FALL OF THE WALL STREET DARLING (2001): AN ANALYSIS

Authored By:

Aryan Manwani

F.Y BAF, Jai Hind College, Mumbai


1. BACKGROUND OF THE ENRON CORP.:


Enron Corporation was formed in the year 1985 following a merger between Houston Natural Gas and IntraNorth. Prior to the merger, Enron Corporation was one of the largest American conglomerate listed on the New York Stock Exchange. It dealt in the energy and commodities sector based out of Houston, Texas. With about 29,000 employees, it claimed revenues of up to $101 billion in the year 2000(Fortune 500, 2001). Back then Enron was considered as the blue-chip stock. After the merger, Kenneth Lay, who had been the Chief Executive Officer of Houston Natural Gas was appointed as Enron’s CEO and Chairman. Lay had appointed Jeffery Skilling to head the Enron Finance Corporation. Jeffery Skilling had earlier worked with Mc Kinsey and Company and was the youngest partner in the Company(Segal, 2020).


2. INTRODUCTION OF THE SCAM:


Enron was involved in a financial scandal (hereinafter referred to as “the Enron Scam”) through misappropriate and misrepresentation of its financial documents. The Enron scam is considered as one of the largest financial scandals of the century. It led to major ripples throughout the financial ecosystem, investors, employment and economy of the United States. Enron committed several misleading and unethical accounting practices which led to a misconception about strong financials of the company. From trading at $20 to highest ever $90 in a very short period of time. It’s quite amusing to see how they kept the regulators at bay and never even gave an opportunity of suspicion until the moment they declared bankruptcy.


3. THE ROLE OF ACCOUNTING FIRM:


Enron had appointed “Arthur Anderson” as their official accountants and auditors of the company. Arthur Anderson was America’s fifth-biggest accounting firm after the Big 4 accounting firms. After the Enron scam came to light, it led to the dissolution of Arthur Anderson because people lost faith and considered this accounting firm as unethical in nature. Later in the court proceedings, Arthur Anderson was held liable for “obstructing justice” since it destroyed very important financial papers except for the basic documents.


4. METHODOLOGY OF THE SCAM: MARK-TO-MARKET METHOD:


Whole Enron scam boils down to this accounting structure. With this accounting method, Enron was successful in hiding amounts of debts to show untrue and inflated profits resulting in the good image of the company before the financial markets. This method of accounting is completely based on the market value and estimates, unlike the historical cost method where the assets are listed on the balance sheet at the price, they are bought in. Whereas, in the mark to the market method of accounting, on a year to year basis, the price of the assets are appreciated based on estimates of the auditors. While this accounting method is not prohibited by law, the accounting firm Arthur Anderson ended up overestimating the value of the assets by about 4x times and showed the same on the financial documents. This method comes under “fair value” method of accounting which was considered as the Generally Accepted Accounting Principles (GAAP) in the United States. The whole basis of this method is that it records current market value and not the original market value of the assets (Tax Guru, 2016). Surprisingly, financial valuation of an asset is not a determinate science but a substantive skill.


a. EXAMPLE:

Suppose a land is bought at the value of Rs. 20/- crore, in the first year, the value of the land will be shown as Rs. 20/- crore. Essentially, in the following years, the value of the land can be appreciated based on a formula but without any sound or established rationale. The amount of Rs. 20/- crore could be fluctuated to about Rs. 25 to 30/- crore with adequate reasoning that under normal circumstances, the market value of real estate constantly increases in a country like India. This is based on the sole assumption of the auditor who finalises the books of accounts of that particular firm.


5. SPECIAL PURPOSE VEHICLE (SPV) :


SPV is a kind of a business entity which could be owned by the main company. Contrary to popular opinion, SPV is not a subsidiary of a company. SPV is used when there is a risky business involved. SPV enables the company to hide its losses incurred from doing business and transfer it in the name of the SPV which it holds. This helps the main company to retain its name in the market even after incurring huge debts and losses. Usually, financial documents of SPV companies are not available to the public at large. So, in other words, SPV is fake companies to misrepresent true financial statements of companies.


6. HOW ENRON USED MARK TO MARKET METHOD AND SPV?

· In a deal with Sithe Energy, Enron had to provide 195mm cubic feet of gas every day. The deal was agreed for $4 Billion. Enron showed the revenue from this deal in their Profit and Loss statement when the operation was not even in started. They assumed the profits which they would make in future with this deal, inflated it to at least 4x times and showed it in the financial documents(Credit Pulse Coverage, Analysis, Perspective, 2008).

