Republic of the Philippines

POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

College of Accountancy and Finance
ACCO 20163 Governance, Business Ethics, Risk Management, and Internal Control

The Enron Collapse

A Case Analysis

Presented to:
Mr. James Robert D. Aguila, CPA, CMA

In partial fulfillment of the requirements for ACCO 20163 – Governance, Business

Ethics, Risk Management, and Internal Control

by:

Aguilar, Sean Nicolas

Cervantes, Hannah Rose
Fernandez, Mark
Javier, Alyanna Carrie
Terencio, Daniel
Tinawin, Celerina
BSA 2-14

September, 2021

PUP A. Mabini Campus, Anonas Street, Sta. Mesa, Manila 1016

Direct Line: 335-1730 | Trunk Line: 335-1787 or 335-1777 local 000
Website: www.pup.edu.ph | Email: [email protected]

THE COUNTRY’S 1st POLYTECHNICU

 POLYTECHNICUNIVERSITY OF THE PHILIPPINES

I. Case Synthesis

Enron Corporation, situated in Houston, Texas, was an American energy,

commodities, and services company. It is a result of a combination between Houston
Natural Gas Company and Omaha-based InterNorth Incorporated in 1985. Kenneth
Lay, the former CEO of Houston Natural Gas, became Enron's CEO and chair after the
merger. Enron was immediately rebranded by Lay as an energy trader and supplier. Lay
established the Enron Finance Corporation in 1990 and appointed Jeffrey Skilling,
whose work as a McKinsey & Company consultant had impressed Lay, to lead the new
corporation. Enron, with the help of Jeffrey Skilling, converted itself into a dealer of
energy derivative contracts, serving as an intermediary between natural-gas producers
and their clients. Enron controlled the natural-gas contract market under Skilling's
leadership, and the business began to make significant profits on its trading. Skilling
continued to make Enron known by hiring MBA graduates. One of his best picks is
Andrew Fastow, who became Enron's chief financial officer.

Enron is best known in its Mark-to-Market approach, a contribution of Skilling to

the company -- a transition from Enron's accounting of traditional historical cost
accounting method. Mark-to-market is a legitimate and utilized practice, that is approved
by the SEC in 1992, that tries to provide a realistic assessment of an institution's or
company's current financial status. Yet, in some circumstances, the approach can be
manipulated because MTM is not based on "real" cost but on "fair value," which is more
difficult to determine. Under the leadership of President and CEO Kenneth Lay, Enron is
the seventh largest company by revenues, with $111 billion, in the United States. Enron
had been praised for its innovative business model as it was named "America's Most
Innovative Company" by Fortune magazine every year from 1996 to 2001, along with
being the Best Sales Force in the Nation — Sales & Marketing Management’s (1999),
and many more. Before the collapse of the company, it reached its peaked shares in the
New York Stock Exchange of 90.75 USD that gave Enron a market cap of about 70
billion dollars, enough to make it the seventh biggest publicly-traded company.
 POLYTECHNICUNIVERSITY OF THE PHILIPPINES

However, on March 5, 2001, Fortune magazine published an article by Bethany

McLean, questioning the current market value of Enron shares. At the end of 2001, it
was revealed that Enron's reported financial condition was sustained by an
institutionalized, systematic, and creatively planned accounting fraud, known as the
Enron scandal. The scandal also brought into question the accounting practices and
activities of many corporations in the United States and was a factor in the enactment of
the Sarbanes–Oxley Act of 2002.

II. Point of View

This case analysis would assume the viewpoint of US Securities and Exchange
Commission (SEC), an independent regulatory agency of United States that is
responsible in the administration of federal securities laws. SEC is in charge of assuring
that there is an adequate, honest, and fair disclosure of material information that will aid
potential investors to make informed decisions and maintain their confidence in being
engaged with investments. Furthermore, the agency has the authority to file civil and
criminal charges against the corporations who produces materials that contain
misleading information, omissions, and blatant fabrications. Thus, they have also
administered the following laws such as Securities Act of 1933, Securities Exchange Act
of 1934, Public Utility Holding Company Act of 1935, Trust Indenture Act of 1939,
Investment Company Act of 1940, Investment Advisers Act of 1940, and Sarbanes-
Oxley Act of 2002 with the objective of preventing deceit and fraud, regulation of
organization’s activities concerning investing, reinvesting, and trading, and to impose
stricter reporting requirements. With this at hand, the clear goal of the agency is to
conduct a rigorous observance and investigation especially when suspicious accounting
practices are probable and to guarantee that those cases such as the Enron’s collapse
are to not occur again in the future.
 POLYTECHNICUNIVERSITY OF THE PHILIPPINES

III. Statement of the Problem

The case analysis aims to give answer to the question stated below as it reflects to the
objectives of the study.

How can good corporate governance, strong business ethics, efficient risk management
and internal control system prevent the Enron-like scandal?

(Explanation: The researchers believe that having a solid understanding in the

fundamental of business, its governance, risk management, ethical practices, and
internal control are matter of great importance in the prevention of committing the same
mistake as Enron did. Thus, the case analysis focuses on the impact of these four
aspects of business in the long-term and sustainable success of the organization.)

