Analysis of Financial statements "case summary: Enron Scandal"

Enron, one of the top 10 companies of United States of America, collapsed in 2001. The major cause behind collapse of Enron was the corruption done by its employees in accurately disclosing the required data in accordance of Accounting Standards. Following a low asset strategy Enron was more of a trader of energy rather the producers. It was because of this reason that it generated a lot of profits over the years.

Employees at Enron Hedged the risk and over stated the profits and understated the debt to make it look as a potential and impressive investment corporation. Between the years 1997-2001 employees stated $586 Million over the profits and understated the debt by $711 Million. Enron’s top management constantly promoted the shares of the failing firm, knowing the fact that understating of profits and debt would destroy the firm’s image in investor’s eyes and would eventually fail to generate profits. Enron’s stock rose up to $ 90 before it started falling. Near the end of 2001, Enron lost its share price and no one was willing to invest in the company. Pressure from the Government and Media forced it to reveal detailed statements of its investments and the debt amount. At the end of 2001 Enron’s share price was selling just over $ 1 and investors had totally lost faith in Enron. In the midst of all this, Enron’s Energy rivals Dynegy called of the deal to buy Enron for $ 9 billion. Top leadership was heavily criticized and Board of Directors was blamed for pursuing personal interests and gains instead of keeping the interest of investor in account. At the end of 2001 Enron filed for bankruptcy, creditors lost their investment, employees lost their jobs and pension plans.

The Accountants:

Anderson was the auditor for Enron since 1985. Being external auditor it was Anderson’s job to search for anomaly in reporting of data by Enron but after Enron collapsed and questions were asked against role of Anderson, many new secrets were revealed. Anderson was not only the external auditor of Enron, it also served as an internal auditor and consultant of Enron after 1993. It received $ 25 million for its auditing services and $ 27 million for its other services.  Many of the officials of Anderson also joined Enron as its senior officials. Anderson was held accountable by the Enron creditors and shareholders. It had to face a law suit not only by Enron’s creditors and shareholders but also a law suit related to fraud and obstruction of Law under the law of state. Many partners of Anderson left it because of its obstruction of law. The trial began on May 8 and jury convicted it in the crime on August 31. Keeping in view the Enron’s and Anderson’s case the Government was forced to pass a regulation in order to avoid any such case in future and to safe guard the rights of investors and shareholders against malpractices and corruption. In July 2002 Sarbanes-Oxley Act was passed to determine the role of auditors. The auditors and their role was questioned and the “BIG FIVE” auditors were reduced to “FINAL FOUR”

The Analysts:

Analysts failed to recognize accurate earning forecast, stock recommendations and detailed research reports to figure out problems and risk that led the downfall of Enron. At the beginning of 2001, Enron’s stock was priced at 70 times earnings and 6 times book value. Most of the analysts also recommended buying or holding of Enron’s stock even when stock prices were falling drastically. One of the reasons that made analysts to make such a recommendation was because of the fact that the investment banks that employed the analysts supported Enron’s ongoing success because they were also partners in the firm’s partnership, as Enron was paying investment banks large fees to raise its public capital markets and for advise on different merger and acquisition transactions. After this Enron’s incident, state regulators started to pressurize some investment banks to seal their research departments entirely from investment banking because research reports written by analysts, who are employees of investing banks, show potential biasness toward the partnership between investing bank and the firm (like Enron). But, observers were still concerned of whether this step taken by regulators would lead to any optimal outcome without increase in further cost due to increased analyst independence.

The Investment Bank

Several of Enron’s bankers had channeled hundreds of millions of dollars in financing to the firm through its partnerships, enabling Enron to effectively borrow secretly. Besides the interest income from the loans, the banks stood to gain fees from underwriting transactions that Enron might direct to them. Apparently, Enron management had promised underwriting business to banks in exchange for their investing in Enron partnerships. Their dual role as investors and underwriters exposed the banks to conflicts of interest. The banks enable Enron to exploit accounting dodge and make it appear that the firm carried less than its actual debt for raising funds by recommending Enron to investors as an attractive investment. Being a special-purpose-partnership, banks mask the weakness of the firm. They use accounting trick rather a true economic hedges. They failed to protect Enron from risk.  By make worse these conflicts, investments in Enron partnerships were made by not only investment banks but also executives of the banks. For instance, besides Merrill Lynch investing $5 million in, and loaning $10 million to, one of these partnerships. Their ownership stakes in the partnerships might have influenced their business decisions. The financial institutions suffered disastrously when Enron failed. Their loans and investments in partnerships were worth nothing. The banks were also blamed for investors’ losses by virtue of having misrepresented Enron’s true state when promoting its securities. Lawmakers were confusing over whether the conflicts facing investment banks had been worsen by letting the last leftovers of the Glass-Steagall Act, passed in 1933 allowing banks to engage in the full panoply of commercial and investment banking activities. The reasoning behind this was that, banks could benefit from the economies of conducting commercial and investment banking jointly, and competition in both businesses would prevent banks from exploiting their strengths in one business to push the other business to the disadvantage of clients and competitors. Observers questioned whether weakening the Glass-Steagall Act had make worse the conflicts without significant improvement in economic efficiency. To benefit most from potential economies and to fully use all available information on firms such as Enron to make mutually consistent decisions in commercial banking, investment banking, private banking, research, and brokerage, the banks would need to break the “Chinese wall” that separated various departments. Breaking down the walls might make operations more efficient and also help the banks arrive at a more holistic and clearer picture of firms such as Enron but would intensify conflicts between the various activities. For example, if the walls separating independent research and dedicated investment banking advice were to be broken down, brokerage clients might have been warned about the potential weaknesses of firms that were investment banking clients, but sharing that information would militate against the loyalty that investment banking clients would justifiably expect from their advisers.

