The Enron Collapse By: Jeff Porter Kevin Clark Jared Sabelhaus
The Enron Collapse By: Jeff Porter Kevin Clark Jared Sabelhaus February 18, 2005 Introduction Companies have mission statements that often read like inspirational leaflets. Enron’s mission was at first to be the world’s greatest energy company then later revised in early 2001 to be the “world’s greatest company”. In the late 1990’s, Enron seemed to have accomplished their mission accumulating vast amounts of assets, had the intellectually elite at the helm, a political climate in their favor and numerous opportunities to expand. Enron gave all appearances of a vastly superior company that could do no wrong.
The thing about king of the mountain is that the ones on top never seem to stay there for very long and in Enron’s case the fall from corporate mountain was spectacular and felt all over the world.
Over the course of three short years Enron went from the seventh largest company in the U. S. to financial ruin. However deep and impressive their intelligent managerial pool was; internal flaws led to a slide of epic standards. In our report, we will analyze these internal flaws that include inadequate control measures, a hostile environment and flawed accounting and financing methods.
Because of the financial severity which the company was in we concluded that Filing Chapter 11 bankruptcy was the only option for Enron and therefore will be assumed in our report.
When we asked Rich Kidwell if there was anything Enron could have done to keep from filing Chapter 11 he said “I don’t know if there was anything that they could do. Enron was like a house of cards and it was only a matter of time before they were blown down. ” We examined different ideas on how to transform these flaws and then suggest which idea we feel is best suited to the needs of this company.
Assumptions While writing this paper we assumed the following points: • • Enron has already filed for Chapter 11 bankruptcy. Enron is unique in regards to size and operations (accounting methods and actions) compared to other regulated commodity companies.
• Due to Enron’s aggressive accounting we understand the financial ratios that are computed using Enron’s financial statements are more than likely not going to give an accurate or clear picture of the company’s current status. Brief History • 1985- Enron is formed by merger of Houston Natural Gas and InterNorth creating the largest company owned natural gas pipeline. 1989- Enron opens its Gas Bank, where consumers can buy long-term supplies of natural gas at a fixed price, setting the stage to become a commodity trading company. • 1990-1998- Enron expands its holdings in the U. K. , Europe, South America, and India.
Enron in this time moved away from natural gas and pipeline operations instead focusing more on marketing other energyrelated commodities. • • 1999- Enron launches its broadband services and Enron Online. August 2000- Enron’s share price reaches an all time high of $90, ranking it the seventh largest energy company in the world. •
October 2001- Enron post its first quarterly loss in four years, $618 million and a reduction in shareholder equity by over $1 billion dollars. • December 2, 2001- Enron files for bankruptcy protection.
S. W. O. T. Analysis Strengths Enron is the largest company-owned natural gas pipeline system in the United States and is ranked seventh on the Fortune 500 giving it an established name with credibility.
Another strength of the company would be its reputation and public perception. Enron has a competitive and almost monopolistic advantage over its competitors because they are the largest energy provider.
They also have market-making abilities that result in price and service advantages (26). Weaknesses It is easy to target Enron’s weaknesses in the company. They have a lack of ethical and moral behavior among employees and auditors by engaging in deceitful and wrongful acts. Management has a lack of control and conflicts of interest occur in numerous transactions.
The culture of Enron was all about results therefore, expectations of financial statements were high and employees were told to make up for losses. Opportunities Name recognition is an opportunity for Enron.
Society recognizes Enron as a high quality energy provider. There are many opportunities for Enron to expand or use to their advantage the many assets they have such as pipeline. Deregulation of the energy industry in the 1970s allowed Enron the opportunity to grow and begin trading. Threats There are many threats Enron faces.
Competitors could come in and steal some partners Enron does business with potentially taking away profits from Enron. Threats exist that newer technology will provide alternative energy sources to oil and gas, Enron’s two major sources of energy.
A possible threat would also be if the energy market became regulated again and trading could not occur. Internal Flaws Accounting Another problem Enron faced was the aggressive accounting style used to inflate many figures on their financial statements. Many complicated partnerships with special purpose entities and other subsidiaries made the accounting even more confusing.
These methods helped Enron manipulate their revenue and earnings. “Mark to Market” Accounting Enron used “mark to market” accounting, which allowed them to adjust the value of a security or asset to reflect the current market value (20).
