Enron Collapse: Financial Analysis Reveals Accounting Tricks and Hidden Debts

1
KIRTI SHUBHAM – KIIT School of Management

2
KIRTI SHUBHAM – KIIT School of Management
ABSTRACT
Enron is one of the major failures of the Corporate Governance in the modern
history. On 2nd December, 2001 the company declared bankruptcy; leading the
stock price to fall from $90.75 to $0.67 and all the reputation of 15 years
shattered within few days. The fall of Enron affected thousands lives be it their
employees or shareholders and shook the New York Stock Exchange from its
core.
The Sarbanes Oxley Act (2002) was drafted by Senator Paul Sarbanes and
Representative Michael Oxley to protect investors by improving the precision
and consistency of the corporate. The SOX was drafted as a result of Enron.
Few other theories such as Tunnelling Theory, Stakeholder Theory and Agency
Theory can be reflected and identified for the collapse of Enron.
The accounting tricks and shady business deals that led to the loss of thousands
of jobs, more than $60 billion in Enron stock and more than $2billion in
employee pension plans when the company collapsed.

3
CONTENTS
S No. Topic Page
1 Abstract 2
2 Contents 3
3 Literature review 4
4 Financial Analysis 6
5 Theoretical Analysis 10
6 Sarbanes - Oxley act 14
7 Conclusion 15
8 Auxiliary 16
9 Reference 17

4
LITERATURE REVIEW
Enron was founded in 1985 as a Natural Gas Pipeline Company by Kenneth Lee Lay, as the
result of Inter North acquisition of Houston Natural Gas (HNG) and then was moved to
Houston from Omaha. During that time the US gas was in the middle of deregulation. Lay
was biggest supporter of deregulations of prices in energy market.
In 1990, Jeffrey Skilling was appointed as president of Enron Finance Corp., which was
responsible for trading operations. Later that year Mr. Skilling refined the trading model,
leading to divesting and syndicating heavy assets to pursue ―Asset Light‖ strategy.
Three years later, in 1993 the company emerged as largest seller of natural gas in North
America generating $316 million EBIT.
In 1995, Enron was entitled with ―America‘s Most Innovative Company‖ by Fortune for six
consecutive years. It also viewed itself as a corporation which was built on innovation.
In 1997, Enron bought Portland General Electric for $2.1 billion for diversification in the
sector of electric power generation, transmission and distribution. Later on it acquired
electricity distributors in Brazil and Argentina. Mr. Skilling created an individual group
called Risk Assessment and Control to analyse risks in the projects.
In 1998, Enron acquired Wessex Water PLC which was encouraged by Rebecca Mark worth
$2.4 billion. This was a part of Enron‘s Azurix subsidiary in order to take advantage of
increased privatisation and consolidation in water industry.
In 1999, Enron had invested just about $3 billion in assets in developing markets even the
troubles faced by them in Indian market by local citizens and national government on the
terms offered. In the same year, it sold 76% of Azurix in a public offering on the NYSE.

5
Enron‘s trading business involved complex and long term contracts; this issue was very
challenging for the financial accountants. Enron used to implement its asset light strategy and
hedge investment gains; this was another challenge for special purpose entities (SPEs).
To hedge on the Rhythms stock Andrew Fastow, CFO proposed creation of SPE called LJM1
and invested $1 million into it. He later reported earnings of $200 million and $2 billion of
cash flow to Enron.
In 2000, Enron‘s stock spiked its highest price of $90.56 per share. Mr. Ken Lay received
$123 million by exercising a portion of his stock options making him highest paid CEO of
that year. Moreover it gave away $750 million as bonuses all together.
In 2001, when Mr. Charles LeMaistre, chairman of the Compensation Committee requested
Mary Joyce, senior compensation officer to produce information on outside income for the
senior officers of Enron, she lacked that information and this matter eventually dropped.
In February 2001, Jeffrey Skilling became CEO of Enron. Eight months later on 14 August,
2001 Skilling resigned from the position of CEO stating ―family reason‖ and 50% stock price
declination till $39.95 followed it. Lay replaced Skilling and reassured investors to invest in
Enron‘s stocks.
In October 2001, Arthur Andersen, Enron‘s external auditor since 1985, destroyed all
Enron‘s files and reports except the basic documents. Prior to this, Andersen had already
classified Enron in its maximum risk category but they never shared these analysis reports
with Enron‘s Audit committee.
On November 8, 2001 Enron admits that it was inflating its income from previous four years
by $586 million. Next day Enron agreed for acquisition by Dynegy for $9 billion which was
its competitor. But after debt report Dynegy retreated their merging.

