conditions as well as the irregular entrance and exit of buyers and
sellers.11 Moreover, in times of financial crisis, a company or financial institution is forced to
calculate selling prices of its assets and liabilities.12
In its purest form, MTM reflects the realistic value of accounts. However, it is susceptible
to manipulation since MTM is not based on “actual” cost but on “fair value.”13 In other words, the
technique measures the value of a security based on its current market value instead of its book
value. As a consequence, Enron logged its estimated profits as actual profits.14 The machination
is as follows: Enron would build an asset, such as a powerplant, and immediately claim the
projected profit on its books, even though the company had not made one dime from the asset.15
On the other hand, if the revenue from the powerplant was less than the projected amount, the
loss would then be redirected to an off-the-books corporation where such loss would go
unreported.16 In order to avoid suspicion, Andrew Faston (Chief Financial Officer of Enron)
orchestrated a scheme to use off-balance-sheet special purposes vehicles (SPVs), also known as
special purposes entities (SPEs), to hide its mountains of debt and toxic assets from investors
and creditors.17 The standard Enron-to-SPV transaction would be the following: Enron would
transfer some of its rapidly rising stock to the SPV in exchange for cash or a note. The SPV would
subsequently use the stock to hedge an asset listed on Enron's balance sheet. In turn, Enron
would guarantee the SPV's value to reduce apparent counterparty risk.18

9
Id.
10
Id.
11
Id.
12
Id.
13
Segal, supra note 3.
14
Id.
15
Id.
16
Id.
17
Id.
18
Id.
Shortly after, investors got wind of their practices; Skilling took over the role of CEO after
Lay retired. Skilling later retired for “personal reasons.”19 Enron was investigated by SEC and the
company’s debt was later found out to be $628 million and losses to be $591 million.20

Penalties
In the end, Enron’s executives were charged for insider trading, securities fraud, and
conspiracy. Lay was convicted of six (6) counts of fraud and conspiracy and four (4) counts of
bank fraud, which eventually led to his demise.21 Skilling was convicted of insider trading, fraud,
and conspiracy but he was released from prison in 2018.22

Effects
As a result of Enron’s (as well as Tyco’s and WorldCom’s) accounting fraud, the Sarbanes-
Oxley Act was passed in order to protect investors from fraudulent financial reporting by
corporations.23 The reason for this is because the high-profile frauds impeded investor confidence
in the trustworthiness of corporate financial statements and led many to demand changes in the
regulatory standards.24

Analysis
Delving into the basic principles, one of the violated principles is full disclosure principle.
In accounting, the records must reflect truthful transactions, accompanied by a faithful recording
of such as there must be full disclosure. The core idea instilled is transparency. Transparency is
important on the part of the company in order for it to be able to assess its current financial
position, so that it could make adjustments in areas needed. Moreover, transparency can help
curb the dangers that companies pose (such as Enron) so that investor confidence will not be
trampled on. Trust on the system is essential in order to have a healthy market condition.

19
Smith, supra note 1.
20
Smith, supra note 1 (citing P.M. Healy and K.G. Palepu, The Fall of Enron, J. Econ. Perspect, 17, 3
(2003)).
21
Smith, supra note 1 (citing Andrew Clark, Disgraced boss Ken Lay dies at luxury ski chalet, available at
https://www.theguardian.com/business/2006/jul/06/usnews.enron (last accessed Dec. 16, 2019)).
22
Smith, supra note 1 (citing Chris Morris, Former Enron CEO Jeff Skilling Released From Prison, available
at https://www.theguardian.com/business/2006/jul/06/usnews.enron (last accessed Dec. 16, 2019)).
23
Will Kenton, Sarbanes-Oxley (SOX) Act of 2002, available at
https://www.investopedia.com/terms/s/sarbanesoxleyact.asp (last accessed Dec. 16, 2019).
24
Id.
In this case, transparency is but a facet of corporate governance. Accordingly, “Corporate
governance is the system of checks and balances of both internal and external to companies. The
system ensures that companies discharge their accountability to all their stakeholders and act in
a socially responsible way in all areas of their business activity.”25 The end goal of corporate
governance is to create stakeholder value. In the larger scheme of corporate governance,
accounting is included because proper accounting actually brings out greater stakeholder value
in the form of faithful representation of financial statements.
It is also important to note that technically, Enron did nothing illegal per se. It followed
the laws albeit lunging into its loopholes. However, abuse of process still falls within the realms
of ethics and proper corporate governance as well as accounting procedures were not followed.
A multitude of concealed financial statements snowballed and eventually wreaked havoc.
However, as money came easy to the executives, the consequences were shouldered by the
stakeholders. Some lost their pension benefits while others lost their investments. A serious hit
in the stock market would unduly have public repercussions. To an extent, it would also have
negative implications on the part of the government because of the lack of legislation would
dampen public trust. Therefore, as evident in the Enron case, the Sarbanes-Oxley Act was passed
in order for history to not repeat itself.
In the end, a critical question would be: Would Enron have succeeded in its accounting
scam were it not for the shattered stakeholder confidence? I believe it would have ended tragically
either way. Active concealment by the senior officers as well as middle management is never a
good sign. In the case of Enron, the corporate executives show that profit trumps ethics and fair
play. The Enron scandal, as well as other corporate scandals that immediately followed, portray
how top executives as well as those in the managerial position can affect the company and
eventually lead to its success or ruin. However, in the end, it is the stakeholders that are greatly
affected; therefore, they must be protected against all forms of fraudulent machinations that
corporations could concoct.
It is apparent how critical the role of accounting is in businesses. When the corporation
shuts its doors and violates one of accounting’s foundational principles, then the whole business
will shake and eventually crumble to the ground. Although profits are to be generated in the short
term, the long term effects would be disastrous. Just like in Enron, lack of transparency is
oftentimes equivalent to fraud. When a person is not transparent, then they cannot be trusted;

25
JILL SOLOMON & ARIS SOLOMON, CORPORATE GOVERNANCE AND ACCOUNTABILITY 17 (2003 ed.).
when a person cannot be trusted, then they have no investors. Moreover, transparency is not
only for the stake of the investors and the company, but also for the company employees. The
employees also need to be informed of the company’s performance because if they see that the
company is doing well, then their work would also be positively affected. Moreover, they need
some kind of security that they will not lose their jobs. As such, they are included in the term
“stakeholders.”
Therefore, companies have a lot of responsibilities on its shoulders. It cannot arbitrarily
choose a course of action which is detrimental to its stakeholders. Luckily for them, in the financial
aspect of their business, there exists accounting principles which they must adhere to. If followed
religiously, then they should have minimal problems with their finances. With this, companies can
avoid the mistake of Enron.

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