Accounting/finance Lessons Of Enron: A Case Study

A Case Study

Harold Bierman Jr

• Publisher: WSPC
• Year: 2008
• Print ISBN: 9789812790309
• eBook ISBN: 9789814338318
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

There is a great deal of confusion regarding the factors that led to Enron's collapse. This important book addresses this problem by providing a coherent explanation of the accounting and finance problems associated with the collapse. The Skilling-Lay trial, as it is related to accounting or finance issues, is critically described as well. Through its well-balanced take on events surrounding the trial, the book therefore enables readers to analyze the validity of the arguments offered by the U.S. attorneys.

Contents:

• The Enron Success and Failure
• Enron as of 31 December 2000
• First Six Months of 2001: Before the Storm
• Sherron Watkins' Letter to Kenneth L Lay
• The Clouds Burst
• The 100-Year Flood
• JEDI and Chewco: Not the Movie
• LJM1 and Rhythms
• LJM2 and Raptors I and III
• LJM2 and Raptors II and IV
• Other Transactions
• The Collapse
• The Indictment of Lay and Skilling
• The Trial
• A Slice of the Skilling–Lay Trial
• The Skilling–Lay Trial: Fair or Foul?
• Mark to Market Accounting: Feeding the Growth Requirement
• Concluding Observations

Readership: Students and academics in accounting, finance, law and banking; accountants, lawyers, board members and finance people; and general public.

Chapter 1

The Enron Success and Failure

In 1984, Kenneth L. Lay became the Chief Executive Officer of Houston Natural Gas Corporation, a pipeline operator. Soon after he took position, his firm merged with Internorth, another pipeline company. Lay became the CEO of the merged firm, and the name of the firm was changed to Enron. As deregulation of energy became more widespread (Lay influenced the rate of change) the mission of Enron widened to include the trading of energy contracts.

Shortly after the merger with Internorth, Lay hired the consulting firm, McKinsey & Co., to help develop a business strategy for Enron. One of the consultants assigned to the Enron study was Jeffrey Skilling. Lay subsequently hired Skilling to develop new business activities for Enron. Skilling successfully launched Enron's highly profitable business of trading energy derivatives.

Andrew Fastow was hired by Enron in 1990 from Continental Illinois Bank in Chicago and was appointed Chief Financial Officer (CFO) of Enron in 1998. Fastow was thought to complement Skilling's interests and abilities. Appointing Fastow as CFO was Enron's second biggest mistake (it probably would not have been made if the first mistake of allowing the departure of Rich Kinder had not been made).

Rich Kinder

In November 1996, Enron announced that Rich Kinder was leaving Enron. Shortly before that announcement the Enron Board of Directors (and Ken Lay) had failed to appoint Kinder as the CEO. The decision not to appoint Kinder as the President of Enron had very little to do with Kinder's acknowledged managerial abilities.

Kinder was (and is) a world-class manager, one of the few effective hands-on managers at Enron. The departure of Kinder was the most significant negative event for Enron during the 1990s. It would likely have been a different firm in 2001 if he had stayed.

When he left, Kinder bought from Enron the Liquids Pipeline Division for $40 million. With Bill Morgan and the $40 million pipeline he formed Kinder Morgan Corporation.

Kinder Morgan went public, but in 2006 Kinder and Morgan took the firm private (the corporation had a market cap of $14 billion).

In 2006, Rich Kinder was one of the world's richest persons and will be even richer when Kinder Morgan goes public again.

The $14 billion of Kinder Morgan value could possibly have been value-added to Enron if Kinder had not been rejected as CEO. Enron needed effective managers of real assets, and Kinder was among the best.

John Wing

John Wing was another great manager (of power plants) who was shown the door by Enron in July 1991. He helped execute the original deal that created Enron and was in and out of Enron from the early-1980s to 1991. He made money for Enron with hard assets.

His biggest moneymaker for Enron was a power plant in England called Teesside. He also did many other profitable deals for Enron.

John Wing did not fit easily into the Enron management structure. He was not the type of person with whom Ken Lay felt comfortable. When Wing wanted to separate his power group from Enron and form a separate publicly owned corporation, Lay facilitated his departure from Enron.