6
$ -
$ 200
$ 400
$ 600
$ 800
$ 1,000
$ 1,200
1995 1996 1997 1998 1999 2000
Millions
Condensed Income Statement Income before
cumulative effect
of accounting
charges
Earnings on
Common Stocks
Dividends on
Common Stock
FINANCIAL ANALYSIS
Operating revenue implied
251% growth in operating
revenue within a year. There
is sudden increment of
$60,677 million in 2000.
[Auxiliary 1]
Enron announced the
formation of Enron
Broadband Services for
expansion into trading.
Income before cumulative effect of accounting charges indicates that there is unusual growth
after 1997. The inconsistency also indicates that in this year there can be unusual steps taken
by the board. [Auxiliary 1]
The Condensed Income Statements drives our attention towards
abnormalities and exponential growth since 1997.
Action: In 1997, Enron began diversifying and acquired electric power generation,
transmission and distribution expertise by purchasing Portland General Electric worth $2.1
billion.
Consequences: Since electric cannot be stored as gas to satisfy peak demand and can result
even high price volatility; so Enron built ―peaking plants‖ to meet short-term growth in
demands. This leads to motivation of management for incorporation of trading model.
$ 0
$ 2,000
$ 4,000
$ 6,000
$ 8,000
$ 10,000
1995 1996 1997 1998 1999 2000
Millions
Operating Revenue
Revenue

7
$ 0
$ 10,000
$ 20,000
$ 30,000
$ 40,000
$ 50,000
$ 60,000
$ 70,000
1995 1996 1997 1998 1999 2000
Millions
Total
Asset
Total
Capital
$ 0
$ 2,000
$ 4,000
$ 6,000
$ 8,000
$ 10,000
$ 12,000
1995 1996 1997 1998 1999 2000
Millions
Condensed Balance Sheet Debt
Minority Interests
Shareholder's
Equity
Company-obligated
preffered securities
of subsidiaries
Action: In order to expand business internationally, Enron focused markets outside United
States where markets were deregulated.
Consequences: Enron invested $3 billion. In India, particularly where 15% of its
investment was focused was proving to be troublesome as there was delay from local
criticism of Indian States and national government over terms offered.
Action: Skilling created an independent group which will report directly to him and called it
as Risk Assessment and Control (RAC), headed by Rick Buy.
Consequences: Annual budget allocated was $30 million to the group of 150 staffs. RAC
reports were presented to top managers and they were forwarded to the board only if they
were appropriate. Even though there were risk associated to the reporting and top managers
discard it the board never gets to acknowledge those risks associated to new business.
Total Assets
There is constant increment
of total asset although the
total capital in 1995 is
almost equal to 2000. The
total asset boomed in year
1999 till 2000. [Auxiliary 1]
Jeffrey Skilling played a
vital role in asset
management of Enron. He
pursued ―Asset Light‖ strategy by divesting and syndicating heavy assets such as pipelines.
In late 2000, it was estimated that Enron sold 20 times its pipeline capacity and still it holds
only 5000 fewer miles than it had when company was formed. – We can clearly see the
inflation in the asset data.
From the Condensed Balance Sheet debt and share holder‘s equity surprisingly
dropped in year 1996 and returned back to its position somewhere near about
where it was in 1995 by year 2000.

8
$ -5,000
$ -4,000
$ -3,000
$ -2,000
$ -1,000
$ -
$ 1,000
$ 2,000
$ 3,000
$ 4,000
$ 5,000
1995 1996 1997 1998 1999 2000
Millions
Net Cash
from Opt
Activities
Net cash
used in
investing
activities
Net Cash
Flow
-$ 600
-$ 500
-$ 400
-$ 300
-$ 200
-$ 100
$ 0
1995 1996 1997 1998 1999 2000
Millions
Dividends Paid
Debt Analysis
Enron‘s investment fund named JEDI, which was formed by joint venture with Californian
Public Employees‘ Retirement System (CALPERS), and was not consolidated; its debt never
reflected on Enron‘s balance sheet. In November 1997 Enron agreed to buy out CALPERS
stakes in JEDI for $383 million, for that it created another SPE, Chewco. This SPE was
constituted a debt of $240 million from Barclays Bank. Many other SPE constituted debts of
millions which were not reflected on the balance sheet of Enron, thus causing hidden piles of
debts.
Net Cash Flow
The company directed major cash flow from operation activities and increased investment
activities to a great
extent since 1995.
The net cash flow
which is
summation of cash
generation from
operation and
investment is
negative. Thus
according to
projected balance
sheet the company
was investing
more than they were actually earning from their operations.
Dividends Paid
Dividends paid are consistently
negative from 1995 to 2000; a
company reflects negative dividends
only when there is risk of insolvency
and cash out situation. But according
to internal reports Enron was able to
produce compensations and bonuses to
its board and management amount
$750 million.

