Case Study: Enron: The Smartest Guys in the Room

Jefferson M. Roberto
Instr. Justine M. Palaypay, CPA
Accounting Information System

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 Introduction and Brief History

This study guide presents the case of Enron Corporation, a major American energy

trading company that went bankrupt in December 2, 2001 owing to the breaking out of its huge

financial and accounting fraud scandal. It is one of the most notorious examples of willful

corporate fraud and wrong corporate governance. Popularly known as the “Enron Scandal”, this

scandal is recorded as one of the largest business scandals and bankruptcy in American history.

The entire story of how Enron Corporation, one of the world’s major energy giant, collapsed is

beautifully portrayed in the 2005 documentary film called “The Smartest Guys in the Room”

which is based on the best-selling 2003 book of the same name, written

by Fortune reporters Bethany Mclean and Peter Elkind. This film shows how the top

management, especially the Founder and Chairman Kenneth Lay, CEO Jeffrey Skilling and

CFO Andrew Fastow, through their blind power of greed and faulty organizational culture led to

the unfortunate downfall of Enron and resulted in the criminal trials for many executives

including themselves. It also played a significant role for the enactment of a revolutionary

legislation called Sarbanes-Oxley Act of 2002(SOX) especially designed to prevent similar

corporate failures and accounting scandals.

            Enron Corporation was founded and established by Kenneth Lay (or Ken Lay) in 1985.

Prior to its downfall, Enron was known as one of the top gas/energy companies of America. In

fact it was named by Fortune as “America’s Most Innovative Company” for six consecutive

years. It was considered as a chief blue chip stock investment company as it enjoyed high stock

positions and market capitalizations for years till its ruin in the late 2001. The first time that

anyone raised a question to the accuracy of its financial condition was a Fortune article entitled

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“Is Enron Overpriced?” written by Bethany Mclean. It was since then that the downfall of Enron

started to take shape.

Transparency and Accountability

From the early stages, Enron’s focus on earnings and share price growth and the related

financial incentives led to a necessary lack of transparency as the figures were fiddled.. One

could argue that Enron felt very much accountable to their shareholders for delivering consistent

above average growth in Enron’s market capitalization. However, this growth was achieved by

subterfuge and deception. Certainly the dealings in California were as far from transparent as it

was possible to be.

Factors Leading to Collapse of Enron

The main cause for Enron’s downfall were its deceptive financial statements that were

deliberately designed to show it profitable even when it had millions of dollars in debt and

losses. They were presented in such a way that they deceive and bewilder their readers and hide

the actual cash flow, profit and financial position of the company. The masterminds behind this

were Jeffrey Skilling and Andrew Fastow, who used such accounting vehicles which would

misinform and mislead anyone who tries to read Enron’s financial statements. TWO such

primary accounting vehicles used by Enron were: Mark-to-market Accounting: Enron used the

Mark-to-market Accounting system for account-keeping and reporting with the help of which its

financial statements were deliberately made very complex and not easily understandable. A lot of

manipulation was done in this regard under the Mark-to-market accounting model to deceive the

stakeholders. Special Purpose Entities (SPEs): Another accounting vehicle and this time the

genius work of CFO Fastow, was the use of Special Purpose Entities (SPEs) to hide Enron’s debt

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and improve its debt-to-equity ratio. Fastow received about $30 million payments for managing

these SPEs.

Defective Corporate Governance

Another major reason why Enron managed to enjoy years of successful deceiving and

cheating was its practice of defective corporate governance. Basically, Corporate Governance

entails the system of rules, regulations, practices and processes by which a company is directed

and controlled by the means of internal control and external cross-examination(audit) to ensure

balance, fairness, accountability for the protection of interests of all the concerned stakeholders.