This procedure allows companies to book as current earnings their expected future revenue from certain assets (7). The introduction of volumetric production payments opened the door for this type of accounting. These payments were contracts that had a predictable future cash flow and could be treated as merchant assets meaning the assets held on Enron’s books could be traded at any time if they received a suitable offer (20). The SEC granted Enron permission to mark these assets to market in 1991 and was supposed to be on a temporary asis, but the SEC has not introduced this topic since.
To create a merchant asset deal, the trader would forecast the future price curve for the underlying product, calculate the future cash flows and apply a discount rate to compute the net present value which could either be sold to a special purpose entity (SPE) created for that purpose or kept on Enron’s books as a merchant asset (20). Market prices for gas futures could be obtained from the New York Mercantile Exchange (NYMEX) but for a limited time range, usually four years.
Enron extended this principle to longer contracts, for which it had to derive its own price curves (20). For example, a 20-year deal where the energy company’s generation unit builds and sells the output of a multi-million dollar power plant. There is no NYMEX for power prices going out 20 years so an estimate must be made. Accounting standards allow management to use its discretion to determine future income and cost.
If it is determined that the company must sell the power for 4. 8 c/KWH (cents per kilowatt hour) while realizing an estimated cost of 4. c/KWH, all these less than certain future profits are recognized in the present earnings. If in future quarters, when the real numbers come in and profits do not meet expectations, the energy company can offset the losses by entering into additional deals. The best way to cover up a bad deal is to make two more (15).
Enron used “mark to market” accounting involving two specific companies, Blockbuster and Quaker. In 2000, Enron entered into an agreement with Blockbuster to deliver movies on demand to viewers’ homes over Enron’s broadband network.
This venture fell apart within months, but Enron still booked $110 million in profits in late 2000 and early 2001, based on the anticipated value of the partnership over 20 years (7). “Mark to market” gains accounted for over half of Enron’s reported pretax earnings in 2000. Another deal created to use “mark to market” accounting involved Quaker Oats in 2001.
Enron agreed to supply 15 Quaker plants with their energy needs, from natural gas and electricity to workers who would maintain boilers and pipes. Enron guaranteed it could save Quaker $4. million from its energy bill (16). Enron then forecast a $36. 8 million profit over the 10-year deal and under “mark to market” accounting booked $23.
4 million of that before they had ever turned on Quaker’s lights (16). The rules permit this to occur for commodities like natural gas and electricity, but when it comes to services, the rules are more restrictive. Profits from service activities are to be booked on an accrual basis, in which a fraction of the profit is realized each year. The Quaker deal projected profits from services, not commodities causing a major problem.
Enron used a method called revenue allocation designed to redefine as commodities some of the money Quaker was paying for services and therefore create more profits for Enron to book up front (16). Internal accountants created a new category called allocated revenues which was based on figures Enron claimed reflected the open market value of the commodities and services, not what Quaker had historically paid for energy commodities (16).
“Mark to market” accounting is very aggressive and overlooked by the SEC, especially in Enron’s case.
Sham Swaps Enron and telecommunications giant Qwest Communications struck a deal in 2001 to swap fiber-optic network capacity and services. Qwest agreed to pay Enron $308 million for assets that included dark fiber, strands that require additional investment before they can be put into service, along a route from Salt Lake City to New Orleans. Enron agreed to pay Qwest $195. 5 million for active fiber-optic cable services over a 25-year period.
This enabled Enron to avoid recording a loss on dark fiber assets, whose value in the open market dropped below the price on Enron’s books, by booking a sale (17, 7).
Prudence Accounts Enron used prudence accounts to make their revenue stream appear less volatile than it actually was. Enron traders split profits from deals into two categories. The first would allow profits to be added directly to the company’s financial statements, and the other category would allow profits to be added to a reserve fund. According to Frank Partnoy, an expert in finance who testified before the U. S.
Senate Committee on Governmental Affairs, the prudence accounts served as a slush fund that could be used to smooth out profits and losses over time (7).
An example would be a trader who earned a profit of $10 million. Of that $10 million, the trader might record $9 million as profit today, and enter $1 million into a prudence account (18). In other words, traders were saving for a rainy day. Enron was misstating the volatility and current valuation of its trading businesses, and misleading its investors.