9
-$ 2,000
-$ 1,500
-$ 1,000
-$ 500
$ 0
$ 500
$ 1,000
$ 1,500
$ 2,000
1995 1996 1997 1998 1999 2000
Millions
Cash Flow
Long
Term
Debt
Short
Term
Debt
Equity
Issuance
From the graphical representation, it was clear that cash flow pattern is not under control,
there are high fluctuations in the debts. The equity issuance was continuous in growth till
1998. To deplete these unregulated debt patterns Enron established hundreds of SPEs to
regulate these debts and cash flow but those SPEs were in long and short term debts
themselves. Many were funded by investors and lenders along with the company; they also
purchased forward contacts from gas producers which eliminated those contracts from
Enron‘s balance sheet and thus created more hidden debts.

10
THEORETICAL ANALYSIS
Stakeholder Theory –
“Every business creates, and sometimes destroys, value for customers, suppliers, employees,
communities and financiers. The idea that business is about maximizing profits for
shareholders is outdated and doesn’t work very well, as the recent global financial crisis has
taught us. The 21st Century is one of “Managing for Stakeholders.” The task of executives is
to create as much value as possible for stakeholders without resorting to tradeoffs. Great
companies endure because they manage to get stakeholder interests aligned in the same
direction.” - R. Edward Freeman
The Stakeholder theory states that the purpose of a business is to create value for stakeholders
not just shareholders as a business needs to consider customers, suppliers, employees and
communities along with shareholders
Stakeholder – Employees
Enron lured new employees with attractive signing bonuses and the promise of earning
annual bonuses of as much as 100% of their salaries and they were encouraged to move
around the organization freely to positions where they felt they could add value and generate
additional revenue.
Enron relied on Biannual feedback system biannual based on 360-degree reviews of
employees from peers, customers, and supervisors. Skilling created performance review
committee (PRC) which was a group of 20 people who valued / evaluated employees and
shorted them on their performance basis by using forced curve. Employees who were ranked
in the bottom 20% risked being fired.
Enron‘s board was completely focused on evaluating and the jobs security was in the hands
of a committee rather than their superiors. The company was focused on consistently value
addition to the firm rather than mutual value addition, that is of company and employees
themselves.
Stakeholder – Community Around
CEO, Kenneth L Lay was among strongest advocate for deregulation of prices of energy
market, so he involved Enron and allies into lobbying and campaign activities in 24 states
across US, later they extended to Great Britain and India. Enron played a major contribution
in deregulating energy markets in those states.
Enron invested $450 million in the Dabhol project, Mumbai. This project was troublesome as
the terms offered were unfavoured by neither locals Indian States nor the national
government. In another words Enron invested for their personal profit as India was emerging
deregulated market.

11
Stakeholder – Government & Politics
Enron had close personal connection with high ranking government officials. The
contribution in presidential campaigns of George W. Bush and George H.W. Bush was
remarkable. Enron was supported firmly from government as the relationship was maintained
strongly between them.
Kenneth Lay was a prominent member of Vice President Cheney‘s task force in development
of a National Energy Policy; he also served as co-chairman of Bush‘s Economic Summit in
Houston in 1990, and headed Houston‘s host committee for the Republican National
Convention. He was also an occasional golf partner of President Clinton.
Stakeholder – Board of Directors / Owners
Former Enron top executive John Cliff Baxter had committed suicide by shooting himself in
head on January 22, 2002, almost a month later of declaration of bankruptcy of Enron. He
joined Enron in 1991 and became vice chairman in October 2000 before resigning in May
2001.
The board entrusted responsibility to an Audit Committee for overseeing the internal and
external auditors and the financial reporting process, and responsibility to a Compensation
Committee for evaluating the CEO‘s performance and setting CEO compensation. Despite of
debts and expenses, board allegedly managed to draw compensations and bonuses to the
members and senior officers.
The issue of unregulated outside income of senior officers was never taken care, there was
lack of information about funding. Board created SPEs to hedge stocks and to report back,
but later on stock prices fell from $60 to $40 and Enron had to invest $35 million to keep
support of those SPEs.
Just eight months after becoming CEO Jeffrey Skilling resigned and stated ‗family reasons‘
for the resignation which lead 50% stock-price declination from its high of $90 in September
2000. In the period of 1999-2000 a series of board member resigned.
Stakeholder – Auditors
During 1980s and 1990s the auditing industry increased in competency so they began
changes prompted audit firms to mechanically apply consistent accounting and auditing
standards, and to develop standardized audit procedures to lower costs and reduce their
liability. Moreover Enron was also into aggressively diversification into higher-growth, and
was interested into higher-margin consulting services.
Arthur Andersen used to be Enron‘s external auditor since 1985. Enron outsourced many of
its internal audit functions to Andersen. About 40 Enron employees shifted to Andersen‘s
payroll.