· Enron had a deal with Blockbuster company (a web series streaming platform of 90’s just like how we have Netflix now) to provide Fiber Optics for 20 years. Similarly, just like the case with Sithe Energy, Enron started showing its revenue and profit in Profit and Loss before starting its services, completely based on future profit assumption(Norris, 2002).

· Enron formed various SPVs and started transferring its Assets to SPV. With this, SPV can easily get loans just by showing assets in their name which led to hassle-free loan approval from Banks and financial institutions. If at all Banks asked for the special guarantee, then Enron used its own goodwill which made the deal undeniable. After a loan was granted, funds would directly get a transfer from SPV to Enron. The Assets which Enron sold or transferred to SPV were shown in the books of accounts as if any services have been provided or products have been sold to those companies. The loan which SPV got used to transfer to Enron and the Assets transferred were shown as Revenue(Segal, 2020).

7. ACCREDITATION/ PRAISING:

· Enron had made it to the first place of most innovative company consecutively for six years by Forbes magazine.

· Enron stocks were considered as blue-chip stocks.

· America’s seventh-largest company of its time.

· Soon it became the fastest-growing company of America.

· It is popularly known as Wall Street Darling as well.

8. FREEFALL OF ENRON:


Around 1999, people lost faith in tech-companies, the dot com boom period of tech companies was felt saturated at the time. One by one companies in America started to dissolve and insolvency cases had risen. It is assumed that Japan’s recession had triggered it to some extent. Many tech companies hit bottom and some scams like Enron did come out but they were peanuts in compared to what Enron did. After people stopped investing, Enron found it difficult to keep up the pace of fraudulent activities and thus after August 15, 2001, the day when Enron CEO, Skilling, unexpectedly resigned stating personal reasons, the suspicion crept in and soon Enron declared Bankruptcy in the month of December 2001.


FOLLOWING IS A GRAPHICAL REPRESENTATION OF THE STOCK PRICE OF ENRON CORPORATION FROM ITS BOOM TO BANE(Matt, 2017):

9. BANKRUPTCY:


The deregulation of energy traders led to overconfidence in investments that Enron made because they thought they were in control. Arrogance caused them to risk more than they could afford, and when the market didn’t end up how they thought, it caused the collapse.

On December 2, 2001, Enron Corporation finally filed for the Chapter 11 Bankruptcy Protection in New York Court. It became the largest bankruptcy in the US surpassing the 1970 Bankruptcy of Penn Central. This title was short-lived as in the following year World Com became the largest bankruptcy. Estimated loss comes to around $74 Billion.

10. CURRENT SITUATION & KEY TAKEAWAYS:

· Currently, the company is renamed as Enron Creditors Recovery Corporation. The company paid its creditors more than $21.7 billion from 2004 to 2011.

· Enron followed Mark-to-Market accounting method which helped them hide losses of the firm and show inflated profits to fool investors.

· Enron smartly made use of Special Purpose Vehicle SPV which was never disclosed to the common people which in turn helped them to quietly hide the loss-making assets to transfer in SPV’s name.

· Enron’s share went from 90$ to 0.26$ before closing its operation at the time of bankruptcy.


Works Cited


Credit Pulse Coverage, Analysis, Perspective. (2008, May 30). Enron Lesson No. 1: Mark To Market (Fair Value) Accounting. Retrieved from Credit Pulse: https://www.creditpulse.com/accountingfinance/lessons-enron/enron-lesson-no-1-mark-market-fair-value-accounting#:~:text=Thus%2C%20over%20half%20of%20the,mark%2Dto%2Dmarket%20accounting.

Fortune 500. (2001). A Database of 50 years of FORTUNE's List of America's Largest Corporations. Retrieved from Forbes: https://archive.fortune.com/magazines/fortune/fortune500_archive/snapshots/2001/478.html

Matt. (2017, December 14). A Brief History of Enron – With Enron Stock Chart. Retrieved from Begin to Invest: https://www.begintoinvest.com/enron-stock-chart/

Norris, F. a. (2002, January 30). ENRON'S MANY STRANDS: THE ACCOUNTING; Fuzzy Rules Of Accounting And Enron. Retrieved from The New York Times: https://www.nytimes.com/2002/01/30/business/enron-s-many-strands-the-accounting-fuzzy-rules-of-accounting-and-enron.html

Segal, T. (2020, September 22). Enron Scandal: The Fall of a Wall Street Darling. Retrieved from Investopedia: https://www.investopedia.com/updates/enron-scandal-summary/

Tax Guru. (2016, May 5). All about Mark To Market (MTM) Concept. Retrieved from Tax Guru: https://taxguru.in/finance/mark-market-mtm-concept.html

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