It is interesting to conject what would have happened if Enron had financed Rich Kinder's gas pipeline company and John Wing's power company. These two entities certainly would have developed into two very interesting merchant assets.

The Year 2001

In the year 2001, Enron was the seventh largest US Corporation (based on revenues) and possibly would have been ranked larger if the revenues of all the subsidiaries and special-purpose entities (SPEs) were factored into the calculation. It would have been ranked much lower if trading transactions were not treated as revenue. Interestingly, Enron was ranked number five in the Fortune 500 listing for 2001, published in March 2002. But no matter where we exactly rank it, Enron was a large profitable corporation before October 2001. If we consider only the available public information as of August 2001, it was a very profitable corporation.

On 17 December 2001, the Enron Corporation filed an 8-K report with the Securities and Exchange Commission (SEC). It stated that on “December 2, 2001, Enron Corp. (the “Company”) and certain other subsidiaries of the Company (collectively, the “Debtors”) each filed voluntary petitions for relief under chapter 11 of title 11 of the United States Code (the “Bankruptcy Code”) in the United States Bankruptcy Court for the Southern District of New York …”

Thus, in December 2001, Enron filed for bankruptcy. How did a seemingly healthy, profitable corporation transform itself into the biggest corporate scandal of the new millennium?

The newspapers have reported extensively on the clienteles that have been harmed by the Enron collapse. These include:

Employees with 401-K plans heavily (or exclusively) invested in Enron stock;

Employees who have lost their jobs at Enron;

Employees and investors who held worthless Enron stock;

Debtholders who owned debt that had lost most of its value (including bank debt).

But, the list of those affected greatly is much longer, including:

Top management with reputations in shatters and significant reductions in wealth.

Arthur Anderson—A once highly respected public accounting firm was struggling to stay afloat and subsequently was forced to shut down operations.

Security analysts who recommended Enron stock.

Bond rating agencies who had imperfect crystal balls.

Politicians who accepted donations from Enron.

At the beginning of 2001, Enron's common stock was high compared to its earnings. How does a CEO manage a company whose stock is overvalued? Enron management chose to take actions that presented a sunny smile to the public while painful events occurred. There were some executives who, fooled by the firm's own accounting and financial tricks, actually thought things were bright.

Five Business Segments

Enron was divided into five different specific business segments and a sixth general unit (catch-all).

1. Transportation and Distribution. This segment included regulated industries (e.g., electric utility operations), interstate transmission of natural gas, and the management and operation of pipelines.

2. Wholesale Services. This included a large portion of Enron's trading operations, energy commodity sales and services, and financial services of wholesale customers, and the development and operation of energy-related assets (such as power plants and natural gas pipelines).

3. Retail Energy Services (Enron Energy Services or EES). Sales of energy-related products (including expertise) to end-use customers (including commercial and industrial firms). On 30 June 2001, Enron had 730,000 retail customers.

4. Broadband Services. Construction and management of fiber-optic networks; the marketing and management of bandwidth; trading bandwith.

5. Exploration and Production. Exploration and production of natural gas and crude oil.

6. The catch-all segment. This included water and renewable energy; the supply of water and energy to end-use customers, the provision of wastewater services; construction and operation of wind-generated power projects.

The Retail Energy Services and Broadband Services were the two primary problem areas identified by the US Attorneys prosecuting Skilling and Lay.

The Three Components

While Enron was organized into five business segments and a sixth catch-all segment, it is useful in analyzing its collapse to describe Enron as consisting of three basic components:

1. A trading unit;

2. Real assets (generating and transportation);

3. Merchant assets (ownership interests in other firms).

While the initial investment in the merchant assets was less than that in the other two components, it was transactions related to the merchant assets that contributed most significantly to Enron's collapse and to Arthur Andersen's audit difficulties.

