The Fall Of Enron Corporation: Analysis Of Questionable Business Decisions
On December 2, 2001 Enron filed for Chapter 11 bankruptcy. This was the largest bankruptcy in U. S. history up to that point. Enron filed for bankruptcy after the value of their stock had fallen to less than $1. 00 per share and were sinking in billions of dollars in debt. At that point their debt was given a junk bond rating, which is the lowest rating credit rating agencies give out. Because of this, no other corporation would want to take on their debt in the form of a bond. Recovery seemed impossible. This late reaction ultimately sealed the company’s decision to cease operations altogether in 2007. After the Securities and Exchange Commission uncovered their illegal practices, many of Enron’s executives were convicted of crimes and sent to prison. Former CEO Jeffrey Skilling and Enron founder and original CEO Kenneth Lay were convicted of conspiracy to commit securities and wire fraud. In a different case seen by a judge, Lay was convicted of one count of bank fraud and three counts of falsifying statements to banks. Both men were sent to prison. CFO Andrew Fastow was convicted of 98 counts of fraud, conspiracy, insider trading, and money laundering. He spent ten years in prison for his crimes. Even top Enron traders of derivative contracts pleaded guilty to fraud.
Enron’s practice of “mark to market” accounting inflated Enron’s net income and deceived investors. With their use of Mark-to-market accounting, Enron was able to write unrealized future gains from derivative contracts into their current period income statements. This policy goes against the Generally Accepted Accounting Principles (GAAP) because GAAP states that revenue can only be recorded when revenue is earned or services are performed. When Enron had derivative contracts on their balance sheets at the end of a quarter, they were supposed to adjust the contracts back to fair market value and book gains or losses to the income statement under unrealized holding gains/losses. If the value of the contract decreased from the time they bought it, Enron should report it as a loss and if the value of the contract increased from the time they bought it, Enron should report that as a gain. Unfortunately, Enron would overstate the value of these contracts and report this increase as a gain. This greatly inflated Enron’s net income because many of the contracts may have lost value and should have reported as a loss. Without using mark-to-market accounting, it is possible Enron reports a loss on their income statements most years.
The other questionable business decision Enron made was their use of special purpose entities (SPE’s). Special Purpose Entities are generally used by smaller businesses to gain capital without spending too much money. Enron wanted to receive a high credit rating from credit rating agencies like Moody’s and Standard & Poor’s, so they used SPE’s to hide their debt and any possible losses. At that time, the Financial Accounting Standards Board required that only 3% of the Special Purpose Entity to be owned by an outside investor to not be classified as a subsidiary. Enron took advantage of this loophole and the Special Purpose Entities were legally separate companies apart from Enron even though Enron owned and controlled them. One of the companies LJM Cayman LP paid CFO Andrew Fastow millions of dollars a year for management fees. Enron would then transfer any assets that were losing their value onto the Special purpose entities. This would keep any losses or debt off of Enron’s books. This practice helped Enron meet their goal, as they received an investment grade bond rating from both Moody’s and Standard & Poor’s.
The first alternative is for Enron to eliminate the usage of mark to market accounting to record their sales and future sales of derivative contracts. This stops Enron from misleading their investors and having their stock price increased artificially. Instead of recording the costs of their derivative energy contracts at their arbitrary “fair market value” they should record the contracts on their balance sheet at their historical cost. Enron should only record gains from the contracts when they are ultimately sold. This will give a more fair and accurate representation of Enron’s net income to potential investors and the credit rating agencies.
The projected outcome from alternative one is Enron’s net income would be much lower than it would be using mark-to-market accounting. It is possible that some years Enron would report a net loss without using mark-to-market accounting. The top executives of Enron would not like this outcome, but at least the investors will get an accurate representation of the company’s financial records. However, there are still some potential benefits for businesses to have lower net income. One of the benefits of this alternative is the lower net income will lead to less income tax expense owed to the government. This will put more money back into the Enron’s hands to invest back into the company.
The second alternative is to stop using Special Purpose Entities to hide their debt from investors and the credit rating agencies. Enron had very little practical use for Special Purpose Entities. Enron was a large corporation with great access to capital, so there would be little need for SPE’s in that case. The most ethical way ownership or cEnron could use Special Purpose Entities is as a limited liability company used to minimize risk and to finance large projects. These companies would not be owned by Enron, an outside company unrelated to Enron would take on Enron’s projects and give some access to capital. Enron should not have control over any of the SPE’s. This prevents any potential conflict of interest.
The projected outcome of this second alternative is Enron does not receive top investment grade bond ratings from both Moody’s and Standard & Poor’s. This may turn some investors away, but at least investors have a clear and accurate representation of what is going on in the company. As long as Enron receives at least a BBB- from Standard & Poor’s ratings and a Baa3 from Moody’s they will be rated as investment grade. Even if Enron was rated as a “junk bond”investors willing to take on risk may still buy their bonds because of the high returns junk bonds offer. Ultimately, there is very little downside to this alternative.
The third alternative is Enron or Houston Natural Gas as they were known back then, declines the opportunity to merge with Internorth, Inc. in 1985. Instead of rejecting the proposal, Houston Natural Gas accepted the proposal and merged with Internorth, Inc. This decision ultimately set in motion the horrible decisions Enron made and led to their downfall. After merging with Internorth, Inc. the newly formed Enron Corporation sat five billion dollars in debt. This was a substantial hole Enron needed to climb out of. Enron was in a bad financial position to begin with and felt the need to resort to illegal accounting practices to satisfy both investors and the executives.
There is very little downside to this alternative because Enron declared bankruptcy in 2001 and ultimately went out of business in 2007. Enron’s actions after their profits started falling only delayed the inevitable and completely ruined the company’s reputation when the Securities and Exchange Commission uncovered their practices in 2001. If they file for bankruptcy earlier, immediately after the merger proposal, they could still be in business today. Filing for bankruptcy does not cost companies very much money, and is a way for companies to restructure their debt. Enron may have had some problems getting other corporations to take on their debt because of their credit risk, but at least their reputation as a trustworthy company is still alive. After filing for bankruptcy in 2001 and after the public knew about their fraud, Enron’s reputation was ruined, and no investor would want to take on their bond issue. It was impossible to earn back investors trust. Clearly, this is the best solution because it stops Enron from trying to hide their debt and using illegal accounting tricks to increase their net income.