Case Study: Enron

Enron was a US-American energy-trading company, at one point rated 7th on Fortune’s list of top 500
U.S. companies. Founder, CEO and Chairman of the Board was Kenneth Lay. He was followed by
Skilling who resigned after only six months of work, Lay became CEO again. In 2000, Enron employed
21,000 people with revenues of $111 billion. Enron filed for bankruptcy in December 2001 which turned
out to be one of the largest corporate scandals in U.S.
What happened?
A trigger of the bankruptcy was Enron’s creative accounting. Its goal was, to keep certain assets and liabilities
off its balance sheet by using for instance Special Purpose Entities (SPEs). Enron covered up huge losses by
using a complex system of SPEs.
Enron founded, for instance, a joint venture (JEDI), for which it recorded gains, but never the liabilities. To
prevent consolidation, instead of looking for an outside investor, it set up complex financing procedures to keep
JEDI (falsely) off its books. Enron also conducted several transactions with LJM, a partnership managed by
their own CFO Fastow, which was clearly a conflict of interests. However, this was approved by the board. A
transfer of an asset between the two companies would be legitimate, if the other party is then taking risks and
benefits from the asset. Enron however, ensured LJM to protect them against any loss. Assets were
transferred back and forth, depending on the reporting periods, creating profits for both parties. For Hedging,
Enron set up SPE’s funded with its own stock, taking LJM as an outside investor to prevent consolidation. If the
value of an investment would decrease, the SPEs would pay Enron with their own stock to compensate for
losses. Of course, since payment was conducted with Enron’s own stock, they actually never hedged any
economic risk. Enron’s internal models in general created potential for abuse, with no fair value benchmarks
used for pricing securities in a very illiquid market. Many specifics were kept confidential, figures and financial
statements were presented in an overly complicated manner. Arthur Anderson (AA) was Enron’s accounting
firm and approved these transactions. AA was at the same time consulting Enron in other matters and the
whole internal auditing was outsourced to AA. Several former auditors from AA worked for Enron.
The management team had appeared defensive about Enron’s business, Skilling for instance, once called a
financial analyst an “asshole” who questioned Enron’s performance. Shortly after, they were announcing a
$544 million charge against earnings related to transactions with LJM and a corresponding 1.2$ billion
reduction in shareholder’s equity, Enron’s share plummeted from $90.75 (August 2000) to $0.26 (November
2001). Lay, in the meantime, began to short large amounts of his Enron stock while at the same time
encouraging employees to buy more, making a profit of $66.3 Million from exercising stock options. CEO and
CFO continued lying to analysts, telling them that Enron was not liable for Bank loan’s of its SPEs.
After Dynegy, another energy company, cancelled the buy-out of Enron, it had to file for bankruptcy. This cost
investors billions of dollars, 5,600 jobs were lost and $2.1 billion in pension plans were liquidated. Former CEO
Skilling was sentenced to 14 years in prison and CFO Fastow to 6 years.

Questions:
1. Which parties of a Corporate Governance system were involved in the scandal?
Which conflicting interests arise from that?
2. What are the signs of weak corporate governance? What is the conclusion?
3. How could good corporate governance have helped to prevent this scandal?
4. Which role did Financial Accounting and Reporting play in the scandal?

14.12.2018 – Corporate Governance: Role and Relevance for Financial Reporting – Maria Line Farhat, Hanna Klarner, Rebecca Kleiss