But the corporate governance practiced in Enron was very far from the very definition of

Corporate Governance. Enron was infected with dysfunctional organizational culture, highly

competitive, unhealthy compensation and appraisal system, defective organizational system

wrapped around the stock-position as its key goal and cult-like leadership style. These factors are

explained in detail as follows: Employee Compensation and Appraisal System: One very

interesting fact that the readers of this case would notice, is the unique Employee Compensation

and Appraisal System Enron followed, which inherently, was supposed to design and retain its

most valuable employees but which turned out to make employees obsessed with short-term

earnings and personal growth in the company at the expense of company’s losses.Organizational

System: Another cause for Enron’s ruin can be attributed to its organizational system which

revolved around the company’s stock price. The stock price was the key metric and all its

decisions were made on the basis of the stock price and it did work momentarily as Enron

became the “darling” of Wall Street as this case refers to it, but all to fail in the end. Leadership

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Style: Skilling followed a cult-like leadership style and was almost viewed with cult-like status.

He was a macho, aggressive and exceptionally smart and he liked and hired people like himself.

It was under his leadership that the devastating culture developed in Enron.

Aftermath of Collapse

The consequence of the Enron Scandal is well-known- the bankruptcy of Enron, dissolution of

AA, Criminal trials and charging of the key players, loss of millions of dollars to the

shareholders and employees, and the enactment of Sarbanes-Oxley Act of 2002(SOX). Enron

was declared bankrupt on December 2, 2001. Enron Employees and Shareholders lost billions of

dollars due to the fraud. The shareholders lost due to huge decline in stock prices and employees

due to their pension plans. But the shareholders got a $7.2 million settlement collected from

settlements with various other parties. Ken Lay resigned on January 23, 2002. He was charged

and found guilty on 10 counts. He was supposed to serve 5 to 10 years for each count but he died

on July 5, 2006 awaiting sentence. Jeffrey Skilling resigned on august 14, 2001. He was charged

and found guilty on 28 counts, fined $45 million and sentenced to 24 years behind bars. He is

serving his term now and is scheduled for release on February 2028. Andrew Fastow, although

indicted on 78 counts on fraud, money laundering and conspiracy, pled guilty to only 2 counts

and agreed to a 10-year sentence. Later on September 2006, he was sentenced to 6 years plus 2-

years probation in a low-security prison.

   Arthur Anderson was convicted of obstruction of justice for destroying documents to its

audit to Enron on June 15, 2002. On August 31, 2002 it surrendered its licenses and rights to

practice.  Sarbanes-Oxley Act of 2002(SOX): Because of the Enron Bankruptcy scandal and later

WorldCom Scandal, a new US legislation was enacted called Sarbanes-Oxley Act of 2002(SOX)

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on July 30, 2002 to provide better means, standards and regulatory practices to prevent similar

accounting frauds and misconduct.

Conclusion

Any of the above listed problems will obviously befall a company if not checked well in

advance. Enron Corporation was highly affected by organizational problems to the point of a

closure and bankruptcy declaration of their accounting firm. The schemes demonstrated by the

management were a sign of poor leadership, bad governance, greed for money, and self-

centeredness. Mismanagement affects the employees, investors and the management itself. In the

case of Enron, more than 20, 000 lost their jobs, two people died out of the faked electricity

demand, senior management was taken to court, investors encountered losses, accounting firm

declared bankrupt and the sudden fall of Enron Corporation.

But since some of these problems are due to ignorance, lack of personal will to do right,

bending the law, and selfish interests, personal conscience and good governance are required to

protect the interests of all in a company. Governments should prescribe stiff penalties for all

forms of mismanagement, corruption and conspiracy in a public owned company. As of such,

managers and directors in such companies should be vetted before assuming management

positions to ensure transparency and professionalism.

References

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Case Review "enron: The Smartest Guys in the Room"
S - https://singhzee.wordpress.com/2013/08/12/case-review-enron-the-smartest-guys-in-the-
room/
The Collapse of Enron
Aakash Khandelwal - https://www.slideshare.net/aakashkhandelwal921/the-collapse-of-enron
Enron: The Smartest Guys in the Room Movie Review (2005): Roger Ebert
Roger Ebert - https://www.rogerebert.com/reviews/enron-the-smartest-guys-in-the-room-2005

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