Introduction

The tale of Enron Corp. depicts a firm that reached a height before enduring a dramatic plunge. The disastrous company’s collapse impacted thousands of employees and rattled Wall Street. When Enron was at its peak, its share price was $90.75 before declaring bankruptcy in December. 2nd 2001, the shares had a value of $0.26. 1

To this day, many wonder how such a powerful business–at the time one of the largest companies in the United States–disintegrated almost overnight. It is also difficult to comprehend the ways its leaders were able to fool regulators for many years with false financial statements and off-the-books accounts.

Key Takeaways

  • The Enron leadership lulled regulators with fraudulent holdings and off-the-books financial practices.
  • Enron utilized Special purpose vehicles (SPVs) or Special Purpose Entities (SPEs) to conceal its massive debts and toxic assets to creditors and investors. 2
  • The share price of Enron ranged from $90.75 at its highest to $0.26 when it declared the time of its bankruptcy. 1
  • The company made its debtors over $21.7 billion between 2004 and 2011.

Enron Corporation was an American energy product, commodities, and services company with its headquarters in Houston, Texas. Kenneth Lay established it in 1985 due to a merger between Lay’s Houston Natural Gas and InterNorth and InterNorth, two regionally smaller businesses.

Financial instruments

MTM:

One of the main reasons that led to Enron’s demise is an off-the-market accounting method called Mark-to-Market (MTM) accounting, where the cost of products and services is determined based on actual market price. This allowed profits to be evaluated based on the current market value and not from the market value itself, including aspects of risk. Enron suffered huge losses in markets due to its broadband telecom service deployed across the United States. They received no compensation to make up for the losses.

Futures Contracts:

Through their contracts for futures, Enron increased the price and stocks, saying that the value in the future of the assets could be higher than the value that initially believed to be. Fair value accounting by Enron led to the restatement of the investments.

SPVs:

The loss disclosure was not disclosed because Enron’s Special Purpose Vehicles (SPVs) were utilized to exchange financial assets. Enron swapped stock value to cash in SPVs. SPVs and the decline of Enron stock added additional risk to the company’s existence. Enron is the name given to the company. It could hide its investors’ debt within these SPVs by exchanging shares. These SPVs were also unsuccessful, which led to further decline.

Commodity Markets:

Enron also utilized Equities to fund the SPVs. Certain SPVs used capital from equity investors. The dealers of Enron manipulated markets by shutting down power plants to raise prices. The contracts of Enron would state that the electricity’s pricing was negotiated through routes that didn’t provide enough bandwidth for the energy transmission. These incidents caused tension in the markets for commodities and ultimately were viewed as the reason for the company’s demise.

Impacts of the fall and rise of Enron

Market Crash: Stock Market Crash:

Because of their MTM accounting procedures, the value of their stock increased and led to more fabricated profits and investments into their business. Their stock wasn’t stable, and any change in stocks, like a crash, could have a devastating impact. In 2002, Wall Street suffered the steepest drop in three months, and the Nasdaq in which several tech companies are listed plunged. In the wake of Enron’s failing and the subsequent questions about the US interest rates and accounting practices.

Publicity:

The top executives of Enron were enticed by the publicity they received. The media attention given to the company and its employees led to Enron concealing its errors and pushed Enron to adopt aggressive strategies in their contracts and develop inadequate financials.

Bankruptcy:

The investors recognized that a positive corporate culture is essential in determining a business’s future. The board of directors was renamed Enron as Enron Creditors Recovery Corporation (ECRC). The bankruptcy of Enron forced its creditors to pay approximately $21 billion, and the last payment was in May 2011. In May 2011, the FASB (Financial Accounting Standards Board) increased its standards of ethical behavior. Boards of directors of companies have become more independent, overseeing the audit firms, and rapidly replacing managers who were not performing.

Risk mitigation techniques

Diversification:

Although the MTM methods were fraudulent and illegal, it would have been possible to avoid having to convert the value of the stock to cash. Instead, to stabilize the Enron stock it could have been used to create diversification of stocks, which included the blending of a portfolio of stocks from different countries and several financial instruments so that any stock decline could have averted the suspicion of investors, thereby preventing the creation of fraud in the management of Enron’s stock price. It would have prevented the market price every time there was a decline in one of its industries, Enron.

Derivatives:

Enron signed contracts with suppliers, whereby the contract that gave the supplier money was deemed to be a win-win-win situation for Enron. The contracts that involved Enron’s assets did not have derivatives, and, if they had, they had set an option or a futures contract in order to limit the risk of MTM Accounting practices and reduce the risk of the margin. Enron rigorously made use of derivatives as insurance against the fluctuation of energy prices and banks utilized more mortgage-backed derivatives, resulting in a risk for the market for debt.

Bonds:

Enron bondholders received additional rewards based on quick-term wins, not being based on a long-term sustainability solution. In their bond and bond markets, Enron could not have provided untrue proof or proof of their financial standing. Through good accounting and financial procedures, Their bonds must yield profits for investors and partners with a long-term approach.

Jim Chanos’ Short Trade on Enron

Jim Chanos of Kynikos Associates is a well-known short-seller. In a roundtable hosted by the SEC on hedge funds held in May of 2003 Chanos stated that his passion for Enron and other companies involved in energy trading were “piqued” in October 2000 following an article in the Wall Street Journal article highlighted that many companies used an accounting method known as “gain-on-sale” accounting method for their long-term energy trading. According to Chanos his experience of companies using this accounting technique was that management was tempted to be too insecure about their assumptions regarding the future. Moreover, “earnings” could effectively be made up of nothing if management was willing to push the envelope making highly favorable assumptions.

Chanos also pointed out that the company’s capital cost was higher than 9 percent and was likely to be higher than the 7percent return on capital, a popular metric for profitability that they claimed. This implies that it wasn’t actually earning money, while reporting its profits to shareholders. Chanos stated that the gap between the cost of capital and return on investment was the foundation of his bearish outlook of Enron and his company began shorting shares of Enron’s common stock to its clients in the month of November 2000. The short-term trade earned Chanos along with Kynikos and his Kynikos company hundreds of millions in profits in the event that Enron fell into financial ruin.

Arthur Andersen and Enron

Alongside Fastow, one of the major players of the Enron scandal was the company’s accountants, Arthur Andersen LLP, and its partner David B. Duncan, who was in charge of the accounting for Enron. It was one of five biggest accountants in the United States at the time, Andersen had a reputation for quality and high standards. risk management.

However, despite Enron’s shoddy accounting methods, Arthur Andersen offered its seal of approval, and signed off on corporate reports for several years. 15 By April 2001, analysts began to doubt the company’s financial performance and the transparency of its operations..

The Shock Feels Around Wall Street

In the end of the year 2001 Enron fell into freefall. Lay had left the company in February, and had handed over the CEO role to Skilling. Then, in August of 2001 Skilling quit as the CEO for personal reasons. The same time analysts began to reduce their ratings for the stock of Enron and the stock plummeted to an all-time lowest of $39.95. In October. 16th Enron had reported its first quarter-end loss and also closed its Raptor I SPV. This news attracted the attention of the SEC.

Just a few days later, Enron altered pension plan administrators, basically preventing participants from trading their stock for a minimum of 30 days. Then, shortly after the change, the SEC announced that it was looking into Enron as well as the SPVs made by Fastow. Fastow was dismissed from the company the following day. The company also revised its earnings prior to 1997. Enron suffered deficits of $690 and $591 million of debt at the end of 2000. The final blow came by Dynegy, the company which had announced that it was planning to join with Enron and backed out of the merger in November. 28. On Dec. 2, 2001, Enron had declared bankruptcy.

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