Off Balance Sheet Transactions Chewco Chewco was the first deal with an Enron employee and a special purpose entity to cause controversy.
The SPE could be treated as if it were an independent, outside entity for accounting purposes if two conditions were met: an owner independent of the company must make a substantive equity investment of at least 3% of the SPEs assets, and that 3% must remain at risk, that is, not guaranteed by someone else, throughout the transaction; and the independent owner must exercise control of the SPE. If those conditions are met, the company can record gains and losses on transactions with the SPE, and the assets and liabilities of the SPE are not included in the company’s balance sheet (21).
Enron used SPEs to shift liabilities, its debt, off its books. Michael Kopper became the independent investor in Chewco.
He and a friend invested $125,000 of their own money, with Enron providing collateral and received an $11 million loan from Barclays Bank. Enron recorded its contractual share of gains and losses from the Joint Energy Development Investment (JEDI) on its income statement and disclosed the gain or loss separately in its financial statement footnotes, but did not show JEDI’s debt on its balance sheet (21).
The purpose of Chewco was to acquire the California Public Employees Retirement Scheme’s (CalPERS) interest in an earlier joint venture with Enron called JEDI so CalPERS would invest in another, larger partnership (7). The only way Enron could avoid consolidating JEDI onto their financial statements were if Chewco had an independent owner with a minimum of 3% of equity capital at risk.
They could not find any outside investor so they financed Chewco’s purchase of the JEDI interest almost entirely with debt, and Enron did not consolidate Chewco into its consolidated financial statements disregarding accounting requirements for non-consolidation (21). Under Enron’s Cod of Conduct of Business Affairs, Kopper was prohibited from having a financial or managerial role in Chewco unless the Chairman or CEO determined that his participation did not adversely affect the best interest of the company, which we have no evidence of (21). LJM Partnerships In June of 1999, LJM 1, a Cayman Islands SPE, was formed.
Fastow served as the general partner and invested $1 million of his own money. He raised $15 million from two limited partners, through an SPE, to get debt off the balance sheet by having Enron purchase certain assets and associated liabilities the company wanted removed from its balance sheet (20). The conflicts of interest prohibited Enron from having any dealings with officers of the company according to their code of ethics.
But, the board of directors gave special permission to Fastow subject to certain checks put in place to protect Enron’s assets. LJM 1 entered into numerous transactions with Enron.
One example, LJM 1 hedged Enron’s position with Rhythms NetConnections stock, which Enron bought for $1. 85 per share and rose to $69 at the end of the trading day (20). The investment in Rhythms was worth about $300 million in May of 1999 so Enron wanted to protect itself against future income volatility (21). By hedging, Enron could offset losses on Rhythms if the price of Rhythms declined.
LJM Swap Sub Limited Liability Partnership, controlled by Fastow, issued a put option on the Rhythms shares in exchange for a supply of restricted Enron stock and various notes.
This option would entitle Enron to recover any loss in the value of the Rhythms shares. LJM Swap Sub would pay for such losses out of the value of the restricted Enron stock it received. Any “mark to market” losses would be shifted from Enron to LJM Swap Sub (22). LJM 2 was formed in October of 1999. Fastow raised $200 million of institutional private equity to purchase assets that Enron wanted to syndicate.
LJM 2 solicited prospective investors as limited partners using a confidential Private Placement Memorandum (PPM) detailing the “unusually attractive investment opportunity” resulting from the partnership’s connection o Enron (21). At the end of 1999, Enron sold interests in seven assets to LJM partnerships. The LJM partnerships were shady because Enron bought back five of the seven assets after the close of the financial reporting period allowing them to report the gain on their financial statements. The LJM partnerships made a profit on every transaction, even when the value of the asset declined and the transactions generated earnings of $229 million in the second half of 1999 for Enron (20). Raptor Partnerships Four new SPEs were established in 1999 and 2000 known as the Raptor Partnerships.
These deals were extremely complicated with Enron funding it with its own stock to hedge against declines in the value of Enron’s merchant investments (21).
LJM 2 provided the outside equity to avoid consolidation of the Raptor SPEs. Talon was the SPE set up for the Raptor partnerships to absorb Enron’s “mark to market” losses. Harrier, an Enron subsidiary, invested $1,000 equity in Talon for “special interest limited partnership equity,” entitling Enron/Harrier to execute equity swap transactions with Talon, and, under certain circumstances, to all of Talon’s profits exceeding $41 million.