12
Internal documents which were later destroyed had evidence that Enron as engaging in high-
risk accounting and hence later on they even classified Enron in maximum risk category.
They never even took any steps to highlight these risks and never reported in the board.
Tunnelling Theory
Tunnelling is an illegitimate business practice in which a majority shareholder or high-level
company insider directs company assets or future business to themselves for personal gain.
Actions such as excessive executive compensation, dilutive share measures, asset sales and
personal loan guarantees can all be considered tunnelling.
There was few tunnelling were involved in this as Enron started as very successful company
but with time the company faced lack of several information and management created
independent body which dragged the company more in debt.
However, in 2000 somehow directed compensations and bonuses worth $750 million in the
pockets of board and senior officers. Moreover there were several other transitions inside the
firm which-when reported by SEC, the board and compensation committee declined about
the information.
The SPEs, RAC, PRC and other independent group having handful amount of employees had
budgets of hundred million dollars. Those transaction where never reflected in balance sheet
also, and they directed these funding towards themselves.
Agency Theory
The agency theory is a supposition that explains the relationship between principals and
agents in business. Agency theory is concerned with resolving problems that can exist in
agency relationships due to unaligned goals or different aversion levels to risk.
Performance Review Committee
Jeffrey Skilling created performance review committee (PRC) which was a group of 20
people who valued / evaluated employees and shorted them on their performance basis by
using forced curve. Employees who were ranked in the bottom 20% risked being fired.
Enron‘s board was completely focused on evaluating and the jobs security was in the hands
of a committee rather than their superiors. The company was focused on consistently value
addition to the firm rather than mutual value addition, i.e. of company and employees
themselves.

13
Risk Assessment and Control
Jeffrey Skilling created RAC which was headed by chief risk officer, Rick Buy. He was
responsible to report risks directly to the board. The team had 150 members with annual
budget of $30 million. The risk evaluated by the employees were sent to top managers and
many-a-times even though there were few risks involved they did not forward it to the board,
thus they create gap between risk and board.
Special Purpose Entities
SPEs were also created with the view of regulating and monitoring the risk, within a year
SPEs hedged several million. They were third-party independents; their debts and
transactions were not recorded the balance sheet of Enron. Within two years there were
hundreds of SPEs created within the company and increased complexity internally, thus they
also contributed in generation of $2 billion debts by 2000.

14
SARBANES - OXLEY ACT
In order to cut down on the incidence of corporate fraud, Senator Paul Sarbanes and
Representative Michael Oxley drafted the Sarbanes-Oxley Act. The goal of the SOX Act is to
increase investor‘s confidence and ensure accurate reporting from some of the world largest
firms. Learning from the past SOX attempts to minimize investor‘s risk by legislation, while
at the same time fortifying the reporting process of companies and their internal controls.
The Enron scandal was certainly enough to show the American public and its representatives
in Congress those new compliance standards for public accounting and auditing were needed.
Enron was one of the biggest and, it was thought, one of the most financially sound
companies in the U.S.
The various misdeeds and crimes committed by Enron were extensive and ongoing.
Particularly damaging misrepresentations pumped up earnings reports to shareholders, many
of whom eventually suffered devastating losses when the company failed. But there were
many other instances of dishonesty and fraud, including actual appropriation of corporate
funds by Enron executives and illegal manipulations of the energy market.
Whistle – One day after Skilling‘s resignation, Sherron Watkins, a vice president for
corporate development, sent an unsigned letter to Lay informing him that she feared the
company was about to ―implode in a wave of accounting scandals‖ – under SOX Section 806
– Protection for Employees of Publicly Traded Companies Who Provide Evidence of Fraud –
can ensure safety of such whistle blowers
Revenue recognition was a singular theme in the Enron Scandal, section 404 understood this
complexity and compensated.