Interestingly, the problems associated with merchant assets were created not by Enron making bad merchant asset investments, but rather by the too-clever and too-imperfect efforts to insure that gains in the value of merchant assets that had been achieved were then not lost by value decreases. The objective of hedging the gains was reasonable. The means chosen to achieve the objective by the CFO Andrew Fastow were far from reasonable.

The Enron Hedge Fund

There was a hedge fund (ECT Investments) within Enron that invested in energy stocks. Investments were not limited to energy stocks, but the large gains were made on energy and technology stocks. The operation started small but grew to $150 million of Enron equity, and there were about $3 of debt for each dollar of equity. The fund earned annual returns of more than 20% (Wall Street Journal, 11 April 2002). We do not know if the profits continued after the stock market retreated in 2001.

The investing community was not at all aware of the hedge fund operations. Given the large amount of debt frequently used by hedge funds, knowledge of the existence of the fund could upset the conservative common stock investors. On the other hand, the fund offered an investment opportunity (a hedge fund) that was not normally available to investors with small amounts of capital. The hedge fund's income amounted to as much as 10% of Enron's earnings in some years.

There is no reason to conclude that the Enron hedge fund was a material contributing factor to the collapse if this fund is separate from the merchant assets that were reported.

A Distraction

The 11 March 2002 issue of Newsweek contains an article titled “Enron's Dirty Laundry” in which it described “sex-drenched out-of-control corporate culture that ultimately wrecked the company”. Enron's managerial culture likely contributed to the firm's collapse but in this book let us leave the subject of sex and other cultural considerations with that conclusion. For more details, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, can be referred to. This is an excellent comprehensive investigation into the events leading to Enron's collapse. In the current book, we will focus on the accounting and finance issues that resulted in Enron's collapse.

Among the titles considered for this book was “Enron: The Dumbest Guys in the Room”, but to be fair, the participants were not dumb. However, they were not the smartest, and sometimes they were too smart.

Rush to Judgment

In the fall of 2001 and in the winter of 2002, newspapers quickly identified the fact that Enron and the system that Enron operated in were corrupt. Paul Krugman had no problem identifying Enron's corruption (The New York Times, 18 January 2002, p. A23).

The Enron debacle is not just the story of a company that failed; it is the story of a system that failed. And the system didn't fail through carelessness or laziness; it was corrupted …

So capitalism as we know it depends on a set of institutions—many of them provided by the government—that limit the potential for insider abuse. These institutions include modern accounting rules, independent auditors, securities and financial market regulation, and prohibitions against insider trading.

The Enron affair shows that these institutions have been corrupted. None of the checks and balances that were supposed to prevent insider abuses worked; the supposedly independent players were compromised.

The truth is that key institutions that underpin our economic system have been corrupted. The only question that remains is how far and how high the corruption extends.

Is “corruption” an accurate and fair description of Enron's activities?

Bob Herbert (The New York Times, 17 January 2002, p. A29) saw the Enron debacle as an opportunity to attack deregulation:

The kind of madness that went on at Enron could only have flourished in the dark. Arthur Andersen was supposed to have been looking at the books, but the vast shadows cast by the ideology of deregulation allowed that company to escape effective scrutiny as well. So you have revolving-door abuses and pernicious financial arrangements between companies like Enron and auditors like Andersen that are similar to those between private companies.

There is also the observation of Senator Peter G. F...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Introduction
• Acknowledgments
• 1: The Enron Success and Failure
• 2: Enron as of 31 December 2000
• 3: First Six Months of 2001: Before the Storm
• 4: Sherron Watkins’ Letter to Kenneth L. Lay
• 5: The Clouds Burst*
• 6: The 100-Year Flood*
• 7: JEDI and Chewco: Not the Movie*
• 8: LJM1 and Rhythms*
• 9: LJM2 and Raptors I and III*
• 10: LJM2 and Raptors II and IV*
• 11: Other Transactions
• 12: The Collapse
• 13: The Indictment of Lay and Skilling
• 14: The Trial
• 15: A Slice of the Skilling-Lay Trial
• 16: The Skilling-Lay Trial: Fair or Foul?
• 17: Mark to Market Accounting: Feeding the Growth Requirement
• 18: Concluding Observations
• Index