Causes and Consequences of the Enron Scandal

Among the many financial scandals that rocked the world before 2001, the worst was the Enron Disaster. U.S Company Enron, which began as a small Midwestern gas pipeline company in 1985, spiraled into the world’s biggest energy trader by May 2001. Its dramatic collapse began in July 2001 and ended with it filing for the biggest Chapter 11 bankruptcy in the history of the US in December 2001.1

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Causes of the Enron Disaster

The 4 architects who caused the Enron disaster were politicians, government agencies, Enron officers and officials from Enron’s auditing firm, Arthur Andersen LLP. The first two architects aided and abetted the last two who were the main perpetrators of the disaster.

Politicians and Government Agencies

Shrewdly recognizing the underlying strong connection between politicians and regulating government agencies, Enron officials contributed lavishly {as much as $ 9.7 million} to the campaign funds of politicians.2 One of the largest beneficiaries was President George W. Bush3 and his Republican Party {it was established that the Enron CEO Kenneth Lay and his wife Linda also personally donated $ 794,700 to this Party since 1989}.4

The first and main cause of Enron’s downfall was the California energy crisis. Enron’s shrewd political move enabled its officials to collaborate with Vice President Dick Cheney in the drafting the National Energy Policy Act.5 The Act was duly passed in 1992, allowing power producing organisations like Enron to sell electricity to public utilities. Enron at once created an artificial power crisis in California by manipulating prices from the existing 3 cents per kilowatt to 33 cents. Its wealth began to grow so astronomically that its stock value registered a yearly increase of 40% over a period of 5 years {1995 to 2000} while Enron itself shot up to Number 7 on the list of large companies in the country.6 When the prices of energy collapsed in California in 2001 as a result of federal imposition of price caps,making it impossible for Enron to continue fleecing consumers with its exorbitant prices, politicians from that State charged Enron with manipulation of prices in May that year; California consumer groups joined the politicians in accusing Enron in June. In July 2001 California started experiencing major power shortages and rolling blackouts, leading to the main utility organisation {Pacific Gas and Electric Company} to apply for bankruptcy. Enron followed its example 5 months later.8

1: The Rise & Fall of Enron: Pbs.org

2: AUDET, J.R. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com.

3: ROTHWELL, J. 2002. Lessons from the Enron Collapse: Infinite Energy Magazine.

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4: The Rise & Fall of Enron: Pbs.org

5: ROTHWELL, J. 2002. Lessons from the Enron Collapse: Infinite Energy Magazine.

The second cause was the Financial Accounting Standards Board {FASB}. It created the Generally Accepted Accounts Principles {GAAP}. GAAP in fact contained literal ‘gaps’ that allowed unscrupulous organisations and officials to hide their actual financial status and cheat Americans of millions of dollars. Officials of Enron and Arthur Andersen took full advantage of this. In fact Andersen’s CEO Joseph Bernardino ‘innocently’ claimed that his firm had audited Enron’s accounts according to GAAP regulations.9

The third cause was the Commodity Futures Trading Commission {CFTC}. It favoured Enron in 1993 with a special exception that allowed it to engage in futures trading in the field of energy derivatives which happened to be the company’s most profitable business line. Significantly, CFTC chairperson Wendy Graham {her husband was a Republican senator from Texas} resigned from her job soon after the ruling favouring Enron and appeared 6 months later as a member of Enron’s Board of Directors.10

6: AUDET, J.R. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com.

7: ROTHWELL, J. 2002. Lessons from the Enron Collapse: Infinite Energy Magazine.

8: The Rise & Fall of Enron: Pbs.org

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9: AUDET, J.R. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com.

10: Ibid.

The fourth cause was the Securities and Exchange Commission {SEC}. It did not bother to audit Enron’s annual financial statements for 4 years {1997 to 2001}.11

Enron and Arthur Andersen

Officials of Enron and Arthur Andersen connived to carry out fraudulent accounting practices that willfully manipulated profit and loss. Firstly, bebt worth $ 20 billion12 and losses worth $ 500 million13 were hidden in nearly 4,000 {out of which 3,000 were offshore} special purpose entities {SPE} that were created to protect Enron from paying income tax. The SPE’s were nothing more than shell entities with Enron stock as share capital, which showed transactions as earnings. The SPE’s structure was such that their financial statements were independent and did not need to be consolidated with the mother company {Enron} financial statements. Enron was thus able to show higher than actual earnings and lower than actual debts by capitalising its SPE’s with Enron stock. Secondly, Enron accounts showed the value of consultancy fees to Andersen as $ 27 million while audit fees to Anderson were $ 25 million. Provision of consultancy services by an auditor is regarded as unfavourable to the public interest because the conflict of interest involved. Thirdly, 29 selected Enron officials acquired $ 1 billion in proceeds by selling Enron stock in 2001. This amount included $ 101 million earned by the same method by Kenneth and Linda Lay. The last cause was huge losses suffered by Enron due to ill-advised investments in the fiber-optic sector in the U.S, in a power plant in India and in a water distribution project in the U.K.14

Judging from the platform of the Seven Deadly Sins in Financial Reporting, the Enron executives as well as auditors of Arthur Andersen were primarily guilty of the Third Sin {Hyping and Spinning, meaning deliberately trying to fool the capital markets by getting them to focus only on good information}, the Sixth Sin {Minimum Auditing, that occurs when the significance of independent audit is underrated}, and secondarily guilty of the First Sin {Underestimating the Capital Markets}, and the Fourth Sin {Smoothing, meaning deliberately concealing the truth}.15

11: AUDET, J.R. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com.