LJM 2 contributed $30 million of equity to Talon, with the understanding that it would receive a return of $41 million on this investment before Enron/Harrier could proceed to trade derivatives with Talon. To fund future hedge transactions, Enron/Harrier issued Talon approximately 3. 7 million restricted shares of Enron stock, and rights to an additional 3.
9 million shares to be issued under certain circumstances in future years. All of these shares had a current face value of approximately $537 million. In exchange for these shares and options, Enron received net notes from Talon worth $350 million. 22) Two of the Raptor SPEs lacked credit capacity to pay Enron on the hedges. So Enron was supposed to take a pre-tax charge against earnings of more than $500 million, but Enron restructured the Raptor deals by having more than $800 million of contracts transferred to receive its own stock before the quarter ended (21). The result of the Raptor deals was a $544 million after-tax charge against earnings in 2001, which forced Enron to reduce shareholders’ equity by $1.
2 billion. Financial Summary To evaluate Enron fully, we need to look at their financial statements and ratios.
The results are from the year 2000 and we feel an assumption must be made about the validity of these numbers. We used the financial statements provided by Enron for 2000, but feel the numbers don’t fully represent the truth and analyzing them any further would not provide us with a more accurate picture of the company. Profit margin tells us for every dollar in sales it generates .
0097 cents in profit, . 97% (20). Another measure of profitability is the return on equity, Return on equity is a measure of how the stockholders did during the year (14). For every dollar in equity, Enron generated around 8. cents in profit, or 8.
54% (20). Return on assets is a measure of the profit per dollar of assets (14). For every dollar of total assets, Enron generated about 1. 5 cents in profit, or 1. 49% (20).
Enron has so many assets that this number is going to be small. Some liquidity ratios are the current ratio, quick ratio, and net working capital. The current ratio is a measure of a company’s short-term liquidity (14). For every dollar in current liabilities, Enron is covered 1. 07 times over (20).
The quick ratio is computed the same as the current ratio except it omits inventory.
Enron’s quick ratio was 1. 036 times. Net working capital is the ability to meet short-term obligations (14). The net working capital for Enron is $1. 975 billion with the net working capital ratio equal to around 3% (20).
The debt to equity ratio is a measure of a company’s financial leverage and the proportion of debt and equity it is using to finance its assets (23). Enron has a debt to equity ratio of . 692 times, which is quite high (24). Enron is very asset heavy. Total assets increased from $33,381,000 billion in 1999 to $65,503,000 billion in 2000, an increase of over 96%.
The net income of Enron is a figure that needs some discussion.
Although it has increased from $703 million in 1998 to $893 million in 1999 to $979 million in 2000, there are some discrepancies about its validity (20). The Chewco and LJM Partnerships reported income, which should not have been booked. According to the Powers Report, this would have reduced reported net income by $133 million in 1998, $248 million in 1999, and $99 million in 2000 (21). Enron’s net income cannot be credible until changes are made to correct their “mark to market” accounting.
The cash flow from investing activities is a negative $4.
264 billion. The biggest component of this is the acquisition of subsidiary stock decreasing cash flow from investing by $485 million and a decrease of $777 million from business acquisition (20). The financial situation of Enron by the books is stable, but the use of “mark to market” accounting and off the balance sheet transactions will distort the numbers and potentially provide insecurity to Enron. Financial Ratios Profit Margin Return on Equity Return on Assets Enron . 97% 8.
54% 1. 49%
Current Ratio Quick Ratio Net Working Capital Debt to Equity Total Debt Total Equity 1. 07 1. 036 $1. 975 billion 69.
2% $10. 229 billion $14. 788 billion International Institute of Management Development (http://www. senate. gov/~gov_affairs/072302roach_a.
pdf#search=’enron%20total%20debt’) Total Equity is equal to Shareholders’ Equity, Company-Obligated Preferred Securities of Subsidiaries and Minority Interests. $70,000 Total Assets Current Assets Total Debt Long Term Debt Total Equity Shareholders’ Equity Millions of dollars $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 999 2000 Control Issues: Conflict of interest A company the size of Enron must maintain such a strict direction in which the company otherwise, it is so easy to get off the beaten path when you’re a company of that magnitude. Having complete control of what the company is and does is essential to its survival. “For any corporation to be healthy and productive, it needs to be strong in…social-spiritual capital in terms of ethics, relationships, meaning and purpose (13). ” The culture of the company must all have the same goal and all be working towards that goal.
