BACKGROUND OF THE CASE

Enron scandal, series of events that resulted in the bankruptcy of the U.S. energy,
commodities, and services company Enron Corporation and the dissolution of Arthur
Andersen , which had been one of the largest auditing and accounting companies in the
world. The collapse of Enron, which held more than $60 billion in assets, involved one of the
biggest bankruptcy filings in the history of the United States, and it generated much debate as
well as legislation designed to improve accounting standards and practices, with long-
lasting repercussions in the financial world.

Enron was founded in 1985 by Kenneth Lay in the merger of two natural-gas-transmission

companies, Houston Natural Gas Corporation and Inter North, Inc.; the merged company,
HNG Inter North, was renamed Enron in 1986. After the U.S. Congress adopted a series of
laws to deregulate the sale of natural gas in the early 1990s, the company lost
its exclusive right to operate its pipelines. With the help of Jeffrey Skilling, who was initially
a consultant and later became the company’s chief operating officer, Enron transformed itself
into a trader of energy derivative contracts, acting as an intermediary between natural-gas
producers and their customers. The trades allowed the producers to mitigate the risk of
energy-price fluctuations by fixing the selling price of their products through a contract
negotiated by Enron for a fee. Under Skilling’s leadership, Enron soon dominated the market
for natural-gas contracts, and the company started to generate huge profits on its trades.

Skilling also gradually changed the culture of the company to emphasize aggressive trading.
He hired top candidates from MBA programs around the country and created an intensely
competitive environment within the company, in which the focus was increasingly on closing
as many cash-generating trades as possible in the shortest amount of time. One of his
brightest recruits was Andrew Fastow, who quickly rose through the ranks to become Enron’s
chief financial officer. Fastow oversaw the financing of the company through investments in
increasingly complex instruments, while Skilling oversaw the building of its vast trading
operation.

The bull market of the 1990s helped to fuel Enron’s ambitions and contributed to its rapid
growth. There were deals to be made everywhere, and the company was ready to create a
market for anything that anyone was willing to trade. It thus traded derivative contracts for a
wide variety of commodities—including electricity, coal, paper, and steel—and even for the
weather. An online trading division, Enron Online, was launched during the dot-com boom,
and the company invested in building a broadband telecommunications
network to facilitate high-speed trading.

As the boom years came to an end and as Enron faced increased competition in the energy-
trading business, the company’s profits shrank rapidly. Under pressure from shareholders,
company executives began to rely on dubious accounting practices, including a technique
known as “mark-to-market accounting,” to hide the troubles. Mark-to-market accounting
allowed the company to write unrealized future gains from some trading contracts into
current income statements, thus giving the illusion of higher current profits. Furthermore, the
troubled operations of the company were transferred to so-called special purpose
entities (SPEs), which are essentially limited partnerships created with outside parties.
Although many companies distributed assets to SPEs, Enron abused the practice by using
SPEs as dump sites for its troubled assets. Transferring those assets to SPEs meant that they
were kept off Enron’s books, making its losses look less severe than they really were.
Ironically, some of those SPEs were run by Fastow himself. Throughout these years, Arthur
Andersen served not only as Enron’s auditor but also as a consultant for the company.

The severity of the situation began to become apparent in mid-2001 as a number of analysts
began to dig into the details of Enron’s publicly released financial statements. An internal
investigation was initiated following a memorandum from a company vice president, and
soon the Securities and Exchange Commission (SEC) was investigating the transactions
between Enron and Fastow’s SPEs.

As the details of the accounting frauds emerged, the stock price of the company plummeted
from a high of $90 per share in mid-2000 to less than $1 by the end of November 2001,
taking with it the value of Enron employees’ 401(k) pensions, which were mainly tied to the
company stock. Lay and Skilling resigned, and Fastow was fired two days after the SEC
investigation started.

On December 2, 2001, Enron filed for Chapter 11 bankruptcy protection. Many Enron
executives were indicted on a variety of charges and were later sentenced to prison. Arthur
Andersen came under intense scrutiny and eventually lost a majority of its clients. The
damage to its reputation was so severe that it was forced to dissolve itself. In addition to
federal lawsuits, hundreds of civil suits were filed by shareholders against both Enron and
Andersen.

The scandal resulted in a wave of new regulations and legislation designed to increase the
accuracy of financial reporting for publicly traded companies. The most important of those
measures, the Sarbanes-Oxley Act (2002), imposed harsh penalties for destroying, altering, or
fabricating financial records. The act also prohibited auditing firms from doing
any concurrent consulting business for the same clients.

(From company point of view) Pros:-

 Enron tried to expand their market by increasing the market size, so they hired top
MBA graduates and created a competitive environment.
 Enron wanted to expand their market so they indulged in trading that anyone is
willing to trade including commodities like coal, electricity, paper and steel.
 Enron also wanted to increase the speed of trading so they launched the Enron Online
and invested in telecommunication Network.
 Falsely inflated the revenue of the company which attracted more no of investors in
the company.
 Became the seventh largest corporation in United States.

Cons:-

 Many of the employees who have been working in Enron have to face many
challenges and job cut due to their unethical practices.
 Enron have faulted their financial statement and the accounting practices due to which
they became bankrupt.
 Their financial statements were not properly designed; they have not assigned the
cash flows that they have earned from the trading of the commodities. Moreover, they
gave illusion of the higher current profits that were actually unrealized future gains,
the unrealized future gains were uncertain so they cannot be considered as current
cash income.
 In very short period of time the share prices of the company has fall down.
 Turned the valuable stock options into worthless papers.
 The downfall of Enron effected other public sector company attached with Enron.
Ethical assessment

As per our observation from the case study we found out that Enron didn’t start out as an
unethical business. But later because of the increasing ratio of competitors and to sustain
among the competitors they started to follow unethical norms for their business. This led to
the introduction of quite extreme incentive schemes to attract and motivate very bright and
driven people, which, in turn, led to an unhealthy focus on short term earnings.

The next step was to look at how earnings could be manipulated to achieve the aggressive
revenue and earnings targets. Since the manipulated figures for growth in earnings still left a
shortfall in cash, Enron quickly ended its borrowing abilities.

But issuing more equity would have affected the share price, on which most of the incentives
were based. So schemes had to be created to produce funding secretly and this funding had to
be hidden. In this way, an amoral and unethical culture developed in Enron in which
customers, suppliers and even colleagues were misled and exploited to achieve targets. And
the top management, who were rewarding themselves with these same incentive schemes,
boasted that a pure, market-driven ethos was propelling Enron to greatness and deluded
themselves that this equated to ethical behaviour.

Hence if they would not have undergone such unethical practices they might have been able
to sustain or there was a probability of not being bankrupted or being defamed for the
unethical practices. This could have also minimized the adverse effects or cons which was
caused by this bankruptcy of Enron scandal.