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The Enron Scandal

Enron was named "America's Most Innovative Company" for 6 years straight. In 2001, it went bankrupt in 24 days. It is the textbook case of Accounting Fraud & Ethical Collapse, leading to the dissolution of Arthur Andersen (one of the Big Five accounting firms).

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Timeline of the Collapse

  • 1985: Merger - Houston Natural Gas merges with InterNorth to form Enron. Kenneth Lay becomes CEO.
  • 1990: Jeff Skilling Hired - Skilling joins Enron and introduces 'Mark-to-Market' accounting.
  • 1999: Enron Online - Enron launches its trading platform. Stock hits all-time highs.
  • Aug 2001: Skilling Resigns - Jeff Skilling abruptly resigns as CEO, citing 'personal reasons'. Stock begins to slide.
  • Oct 2001: The Disclosure - Enron announces $638 million loss and $1.2 billion reduction in shareholder equity.
  • Dec 2001: Bankruptcy - Enron files for Chapter 11 Bankruptcy. It was the largest in US history at the time.

How the Fraud Worked (Technical Details)

1. Mark-to-Market Accounting (The "Hypothetical Profit" Trap)

Traditionally, companies book revenue when they actually sell a product/service.

  • Enron's Method: If Enron signed a 20-year deal to supply gas, they estimated the total profit for the next 20 years (say $100 Million) and booked it TODAY as current income.
  • The Problem: If the deal went bad later, they didn't reverse the profit. They just created a new deal to cover it up. They were booking "Paper Profits" with zero cash.

2. The Special Purpose Entities (SPEs) - "The Raptors"

Enron had massive debt. To keep its credit rating high (Investment Grade), it needed to hide this debt.

  • The Mechanism: CFO Andrew Fastow created thousands of shell companies (named LJM, Chewco, Raptor).
  • The Trick: Enron would sell its bad assets and debt to these SPEs.
    • Enron Books: Look clean (High Assets, Low Debt).
    • SPE Books: Full of toxic debt (Hidden from public).
  • The Conflict: Fastow secretly owned these SPEs and paid himself millions in "management fees" from Enron's money.

The Players involved

  • Kenneth Lay (Chairman): The face of Enron. Politically connected (friend of President Bush). Claimed he "didn't know" about the fraud. Died before sentencing.
  • Jeff Skilling (CEO): The "Idea Guy". Arrogant. Believed he was smarter than everyone. Famous for calling an analyst an "asshole" on a public call when asked about the balance sheet. Sentenced to 24 years.
  • Andrew Fastow (CFO): The Architect. Created the SPE web. Cooperated with FBI for a reduced sentence (6 years).
  • Sherron Watkins (Whistleblower): VP of Corporate Development. Wrote the famous memo to Ken Lay laying out the fraud: "I am incredibly nervous that we will implode in a wave of accounting scandals."

Failure of Gatekeepers

Why did no one stop them?

  1. Auditors (Arthur Andersen): They were earning $1 Million per week from Enron. They didn't want to lose the client. They even shredded tons of documents when the SEC signaled an investigation.
  2. Banks (Citi, JPMorgan): They lent billions to the SPEs, knowing they were off-balance-sheet vehicles, to earn huge fees.
  3. Analysts: Wall Street analysts kept "Strong Buy" ratings even as the stock collapsed, fearing they would lose investment banking business.

Regulatory Response: The Sarbanes-Oxley Act (SOX) 2002

The US Congress passed SOX to ensure this never happens again.

  • CEO/CFO Certification: Top execs must personally sign off on accounts (risk of jail).
  • Ban on Consulting: Auditors cannot do consulting work for audit clients.
  • PCAOB: Creation of a board to police the auditors.

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