12: Ibid.

13: ROTHWELL, J. 2002. Lessons from the Enron Collapse: Infinite Energy Magazine.

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14: AUDET, J.R. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com.

Consequences of Enron Disaster

The consequences were two-fold: immediate and long term.

Immediate Consequences

The first consequence was the losses incurred by Enron employees. Not only did 5,000 of them lose their jobs, but all those who had accounts in the Enron 401K retirement scheme found that their holdings were not worth the paper they were printed on.16 The second consequence was the huge losses suffered by Enron stockholders as the company’s once sky-high stock plummeted to penny levels.17 The third consequence was that the previous Big Five auditing firms – Price, Waterhouse, Coopers {PwC}, Klynveld, Peat, Marwick, Goerdeler {KPMG}, Ernst & Young {E&Y}, Deloitte & Touche {D&T}, and Arthur Andersen {AA} – that audited 80 percent of organisations in the UK FTSE 100, the US DOW, the Japanese Nikkei and the Chinese Hang-Seng as well as in other important global markets, were reduced to the Big Four after Arthur Andersen LLP, at one time the darling of the global accounting scene that was most discerning in its choice of employees and customers, was intensely scrutinised by the U.S Congress, SEC and ICA, and went down in disgrace.18 Its U.K business was taken over by D&T in 2002.

15: MILLER P.B. & BAHNSON P.R. Quality Financial Reporting. Pages 17-21.

16: AUDET, J.R. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com.

17: Ibid.

18: The ‘Big Five’ Accountancy Firms: Bbc.co.uk.

Long-term Consequences

The first consequence was that public interest in, and discussion about, the specific functions of auditors and whether their independence can be compromised in certain situations, recorded a huge increase ever since Enron’s chaotic disaster; the high profile case not only lowered the esteem of the auditing profession as a whole in the eyes of the world, but also eroded confidence of shareholders, making them doubt the authenticity of the reports published.

The second consequence was that government authorities around the world moved quickly to place additional restraining regulations after 2001. The U.S passed the of the Sarbanes-Oxley Act by the U.S. in 2002, while EU countries formed independent auditor oversight bodies under its already existing Eighth Company Law Directive to enhance standards and be internationally competitive with ‘very good’ {meaning the UK and US} countries.19 The UK passed its own equivalent to the US and EU regulations on January 29, 2003 in the form of the Hewitt-Brown reforms that are applicable to all listed companies in the UK.

Conclusion

Justice was finally meted out satisfactorily to stockholders in the Enron Debacle on September 10, 2008 when a US Federal judge awarded $ 7.2 billion to be divided among Enron shareholders numbering nearly 1.5 million individuals and entities.20 While there have been other high profile financial disasters after 2001 such as the WorldCom disaster in June 2002 and Lehman Brothers filing for bankruptcy in September 2008, none have yet matched the magnitude of the Enron disaster. The chilling report of the February 2002 Financial Times: ‘individual greed’ on an unprecedented level, a ‘shocking willingness’ to ignore suspicious practices by organisations, a ‘shameful determination’ to hide proof, and the ‘enthusiasm of politicians’ to

19: KERSNAR, J. Mending Fences: CFO Europe Magazine.

20: Judge Rules Enron Shareholders Can Share in $ 7.2B Settlement: San Jose Business Journal.

accept bribes from an organisation that was eventually exposed as a ‘sham,’ in addition to the then Head of U.S Federal Reserve Paul Volcker admitting in the wake of the Enron disaster: “Accounting and Auditing in this country is in a state of crisis”21 will always be engrained in global public memory. In the event of another loss of a Big Four firm caused by professional misconduct, the effects of a four-to-three scenario would, among other effects, erode investor confidence to an unprecedented low, one from which it would take years to recover.

21: BEAMS, N. Enron Fallout is Spreading: World Socialist Web Site.

References

  1. ANON. 2007. The ‘Big Five’ Accountancy Firms: Bbc.co.uk. [Online].
  2. ANON. 2002. The Rise & Fall of Enron: Pbs.org. [Online}.
  3. AUDET, J.R. 2008. An Octopus of Greed – The Enron Financial Web of Corruption: Quarterly-report.com. [Online].
  4. BEAMS, N. 2002. Enron Fallout is Spreading: World Socialist Web Site. [Online] Web.
  5. KERSNAR, J. 2008. Mending Fences: CFO Europe Magazine. [Online]. Web.
  6. MILLER P.B. & BAHNSON P.R. 2002. Quality Financial Reporting. McGraw-Hill, USA
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