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Enron: The Good, the Bad, and the Ugly

Coenen
Tracy L. Coenen

After a trial that lasted almost four months, Kenneth Lay and Jeffrey Skilling, both former heads of Enron Corp., have been convicted of multiple federal offenses related to the collapse of the company. The guilty verdicts were rendered on charges of conspiracy, wire fraud, and securities fraud.

The Enron executives engaged in a broad scheme to inflate the company’s earnings, which in turn increased the company’s stock price. The scheme lasted at least from 1999 through 2001, and was aimed at showing that Enron was steadily growing and meeting analysts’ earnings expectations. In reality, Enron was making bad investments and recognizing non-existent revenue.

The schemes hid the fact that the company’s cash flow was terrible and did not deserve an investment-grade credit rating. Ultimately, the manipulation of the financial statements helped Enron’s stock price to grow from $30 per share in early 1998 to more than $80 per share in early 2001. Even when the stock price started to fall, executives slowed the fall by continuing to manipulate the financials.

A U.S. Department of Justice press release praised the guilty verdicts, which came after a four-year investigation and prosecution. Representatives said that the public deserves honesty and integrity by public companies, and Enron executives mislead analysts and investors.

The mere mention of the names Enron or Arthur Andersen, the company’s outside auditors, can bring out emotions in executives everywhere. In the eyes of many, these companies stand out as prime examples of greed, mismanagement, and dishonesty.

The Good

It’s hard to believe that anything good would come out of the collapse of one of the country’s largest companies. Yet even with the loss of thousands of jobs and millions of dollars, we can still find some good. There are lessons to be learned from Enron, and those lessons in and of themselves may be a valuable byproduct of the company’s downfall.

With the advent of new accounting regulations, such as the Sarbanes-Oxley Act of 2002, companies have had an opportunity to reevaluate their processes and their controls over financial reporting. Companies have been forced to improve the controls surrounding their accounting systems, and certainly this helps make financial information more reliable.

Many believe that it was important for the government to go to the mat on the case against the Enron executives. They believe it sends a message that financial statement manipulation will not be tolerated. In that respect, the prosecution of Lay and Skilling met a goal for many.

Most importantly, the collapse of Enron brought attention to the closely related issues of financial statement fraud and fraud by executives. Good corporate governance has become a priority for many companies, and the focus on ethics and integrity in financial reporting has helped increase investor confidence in some companies.

The Bad

Intuitively, the bad outweighs the good that we can find in the Enron collapse. Thousands lost their jobs and their retirement funds. Investors lost millions. The effects went beyond money. The trust of the investment community and the public at large was violated.

The aforementioned accounting regulations have created tremendous costs for many companies. The implementation of Sarbanes-Oxley has cost public companies millions and millions of dollars. And even though there are undoubtedly positive results from revamping the controls over the accounting systems and financial statements, one wonders whether those positive results can justify the enormous costs.

Arthur Andersen, the company’s outside auditors, had to deal with the fallout as well. Many think the auditors were asleep at the wheel. That may not be entirely accurate, however. It appears that the auditors played a very active role in how Enron accounted for its transactions.

Some transactions fell below the threshold of “materiality” and therefore the auditors had no real power over those items. Others were within reach of the auditors, and it seems that Arthur Andersen’s inaction on these issues contributed to the faulty financial statements presented by Enron executives.

The failure of the auditors to maintain their independence and advocate for the correct accounting treatment was paramount to honest financial statements. Yet Enron executives exerted too much control over the accounting firm. Arthur Andersen recognized that Enron was one of its largest clients, and good client relations were necessary to retain the business and the fees.

The compromise of auditor independence in the Enron debacle has changed the auditing profession forever. New auditor regulations have been created, while others have been modified to more clearly outline auditor responsibilities. Fraud now plays a bigger role in the planning and performance of audits, and the audit process will never be the same.

There is no finite cost to the fallout from the Enron scandal and collapse. The costs continue as former employees try to rebuild their lives and their retirement accounts.

Corporations will continue to incur costs year after year as they comply with regulations that came about after the fall of Enron. Auditors have increased their fees to account for additional audit procedures on each engagement.

The Ugly

The cost of the Enron scandal easily crosses from “The Bad” into “The Ugly.” Each time you turn around, another cost to companies and individuals is uncovered. The four year investigation and prosecution of Lay and Skilling undoubtedly cost massive amounts of money. And what did that achieve? The investigation and prosecution certainly can’t get back the jobs and investment dollars that were lost.

One might argue that the convictions will create a valuable deterrent effect. Executives who are considering defrauding auditors, analysts, and investors will think twice before doing so when they consider the convictions of Lay and Skilling. But will the convictions really have a meaningful deterrent effect? Or will they only have a minimal effect as executives consider how unlikely they are to be caught?

The varying reactions to the convictions of Lay and Skilling have been interesting, to say the least. On the one hand you have those who believe that Lay and Skilling were thrown under the bus for being poor managers and making bad business decisions. On the other hand you have those who believe Lay and Skilling aren’t paying a high enough price for trashing a company and looting it prior to its fall.

Everything that I have seen indicates that the financial statement manipulation at Enron went far beyond bad management. It is one thing to make a bad investment or a poor management decision. It is another thing to create sham transactions and entities that significantly and unfairly boost the earnings of a corporation.

It is not just the phony transactions and the financial statement manipulation that give me pause. It is the arrogan
ce with which the financial statement fraud was carried out. It is the greed of the executives who cashed out millions before the collapse of Enron. The attitudes of the executives add insult to injury in this case.

Will any prison sentence for the executives be long enough? No prison sentence can restore the public’s full faith in the financial statements of public companies. As we await the sentencing of Lay and Skilling, we are left to wonder what effect the Enron scandal will have on the business community five, 10, or 15 years from now.

The business world has been undeniably changed by the Enron scandal. Investors and analysts have become more skeptical, and we can only hope that executives have become more prudent. It is safe to say that the Enron name will be around for a while, and it will be forever linked with the word fraud.

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