15
CONCLUSION
Enron‘s leadership made decisive illegal moves to ensure that the company continued to
engage in the market despite high debt levels. The overt limitations of the company‘s
solvency and inadequate controls fed a complex cocktail to investors. Former CEO Jeffery
Skilling had no intentions to discourage fraudulent actions that eventually lead Enron into
collapse. The impact of the loss of billions of dollars of employee pensions even for 20-year
Enron veteran employees, gives this case all the markings of a major fraud case. Looking
backwards fraud symptoms existed, but there was no company culture to detect these
symptoms or ―whistle-blowing‖ channels. Employees might not have been aware of the
accessibility of government ―whistle-blowing‖ agencies that are equipped to deal with such
crimes. It is within corrupt environments such as the Enron case that leads shareholders to a
loss of billion of dollar; affecting the overall U.S economy in extremely problematic and
irreversible way.
Like Enron, once an industry leader, conducted actions of merger acquisition fraud. Fraud
that occurred in a period of 10 years; ―mergers‖ conducted in an attempt to preserve
shareholder value of WorldCom. The size of the company‘s fines from the Security Exchange
Commission (SEC) speaks to the fraudulent activities of the firm. The near miss of an
economical disaster with the proposed merger with Sprint; could have easily became one of
the largest bankruptcy claims of all time to date.

16
AUXILIARY 1
(in $ millions except for per
share and share data)
1995 1996 1997 1998 1999 2000
Condensed Income Statement
Operating revenues $9,189 $13,289 $20,273 $31,260 $40,112 $100,789
Income before cumulative effect
of accounting changes
520 584 105 703 1,024 979
Earnings on common stock 504 568 88 686 827 896
Dividends on common stock 205 212 243 312 355 368
Income before cumulative effect
of accounting changes per share
Basic $1.04 $1.16 $0.16 $1.07 $1.36 $1.22
Diluted $0.97 $1.08 $0.16 $1.01 $1.27 $1.12
Earnings on common stock
Basic $1.04 $1.16 $0.16 $1.07 $1.17 $1.22
Diluted $0.97 $1.08 $0.16 $1.01 $1.10 $1.12
Common dividends per share $0.41 $0.43 $0.46 $0.48 $0.50 $0.50
Shares outstanding at year-end
(m)
490 502 614 662 716 752
Condensed Balance Sheet
Total assets $13,239 $16,137 $22,552 $29,350 $33,381 $65,503
Short-term and long-term debt 10,229 3,349 6,254 7,357 8,152 10,229
Minority interests 2,414 755 1,147 2,143 2,430 2,414
Company-obligated preferred
securities of subsidiaries
904 592 993 1,001 1,000 904
Shareholders‘ equity 11,470 3,723 5,618 7,048 9,570 11,470
Total capital 25,017 8,419 14,012 17,549 21,152 25,017
Condensed Cash Flow
Statement
Net cash from operating
activities
-$15 $884 $211 $1,640 $1,228 $4,779
Net cash used in investing
activities
13 -1,074 -2,146 -3,965 -3,507 -4,264
Net increase (decrease) in long-
term debt
519 65 1,210 1,033 -61 1,657
Net increase (decrease) in short-
term borrowings
-250 217 464 -158 1,565 -1,595
Equity issuance (retirement) -230 102 555 1,695 1,420 807
Dividends paid -254 -281 -354 -414 -467 -523

17
REFERENCE
 Product Title: The Fall of Enron, 109039-PDF-ENG
 https://cb.hbsp.harvard.edu/cbmp/pl/71122618/71122620/8b04fcea3f3d3bd5c517177
16f7ce468
 Enron Scandal: The Fall of a Wall Street Darling by INVESTOPEDIA | Updated
October 23, 2017 — 9:32 AM EDT
 Sarbanes Oxley Act Summary of Major Sections
 Rosemary Peavler, ―The Enron Scandal That Prompted the Sarbanes-Oxley Act‖,
Updated July 01, 2017
 Tobias Pavel & Mylene Encontro, ―The Enron scandal‖, Chalmers University of
Technology Financial Risk, MVE220, 2012-12-02 Göteborg
 Rosemary Peavler, ―The Sarbanes-Oxley Act and Corporate Fraud‖, Business Insider
 http://redwardfreeman.com/stakeholder-management/
 https://www.investopedia.com/terms/a/agencytheory.asp
 https://www.stakeholdermap.com/stakeholder-theory.html
 http://www.corplaw.ie/blog/bid/317212/Shareholder-Stakeholder-Theories-Of-
Corporate-Governance
 https://www.investopedia.com/terms/t/tunneling.asp
 http://www.foxnews.com/story/2002/01/25/former-enron-executive-kills-himself-
police-say.html
 https://medium.com/@MontangeUpdate/financial-statement-fraud-in-enron-
worldcom-scandals-fraud-motivation-triangle-and-the-sox-act-f055a507f89

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