One of the problems with Enron was all of its conflicts of interest in its infrastructure, its financial transactions and its accounting practices.
Mark & Skilling From the moment Kenneth Lay hired Jeff Skilling in 1989 there was a struggle in upper management between he and colleague rival Rebecca Mark. Both wanted sole control of the strategic direction which the company was to head and both directions were extremely different. Skilling wanted Enron to go from being a generator and supplier of different energy commodities to becoming a middleman by focusing directly on trading in energy (7).
He believed in an “asset light” company. Mark was more traditional and had a reputation for pushing hard to seal deals (4). She wanted to focus on power generating assets at home and abroad (7).
As a result of this, the company would continue to pursue different investing strategies until Skilling’s appointment as chief operating officer in 1996. Andersen Arthur Andersen was an eighty-nine year old firm built on the reputation of strong ethics, accounting and auditing guidelines. They were among what the industry calls “the big five” accounting firms in the world. They were respected, law abiding, and above all ethical.
But when a firm like Enron comes along and pays you $51 million a year for your accounting and consulting services an auditor wouldn’t dare “offend a big client with uncomfortable scrutiny (10).
” After a while hands start washing each other and a new unwritten company policy is formed. Many thought the relationship was closer than usual. Andersen’s auditors were in-house. Some Enron employees were quoted as saying that “people just thought they were Enron employees (7). ” Andersen’s own infrastructure had conflicting views about the way difficult accounting issues should be handled.
Andersen had a professional standards group (PSG) at its corporate headquarters whose job was to review these difficult issues shall they occur (7).
PSG’s are set at most big accounting firms, but unlike all the other firms Andersen’s PSG did not have the authority to overrule its field auditors if one of these difficult issues were to arise. On several occasions the Enron audit team proceeded with their accounting procedures despite the objections of the PSG (7). Fastow Deals Andrew Fastow, Enron’s chief financial officer, formed many small offshoots of Enron called Special Purpose Entities (SPEs).
The only purpose proved to be building his and other top executives wealth while mounting debt. Fastow originally started LJM and formed many subsidiaries from this original SPE. By having Fastow play this dual role Enron was violating one of its codes of ethics, which prohibited an officer from owning or participating in “any other entity which does business with…the company (6).
” The only exception is if the participation was disclosed to the chairman and CEO and was judged not to “adversely affect the best interests of the company (6). As a result, the board reviewed and approved the LJM partnerships and voted to suspend its code of ethics in this instance to permit Fastow to run the partnerships. Ethics: Disclosure of Info Officials to employees and public All markets are considered efficient. Stock prices are a reflection of all available information to the public about any certain company and the price is a good indication of whether or not a company is doing bad or good or going to do worse. There is no predicting the market because it is perfectly efficient.
That is why the fall of Enron had such an impact on the business world, no one saw it coming.
The financial statements were looking good and the mainstay of the company Kenneth Lay was still stating that the company is the strongest it has ever been just weeks before its demise. Stock prices stayed steady because the market had no information to report otherwise. Insiders were still ranking Enron’s stock as a “hold” the day they filed Chapter 11. The whole time Lay talked up the company’s financial stance he and other top officials were dumping millions of dollars worth of Enron’s stock.
No one knew and no one could react until it was too late. Ethical Summary In the weeks leading up to Enron’s demise CEO Kenneth Lay was still selling Enron as being in perfect financial health.
He told employees that the company was financially stronger than it’s ever been, while he turned around and dumped the majority of his stock. The company eventually lost millions, employees lost their retirement and shareholders lost their investment. Enron kept accounting documents hidden and well manipulated and while the auditing team at Andersen stood by and said nothing for fear they would lose the account.
These kinds of issues question the ethics in which Enron and Arthur Andersen did business. When I asked Rich Kidwell, financial advisor for Merrill Lynch and former CPA, if he could pinpoint one thing that directly led to the downfall of Enron he said “fraud. ” And when I asked Ken Flora, Team Leader of Accounting Operations at Indianapolis Power and Light, the same question, I got almost the same answer, “unethical accounting and operations.