The Lawyers

Enron had an in-house staff of 250 lawyers. Company’s general counsel had not questioned the legal modesty of the various partnerships into which Enron was entering. When Enron was buying puts from itself through the special-purpose partnerships, when it was granting hundreds of millions of dollars of stock to the partnerships without consideration, the general counsel’s office restricted its concerns as to whether the arrangements proposed by management and approved by the board were technically legal, rather than seeing its duty more broadly as protecting the firm’s interests. Also Enron executives had taken positions in partnerships that placed them in conflict with their responsibilities as Enron employees. The executives were expected to seek waivers proactively about the code of conduct; the lawyers claimed they had no say in identifying, preventing, or monitoring such conflicts. Supporting the inside counsel was Enron’s outside counsel, Vinson & Elkins a law firm in USA. Enron’s general counsel, James Derrick, had practiced law at Vinson & Elkins for 20 years before joining Enron, and more than 20 of the firm’s in-house legal staff had previously worked at Vinson & Elkins. Vinson & Elkins had billed Enron more than $36 million in 2001 and more than $150 million over the previous five years. Enron was the law firm’s biggest client.

Watkins Enron executive, approached chairman Kenneth Lay that company could involved in accounting scandals. Vinson & Elkins was asking to conduct investigation. After an investigation that primarily comprised interviews with very senior Enron and Andersen executives, Vinson & Elkins quickly concluded that Watkins’s concerns did not merit a wider investigation. Outsiders questioned whether Vinson & Elkins had served their client Enron’s best interest by conducting a quick though less-than-comprehensive investigation to expeditiously judge the merit in Watkins’s allegations or had hurt the client’s long-term interest by contributing to a 7cover-up to quickly mollify Watkins without warning outsiders that something might be wrong.

Lawyer’s assumptions of broad fiduciary or narrow fiduciary toward their clients may favor either lawyers or their client. Assuming their responsibility narrowly would be in the lawyers’ own interest since it reduced potential resistance that standing up to clients might involve. But assuming narrow responsibility might not be in the clients’ best long-term interest.

In addition, close ties between inside and outside counsel ensured efficient exchange of information but jeopardized the mutual independence of the two corporate watchdogs.

The Consultants’:

The prime consultancy firm attached with Enron was Mckinsey. In 1990, Mckinsey partnered with Enron to make it Enron Trade and Capital from just a natural gas producer and distributor. Mckinsey consultants closed worked on Enron projects. After Enron surprise debacle in 2001, Mickinsey tried to wash his hands by saying “We advise clients on their strategy,there soley responsible for the actions they take”.

Many consultants not only closed worked with Enron but also portrayed Enron as the “new economy” and a trend setting firm. They openly applauded their leadership’s style, innovative thinking and organizational culture.

Although these consultants’ said they were hoodwinked by Enron management. Neutral believe that these consultants played a huge part in shaping the image of Enron,that was partially earned and partially manipulated.

The credit raters

Credit rating agencies are dominated by three main agencies-Moody ,Standard and Poor and Fitch ratings that are consider as a reliable source to understand a company’s creditworthiness and other financial obligation.

In Enron case, it seemed that they credit agencies were late to identify the Enron’s credit riskiness  Neutral observer believe that these credit rating agencies were providing services like research to the same firms they were rating.

Non-competitiveness in the credit rating industry leads to weak analysis of Enron’s securities. Observers believe that non-competitiveness led to oligopoly of credit-rater who paid less attention to Enron poor creditworthiness.

The Professional Associations:

After the Enron collapse, commentators, regulators and policy makers came under severe criticism. AICPA consisted of professional like financial managers, researcher, analysts’, investment bankers soon made a task force to study Enron’s manipulation and incorporate new standards. Observers saw these attempts as futile and a way to escape for been monitored more strictly by SEC.