1. What important internal controls were ignored when LJM1 was created?
2. How might Enron's harsh Performance Review Committee have aided company executives in committing the fraud?
3. The fraud at Enron is one of many major financial statement frauds that have occurred in recent years (Quest, Global Crossing, WorldCom, etc.). What are some factors that could explain why the falsifying of financial statements is occurring so frequently? List four factors.
4. Suppose you are a certified fraud examiner but enjoy investing in the stock market as an additional source of income. Upon research of Enron's stock, you notice that although its stock has a history of strong growth and a seemingly promising future, Enron's financial reports are unclear and, frankly, confusing. In fact, you can't even explain how Enron is making money. Could this lack of clarity in its financial reporting serve as a red flag in alerting you to the possibility of fraud at Enron? Why or why not?
5. How could the auditor, Arthur Andersen in this case, have performed its audits and not caught the Enron fraud? Is it possible for a financial statement auditor to perform an audit in compliance with generally accepted auditing standards (GAAS) and not catch major financial statement fraud? How would GAAS auditing need to change to guarantee that all frauds are caught?
The Enron Fraud
Enron Corporation began as a small natural gas distributor and over the course of 15 years grew to become the seventh largest company in the United States. Soon after the federal deregulation of natural gas pipelines in 1985, Enron was born by the merging of Houston Natural Gas and InterNorth, a Nebraska pipeline company. Initially, Enron was merely involved in the distribution of gas, but it later became a market maker in facilitating the buying and selling of futures of natural gas, electricity, broadband, and other products. However, Enron's continuous growth eventually came to an end as a complicated financial statement fraud and multiple scandals sent Enron on a downward spiral to bankruptcy.
During the 1980s, several major national energy corporations began lobbying Washington to deregulate the energy business. Their claim was that the extra competition resulting from a deregulated market would benefit both businesses and consumers. Consequently, the national government began to lift controls on who was allowed to produce energy and how it was marketed and sold. But, as competition in the energy market increased, gas and energy prices began to fluctuate greatly. Over time, Enron incurred massive debts and no longer had exclusive rights to its pipelines. It needed some new and innovative business strategies.
Kenneth Lay, chairman and CEO, hired the consulting firm McKinsey & Company to assist in developing a new plan to help Enron get back on its feet. Jeff Skilling, a young McKinsey consultant who had a background in banking and asset and liability management, was assigned to work with Enron. He recommended that Enron create a "gas bank" to buy and sell gas. Skilling, who later became chief executive at Enron, recognized that Enron could capitalize on the fluctuating gas prices by acting as a middleman and creating a futures market for buyers and sellers of gas; it would buy and sell gas to be used tomorrow at a stable price today.
Although brilliantly successful in theory, Skilling's gas bank idea faced a major problem. The natural gas producers who agreed to supply Enron's gas bank desperately needed cash and required cash as payment for their products. But Enron also had insufficient cash levels. Therefore, management decided to team up with banks and other financial institutions, establishing partnerships that would provide the cash needed to complete the transactions with Enron's suppliers. Under the direction of Andrew Fastow, a newly hired financial genius, Enron also created several special purpose entities (SPEs), which served as the vehicles through which money was funneled from the banks to the gas suppliers, thus keeping these transactions off Enron's books. As Enron's business became more and more complicated, its vulnerability to fraud and eventual disaster also grew. Initially, the newly formed partnerships and SPEs worked to Enron's advantage. But, in the end, it was the creation of these SPEs that culminated in Enron's death.
Within just a few years of instituting its gas bank and the complicated financing system, Enron grew rapidly, controlling a large part of the U.S. energy market. At one point, it controlled as much as a quarter of all of the nation's gas business. It also began expanding to create markets for other types of products, including electricity, crude oil, coal, plastics, weather derivatives, and broadband. In addition, Enron continued to expand its trading business and with the introduction of Enron Online in the late 1990s, it became one of the largest trading companies on Wall Street, at one time generating 90 percent of its income through trades. Enron soon had more contracts than any of its competitors and, with market dominance, could predict future prices with great accuracy, thereby guaranteeing superior profits.
To continue enhanced growth and dominance, Enron began hiring the "best and brightest" traders. But Enron was just as quick in firing its employees as it was in hiring new ones. Management created the Performance Review Committee (PRC), which became known as the harshest employee ranking system in the country. Its method of evaluating employee performance was nicknamed "rank and yank" by Enron employees. Every six months, employees were ranked on a scale of 1 to 5. Those ranked in the lowest category (1) were immediately "yanked" (fired) from their position and replaced by new recruits. Surprisingly, during each employee review, management required that at least 15 percent of all the employees ranked were given a 1 and therefore yanked from their position and income. The employees ranked with a 2 or 3 were also given notice that they were liable to be released in the near future. These ruthless performance reviews created fierce internal competition between fellow employees who faced a strict ultimatum-perform or be replaced. Furthermore, it created a work environment where employees were unable to express opinions or valid concerns for fear of a low-ranking score by their superiors.
With so much pressure to succeed and maintain its position as the global energy market leader, Enron began to jeopardize its integrity by committing fraud. The SPEs, which originally were used for good business purposes, were now used illegally to hide bad investments, poor-performing assets, and debt; to manipulate cash flows; and eventually, to report over $1 billion of false income. The following examples illustrate how specific SPEs were used fraudulently.