The fall of Enron and Arthur Anderson

Goodmorning everyone,

So in this post, I'll do something totally different compared to posting a funny video that I found on YouTube and post something that is more closely to my everyday life and that is a topic in accounting/auditing, which I am studying. The text below describes some of the main factors of the fall of Enron and how Arthur Anderson, once one of the big 5 auditing firms of the world, also fell to the ground. I made this article with some fellow students and if you want the references, feel free to reply to this text.

What is Enron Corporation?

Enron Corporation was an American firm that was founded in 1985 through a merger of Internorth and Houston Natural Gas, which quickly became one of the leading traders in energy- and petrochemical commodities (Munzig, 2003). However, this rapid growth was not only due to ‘conducting normal business’, but also because of shady SPE’s, questionable decisions by their external auditor and audit committee and the role of inflexible accounting regulations to name just a few of them.

Some of the main causes

Firstly, one of the main causes of Enron’s collapse was that shady transactions could be made through using special purpose entities (SPE’s). These vehicles were being sponsored by Enron using their stock in return for notes receivable from the SPE and could then borrow money, which it used to repay the note payable to Enron. This way the debt did not appear on the balance sheet, but they reported the revenues as part of share price increase of the different holdings in the SPE’s (Scott, 2015). This way, the balance sheet did not give a fair view of the situation at Enron. You could argue that the external auditor of Enron, Arthur Anderson, is also to blame, because they should have noticed these shady transactions and bring them to the attention of the SEC or at least have corrected them (Healy & Palepu, 2003). However, it appears to be that Arthur Andersen even aided in creating these SPE’s by confirming to the letter of GAAP (Bengston & Hartgaves, 2002). There clearly can be seen a conflict of interest, because Arthur Anderson as external auditor of Enron should bring these kind of constructions to the attention of the authorizations, but failed to do this, because they made these constructions themselves as consultant of Enron. They also failed to see that some of the SPE’s should have been consolidated with the financial statement of Enron, which might also have happened because of this conflict of interest. The audit committee of Enron also could have seen some of these transactions, which were clearly motivated by accounting goals, but did not require full disclosure on these transactions (Powers, Troubh and Winokur, 2002). It is however, still unclear why the audit committee of Enron accepted the inadequate disclosures of the different SPE’s according to the Powers’ rapport.

Problems with U.S. Gaap

Further, there can be concluded that the U.S. GAAP might also be a possible problem, because of its inflexibility and clear-cut rules. Enron might have, in some cases, followed the letter of the U.S. GAAP, but still have violated the basic objectives of GAAP accounting. Also, the FASB made use of the fair-value requirement for financial instruments, which made it possible for Enron to hide its losses through increasing its reported assets and net income which in turn were accepted by Arthur Anderson, because they followed U.S. GAAP(Bengston & Hartgaves, 2002). Another possible cause for the collapse of Enron were the abnormal high compensation (in stock options) for the different Enron executives (Munzig, 2003). The Enron chairman, Kenneth Lay, for example got 152,7 million dollar per year, 123 million of which were from stock options (Pacelle 2002). These stock options were being used in order to align the interests of the managers to that of the shareholders on creating long-term value (Munzig, 2003). However, these stock options might also work in the opposite way, in that they entice managers to manipulate the accounting numbers and investment policy in order to increase their pay (Shleifer and Vishny, 1997). In the case of Enron the executives all received high amounts of stock options. This also might be the reason why they went for risky and even illegal activities in order to keep the stock price rising and increase their pay. This might also have given the incentive to hide bad news, because that would have made the stock price drop, which would mean personal losses for executives.

So all the causes mentioned above are contributing to the collapse of Enron, which eventually happened in 2001, when more and more news of the ‘bad’ transactions Enron made and the tricks they used to give an unfair presentment of their financial statement came to light, which lead to a dramatic decline in Enron’s stock price. Eventually, Enron had to file for bankruptcy at the end of 2001.

I hope you enjoyed this short article and feel free to reply to this article and start a discussion!

Have a great day everyone!