” Joe McGee, CLU and ChFC at AUL Tower Agency, he gave a similar response.
Three industry experts all agreed that the leading cause of Enron’s collapse was the breakdown in moral and ethical business practices. Culture A company’s culture is what determines in large degree how their employees act. Organizational culture spurs from customs, traditions, and the general way things are done that have evolved over time (12). As Enron transformed from an old regulated gas company to a fast deal making powerhouse, the culture it developed was a major reason of for its downfall.
Touted throughout the nineties as the triumph of the new economy, they believed that their culture was fast, adaptive and innovative (2).
To get the whole picture of what working at Enron is like an examination must begin with new employees. Enron’s size and new innovative business plan attracted the top MBA talent from the best business schools in the country, mostly new graduates. Enron emphasized risk-taking and entrepreneurial thinking (2). As a result, Enron’s managers tended to be over confident and cocky, as is the tendency of most young people. Enron had a typical turnover for a large company and it placed great stress on having a young, intelligent, high energy work force.
For instance top management positions were filled by people younger than 50; CEO Jeff Skilling was 46, CFO Andrew Fastow was 38 and top trader John Arnold was 26. Youth and arrogance lead Enron to push its employees to maximize revenue at all costs. Executives were at the forefront, encouraging new ideas and initiatives that might have looked good on paper but were drains when put into action. Their slogan in the late 90’s became “We make Markets” expanding into broadband, paper, electricity, weather, along with others all in the name of revenues.
The problem with these ideas and initiatives was that no one seemed to care if they were drains or not. They cared more about making their “quota” to make the books look good.
Bosses at Enron frequently made “tweaks” to the numbers to squeeze out more of deals in efforts to make deals look good. Enron was not only spending money expanding into new markets it also spent a great deal trying to expand their influence into politics. Enron routinely requested and was granted less government regulations (7). They spent millions lobbying government officials and members of the SEC to get less government oversight.
Their success in getting several exemptions gave them a free range in several areas that they took advantage. For instance, the last thorough examination of Enron’s annual reports was in 1997 (7).
With the insistence on growth, managers were constantly being rated on performance. Every six months or so analysts in training would be ranked and the bottom ten percent would be given their walking papers. These ranking were based on different criteria but certain areas got more attention than others. More stress was put on creativity than integrity.
For instance, “intellectual curiosity” was one criterion that counted as much as anything in the performance evaluation.
This consisted of how many ideas the person came up with and started up a new business or process, even if there wasn’t a demand for the business (3). For example, Lynda Clemmons in 1997 launched weather derivatives. Her start up, within two years, had written $1 billion in weather hedges to protect against short-run spikes in power prices (3). Enron declared this as another high-potential market for the company but the idea never panned out and was scraped shortly after.
Whether an idea was successful or not did not seem to matter, only if employees kept coming up with new ideas to make sure that they survived the routine purges.
The pressure to come up with deals was enormous and lead to what became called as “Friday night specials”. These deals were hastily put together and often with no apparent planning on how to manage the deals. These “specials” were often done with aggressive accounting that took ethical shortcuts, for illustration would be when they would book huge amounts of revenue before the contracts were signed and they would keep the revenue even if the deal fell through.
Though most of these cases did knowingly cross that ethical line, some might have just been because of young executives. In pursuit of never-ending growth Enron expanded into unfamiliar areas and with executives churning into new positions, sometimes as much as once a year, there is a possibility that inexperience played a role in some mistakes.
We would however not suggest that Enron’s unethical behavior was caused by inexperience due to the wealth of information coming out on the corruption. The pressure to perform had its consequences but it also had its rewards.
During the period from 1998 to 2000 total compensation for the top 200 employees went up more than 630% from $193 million to $1. 4 billion. The majority of the gains were given in stock options.
These executives started to care only about keeping the stock price as high as possible. Along with the compensation packages Enron routinely lent money to top executives, which were forgiven if the terms of their contracts were fulfilled (7). To complete the performance review a group of twenty people were selected to rank more than 400 vice presidents, then all of the directors, then all Enron managers (2).
The reward for being a manager rated superior (top 5%) were bonuses of 66% higher than those in the excellent group. This ranking policy had the effect of making people incredibly careful not to offend any of the reviewers, thereby creating a culture of “yes-men” (3).
