Enron Company was formed in 1985 when natural gas pipeline companies of Inter-North and Houston Natural Gas merged. The presence of a free market system in the 1990s allowed traders like Enron to increase their revenues significantly (Healy & Krishna, 2003). Enron pursued a diversification strategy in an attempt to expand further leading to a significant increase in its growth rate. The rise in stock value was a clear indication of Enron’s stock market’s great expectations for the company’s future achievements.
Nature of Its Fraudulent Activities
Enron became nontransparent about its financial statements, failing to depict its finances and operations with all the stakeholders, especially with the shareholders, in the clearest way. The company’s unethical practices and its complex and rather difficult business model required an organization to misrepresent its earnings and change them in order to give a favorable picture of the company’s performance. As reported by McLean and Elkid, the Enron scandal resulted from the practice of habits actions, and values that started in the preceding years and finally grew out of control. The Company’s financial and accounting operations kept its reported cash flow and profits up, reported inflated asset values, and kept liabilities off-balance-sheet (McLean & Elkind, 2001). Enron, through the use of accounting loopholes, poor financial reporting, and special purpose entities was able to hide billions in debt from unsuccessful projects and deals. The Enron scandal is not only one of the largest corporate bankruptcies in the U.S. but it is also the biggest audit failure (Healy & Krishna, 2003).
The Responsibility of the Management to Shield Stakeholders from Fraud
Before its fall, Enron was praised for applying sophisticated financial risk management tools. Risk management was a necessity to Enron because of its regulatory environment as well as its business plan. The company put in place long term fixed commitments, which required hedging to prepare for the inevitable change in the future energy prices (McLean & Elkind, 2001). The reckless use of derivatives and special purpose entities were the contributing factors to its bankruptcy downfall.
The board of directors was well informed on the rationale for using the entities, and after approving, they received status updates on their operations. However, the company’s board and finance committee lacked comprehensive backgrounds in derivatives to understand what was reported to them. With a detailed understanding of the organization of the derivatives, the board would have prevented their use (McLean & Elkind, 2001).
Corporate Environment and Culture Contributing To the Fraud
Enron reported the value of its entire trade as revenue. The company reported inflated trading income, a method that was further adopted by a number of organizations in the trading industry, trying to remain more competitive with the company’s rise in revenue. By adopting the same trading revenue and accounting approach as Enron, other energy companies managed to join Enron in the top fifty of the Fortune 500 (Healy & Krishna, 2003).
The passing of legislation deregulating the sale of natural gas increased energy markets, making it possible for traders like Enron to sell energy at high prices. The resulting price volatility caused decry from producers and local governments, pushing for increased regulation. This resulted in strong lobbying on the part of Enron and other energy companies and succeeded to maintain the free market system (McLean & Elkind, 2001).
Impact of the Fraud on the Company
Loss of Investor Trust
Enron’s stock kept falling and some observers felt that its investors were in significant need for reassurance. This was because it was difficult to describe Enron in financial statements and also because the company’s operations were difficult to understand (Gilpin, 2001).
Credit Rating Downgrade
One of the short-term effects of the resulting problems seemed to be a possible downgrade in its credit rating. This would force Enron to offer millions of stock shares to cover its enormous loans it had guaranteed, which would further bring down the value of the existing stock. The rating of the company was just one notch above junk status (Gilpin, 2001). Many traders and investors either stopped doing business with Enron or limited their involvement with the company because of the fear of more bad news.
On November 2001, Enron’s credit rating fell to junk status and Dynegy Inc. disengaged from the proposed acquisition of the company. These were the two worst possible inevitable outcomes of the company since it lacked cash to run its business as well as satisfy its enormous debts. Enron’s creditors and other energy trading companies sustained the loss of several points (Berenson & Andrew, 2001).
Enron and Anderson Trial
A number of executives at Enron Company were indicted for a number of charges with subsequent sentencing. The indictment of Enron covered a wide range of financial crimes, including false statements to auditors and banks, bank fraud, money laundering, insider trading, wire trade, securities fraud, and conspiracy (Healy & Krishna, 2003). The fraudulent activities of Enron also affected Arthur Anderson, the Company’s auditor firm. He was charged with obstructing justice, although the conviction was later overturned. However, the damage had already been done and the resuming of operations was limited. Enron’s creditors, employees, and shareholders received little assistance, if any, apart from severance from the company.
Measures That Would Have Assisted to Prevent/Detect the Fraud
These fraudulent activities could have been prevented if several measures had been established. Proper legislation regulating the market system was necessary to shield stakeholders from the outcomes of fraud. The auditor and the executives needed to be independent and in a position to comprehend the company’s activities. The company should also have disclosed its relationship with unconsolidated entities.