The Enron scandal

The Enron scandal, publicized in October 2001, eventually led to the

bankruptcy of the Enron Corporation, an American energy company based in
Houston, Texas, and the de facto dissolution of Arthur Andersen, which was
one of the five largest audit and accountancy partnerships in the world. In
addition to being the largest bankruptcy reorganization in American history
at that time, Enron was cited as the biggest audit failure.[1]

Enron was formed in 1985 by Kenneth Lay after merging Houston Natural
Gas and InterNorth. Several years later, when Jeffrey Skilling was hired, he
developed a staff of executives that by the use of accounting loopholes,
special purpose entities, and poor financial reporting were able to hide
billions of dollars in debt from failed deals and projects. Chief Financial
Officer Andrew Fastow and other executives not only misled Enron's board of
directors and audit committee on high-risk accounting practices, but also
pressured Andersen to ignore the issues.

Enron shareholders filed a $40 billion lawsuit after the company's stock price,
which achieved a high of US$90.75 per share in mid-2000, plummeted to
less than $1 by the end of November 2001.[2] The U.S. Securities and
Exchange Commission (SEC) began an investigation, and rival Houston
competitor Dynegy offered to purchase the company at a very low price. The
deal failed, and on December 2, 2001, Enron filed for bankruptcy under
Chapter 11 of the United States Bankruptcy Code. Enron's $63.4 billion in
assets made it the largest corporate bankruptcy in U.S. history until
WorldCom's bankruptcy the next year.[3]

Many executives at Enron were indicted for a variety of charges and some
were later sentenced to prison. Enron's auditor, Arthur Andersen, was found
guilty in a United States District Court of illegally destroying documents
relevant to the SEC investigation which voided its license to audit public
companies, effectively closing the business. By the time the ruling was
overturned at the U.S. Supreme Court, the company had lost the majority of
its customers and had ceased operating. Enron employees and shareholders
received limited returns in lawsuits, despite losing billions in pensions and
stock prices. As a consequence of the scandal, new regulations and
legislation were enacted to expand the accuracy of financial reporting for
public companies.[4] One piece of legislation, the Sarbanes-Oxley Act,
increased penalties for destroying, altering, or fabricating records in federal
investigations or for attempting to defraud shareholders.[5] The act also
increased the accountability of auditing firms to remain unbiased and
independent of their clients.

Enron: What Went Wrong?

Formed in 1985 from a merger of Houston Natural Gas and Inter north, Enron
Corp.was the first nationwide natural gas pipeline network. Over time, the
firms business focus shifted from the regulated transportation of natural gas
to unregulated energy trading markets. The guiding principle seems to have
been that there was more money to be made in buying and selling financial
contracts linked to the value of energy assets
(And to other economic variables) than in actual ownership of physical
assets. The central issue raised by Enron is transparency: how to improve the
quality of information available about public corporations. As firms become
more transparent, the ability of corporate insiders to pursue their own
interests at the expense of rank-and-file employees and public stockholders
diminishes. Several aspects of this issue are briefly sketched below, with
reference to CRS products that provide more detail.

Auditing and Accounting Issues

Federal securities law requires that the accounting statements of publicly
traded corporations be certified by an independent auditor. Enrons auditor,
Arthur Andersen, not only turned a blind eye to improper accounting
practices, but was actively involved in devising complex financial structures
and transactions that facilitated deception. An auditors certification
indicates that the financial statements under review have been prepared in
accordance with generally-accepted accounting principles (GAAP). In Enrons
case, the question is not only whether GAAP were violated, but whether
current
Accounting standards permit corporations to play numbers games, and
whether investors are exposed to excessive risk by financial statements that
lack clarity and consistency.

Corporate Governance Issues

In the wake of Enron and other scandals, corporate executives and boards of
Directors were subject to critical scrutiny. At Enron, WorldCom, and
elsewhere, top management sold billions of dollars worth of company stock
while serious financial problems were being hidden from the public.
Several provisions of Sarbanes-Oxley were intended to remind CEOs of their
duties to their firms and their public shareholders. Stock trades by corporate
insiders must be reported in a matter of hours, rather than weeks or months.
CEOs must personally certify the accuracy of their companies