Skilling was very hands on when it came to ranking employees for compensation. There were several people who cited that Skilling on several different occasions held up a persons performance review because he was trying to get back at them for criticizing or what they called stepping out of line (2).
This led to a development in the number of “yes men” that were afraid if they criticized or expressed disagreement that their careers would be severely damaged when it came time for performance review. The Enron environment bread a risk-taking culture that only cared about growth at any cost. There was no manager to set the example on what to do or not to do. Criticism and dissention were met with hostility and there was no counter balance to new ideas that were presented.
The emphasis on earnings lead employees to take ethical short cuts to keep up since creativity was reward more than integrity (3).
A definite agency problem came to light between the managers and shareholders. With the compensation packages and performance reviews, employees cared more about their own welfare and not the welfare of the company. Suggestions Enron had a code of ethics in place but did not comply or enforce its own rules. We feel that along with changes to accounting methods there also needs to be drastic changes in the culture and operational control management. Alternatives to current culture that Enron could adopt • Progressive-adaptive- A culture which stresses openness to new ideas, adapts quickly to shifting market conditions.
Company is future-oriented and wants to catch waves of change (13). • Purpose-driven- Leadership effectively directs the company on a clear course. A common purpose is defined that is shared by all employees who are committed to the same set of core values (13). • Community-oriented- A strong emphasis is placed on collectivity and cooperation. Leadership builds a company in which people respect, support each other.
Employees express their ideas rather than try to just “fit in”. (13). • People centered- A genuine caring for each worker by the company.
Individual employees are encouraged to develop their full potential, personally and professionally (13). Strengths and weaknesses of cultural system Strengths Progressive-adaptive culture Purpose-driven • • • • • • Community-oriented • • • • • Open to new ideas Reacts quickly Future oriented Clear Company direction Commitment to core values Cares about more than bottom line Team oriented Empowers employees Openness to ideas Freedom to grow People oriented • • • • Weaknesses Risk taking Outcome Oriented Risk averse Outcome Oriented • Less independence People-oriented Possible conflicts of interest Type of control systems • Market- Uses external mechanisms like market share, price competition.
Under this system a company’s divisions are evaluated by how much profits they achieve for the company as a whole (12). • Clan- Workers are regulated by shared values, traditions, rituals, and norms. Behavior depends on identifying with a certain group and behaving in a way that reflects on the group or team (12). • Bureaucratic- Emphasizes an organizational authority.
That authority has set up an extensive set of rules, regulations, polices, and procedures (12). Strengths and weaknesses of Control Systems Strengths Market Control • • • • • • Easy to monitor Flexible Shared values Flexible Formal Extensive • • • • • • Weaknesses Profit driven Results oriented Informal Variations possible Slow Inflexible Clan Control Bureaucratic control Alternatives to Accounting and Finance • Transparency committee- Investors want adequate information to reliably assess how a company is being run and what its risks are.
An audit committee is only there to assure that the firm is following GAAP as certified by the outside auditors. A “transparency committee” would spend its time evaluating the efficiency of the policies and decisions that have a greater impact on investors’ perceptions of the company. The goal should be to help investors and other members of the board of directors understand the firm’s value proposition, strategy, key success factors and risks (25). • Auditing Business Model Reform- Auditors are to help investors identify stocks that are good investments and those that are not.
Auditors need to change their strategy from minimizing the costs and legal risks of performing this task and trying to increase profits in other areas like consulting, while instead focusing on maximizing the value of audits. Auditor independence can be achieved when auditors see audit committees as their real clients, not top management.
Incentives inside the audit firms need to encourage audit professionals to exercise judgment, and walk away from clients that don’t deserve their certification, even when they are big and important (25). Accrual Accounting- Companies need to use accrual accounting to provide a more accurate description of a company’s value. • SEC Review- A semi-annual review by the SEC would almost guarantee a more accurate representation of a company’s statements. It could also prevent executives from participating in transactions with a conflict of interest. Strengths and weaknesses of Accounting and Finance Strengths Transparency Committee • • Key business risks transparent to investors Detail and attention to key issues of importance • • Weaknesses Still violation of accounting rules Reliance on external auditors advice
Auditing Reform Accrual Accounting • • • Maximize audit value Revenue and expenses recorded in period incurred Stable and accurate statements Restore confidence to consumers and investors More accurate financial statements • • Compliance still an issue Requires highly skilled accountants SEC Review • • • Too much government control Recommendations • Accounting and Finance. We need better disclosure to public, board members and employees.
First, we want to go back to accrual accounting and stop the aggressive accounting immediately.
We feel accrual accounting gives a clear and more accurate representation of earnings, financial statements and the overall welfare of the company. To regain consumer confidence we will submit ourselves to semi-annual review of our financial statements by the SEC. In our new financial statements we plan to put footnotes describing transactions terms and finance methods involved. This is in an effort to provide clarity on how we do business. Also, auditors will no longer be permitted an office space in Enron’s buildings.
In addition, Enron will voluntarily rotate auditors every 5 years. An effort will be made also to control the quality of trades. To simplify and control small acquisitions and transactions we want to institute a payback period of 3 years, in which cash flows must result in a positive net present value using accrual methods. For major project initiatives where a large initial investment will be involved, a decision making panel will consult to decide whether to proceed or not. The hope of this decision making panel is to get a wide variety of opinions.
Feedback will be collected through quarterly and annual internal audits of financial statements.
We will submit to SEC audits at their request and we will hire an outside firm to do annual audits also of financial statements. Along the same lines several former finance policies will be stopped such as, executive loans and compensating top executives with huge chunks of stock options. • Control Systems. As far as control issues are concerned we feel that enforcement was extremely deficient. We suggest a change in the current control system to a bureaucratic system.
This will formalize rules, procedures and polices especially in regards to integrity and ethics which will stop such behavior in employees. The major fault of this system is that it will slow our business down and decrease the number of transactions. We understand that this could hinder some of our deals but feel that a bureaucratic system will be strong and able to deal with the size of Enron especially when it comes to dealing with ethical issues. Included in this control system will be several checks and balances that were not in place before.
First, during new hire orientation, employees will have to attend an ethics workshop.
Also, employees will be required to attend one ethics seminar a year. In regards to advancement an effort will be made to keep people in their current jobs for at least 6 months in order to gain operational experience. As a way to insure quality trades the risk assessment and control division will be allowed more people and time to analyze trades and projects. In regards to reporting unethical activity, we propose an open door policy to report wrong doing.
We also want to establish a position or committee to have the power to investigate and enforce company’s guidelines on ethics and values made up of employees from every level of management where each has an equal vote. These changes are rather large but we feel that they could take place immediately, within a few months.
• Culture. Enron’s culture is one where there is no clear direction with a dual role of both an owner and trader of commodities. They stress a highly competitive, arrogant, distrustful culture that made objecting to unethical behavior very difficult.
We want to change the current culture to a more purpose-driven culture (13). We choose this culture because in this culture leadership will effectively stress a clear purpose of the company. Since everyone has the same common goal we feel that this will stop some of the bad investments while uplifting employees unlike the old culture.
We want to start the transition immediately. Meetings will be held with management to discuss the focus and their role in this changing culture. Human resources will be extremely important in getting the company’s message across.
They will post informative notices and answer any questions about new polices. They will phase it in starting with new employee orientation. Along with the ethics workshop mentioned in the control system, new hires will also go through a session about Enron’s purpose and core values.
The “rank or yank” system of review will be scraped and a probationary system will be put in its place. It will involve those that are below the 10% will be sent for more training and given a period to show improvement before being let go. We believe that this relieves pressure to perform that led to those unethical shortcuts.
Along the same lines, criteria for performance review will be weighted equally instead of having highly weighted categories like “intellectual curiosity”. Top managers should encourage criticism and alternative thinking by offering incentives to those who come up with quality constructive opposing view points. Managers will also be responsible for upholding the control system and not letting ethical standards fall.
It will be required of heads of departments to hold quarterly sessions to reaffirm the Enron’s purpose and values.
Feedback information will be gathered on the efficiency of the new culture by annual surveys given to all employees to rate different areas of Enron’s business practices, most notably the new control and culture initiatives. In addition, a third will be contracted to do a cultural audit every three years. Enron is an example of what unethical business practices can do to even the seventh largest corporation in the US. Ethical management control systems, aggressive accounting methods, and the organizational culture were significant problems that directly led to their demise.