IV. Objectives

The case analysis aims to achieve the following objectives:

 Investigate the roles, responsibilities, and accountabilities of the stakeholders in

Enron scandal (The researchers aim to study the contribution of each
stakeholder to Enron’s downfall)
 Examine the company’s corporate governance and its basic principles as
abidance to these should have reduced the opportunity for such fraudulent
actions (The researchers aim to examine how the basic principles of corporate
governance, such as transparency, integrity, and accountability, are practiced in
the company)
 Illustrate the ethical standards that have been violated by Enron which
contributed to its downfall (This study aims to illustrate the ethical issues faced
by Enron and how Enron dealt with them)
 POLYTECHNICUNIVERSITY OF THE PHILIPPINES

 Evaluate the implications of aggressive accounting practices and off-balance

sheet arrangements of Enron that lead to fraudulent financial information (This
case analysis aims to understand the implications of the mark to market
accounting method as well as the use of special purpose entities by Enron as
means of hiding its debt)
 Analyze the inadequacies in the management control system of Enron Company
(The researchers aim to analyze the inefficiency of its internal control system
specifically the lack of auditor independence)
 Identify the consequences of Enron collapse and its impact to the corporate
world (This case analysis aims to determine the consequences of Enron
Collapse in different industries where it belonged as well as the enactment of the
Sarbanes–Oxley Act of 2002)
 Provide sustainable and effective systems, strategies and policies to prevent
Enron-like scandal (Finally, after a thorough analysis, the researchers aim to
provide relevant and effective recommendations that can prevent the occurrence
of Enron-like scandal)

V. Analysis

This section aims to discuss the governance practices, ethical dilemma faced, risk
management framework, breach of internal control policies, business ethical issues,
different stakeholders and their impact to the business, profession, and the society. For
better analysis, the researchers focus on the four categories namely corporate
governance, business ethics, risk management and internal control. Corporate
governance discusses the structures and systems by which companies are directed and
controlled. Meanwhile, business ethics emphasizes the various forms of unethical
business practices. On the other hand, risk management highlights the nature, forms
and basic management
P O L Y T E C Hof
N risks
I C U Nrelated
I V E R to
S Ibusiness.
T Y O F TLastly,
HE PH internal
I L I P Pcontrol
I N E S covers topics
related to the fraud prevention, detection and reduction if not fully eliminated.

Corporate Governance

 Inadequate Oversight of Key Business Transactions

 Lack of Independent Directors in the BOD
 Inefficient Remuneration Scheme (stock options policy, excessive remuneration)
 Rank or Yank Policy

Business Ethics

 Breach of Code of Conduct (CFO exemption from conflict of interest policy)

 Greed and Corruption of Executives (took advantage of energy deregulation and
manipulation of electricity in California)
 Misuse of Special Purpose Vehicle (manipulation of financial information, off-
balance sheet transactions)

Risk Management

 Profit-driven Commodity Derivatives (use as means of making profits instead of

managing the risks)
 Excessive Leverage (high debt-to-equity ratio, entered various contracts financed
by debt)
 Authorized High Risk Accounting Policy (mark to market accounting policy, hide
the true financial performance of the company which increase the risk of
bankruptcy, make the problems more troublesome and risky)

Internal Control

 Lack of Whistle-blowing System

 Audit Failure (Lack of Auditor’s Independence - Andersen conduct consulting and

auditing practices at the same time, ignored the company’s accounting
improprieties and valuation issues and risk of raptors transactions or SPE)
  Inefficiency
P O L Y Tof
ECManagement
H N I C U N I VControl
E R S I TSystem
Y OF THE PHILIPPINES

VI. Recommendations

ESTABLISH WHISTLEBLOWING POLICY

If an effective whistleblowing policy had been placed back in 2001, Sharon
Watkins, an Enron employee, would have been reported her concerns to the Securities
and Exchange Commission earlier while keeping her name confidential. Anchored on
this concern, the government, as well as every corporation, shall institute an effective
whistleblowing policy to encourage anyone to report illegal, unethical or irresponsible
behavior within the organization. The policy should clearly indicate possible issues,
explain the confidentiality of the whistleblower, and elaborate the procedures and
investigations under the policy.
HIGH-RISK DECISIONS SHOULD HAVE CORRESPONDING INTERNAL
CONTROLS.
One of the accusations on the Enron board was the authorization of excessive
remuneration that discharge conflict of interest and withstand against maximizing
shareholder’s wealth. Anchored on such premise, the company should ensure that
internal controls are in place in high-risk decisions such as excessive compensation and
incentives to monitor the real purpose of such decision. In the case of Enron, though, it
was designed to retain and reward its most valuable employees; it led to conflict of
interest satisfying the personal needs of the management leaving the cost to fall on the
shareholders. To avoid such management fraud, internal control that could be proposed
is that there should be independent auditors who will verify the accounting for these
revenue and share price growth, especially if additional remuneration, bonuses, and
other incentives are financial performance-based.
ADAPT THE ACCRUAL METHOD OF REPORTING
The principal method that was employed by Enron to “cook its books” was an
accounting method known as mark-to-market accounting. In this approach, the
expected future cash flow of Enron is treated as merchant assets that could be traded
anytime if they received a suitable offer. Anchored on this misleading financial reporting,
the company should incorporate and adapt accrual method of reporting to ensure
accurate description of the company’s value --- both its position and performance.
Accrual method generally makes the relationships between revenue and expenses
clearer, providing better insight into profitability. It also offers a more accurate picture of
a company's assets and liabilities on its balance sheet.
 POLYTECHNICUNIVERSITY OF THE PHILIPPINES

ESTABLISH AN INDEPENDENT AUDIT COMMITTEE

The company should establish audit committee composed of independent auditors to
ensure transparency, integrity and accountability in the financial reporting process,
system of internal controls and compliance with laws and regulations.

STRENGTHEN BOARD OVERSIGHT

Enron’s board had failed to perform its function as a governing body of the seventh
largest publicly listed company in the United States. Although, the board witnessed
numerous indications of questionable practices by Enron management over several
years, but chose to ignore them to the detriment of Enron shareholders, employees and
business associates. Anchored on this oversight failure, the company should prohibit
accounting practices and transactions that are high-risk of non-compliance with GAAP
resulting to misleading and inaccurate financial statements. Moreover, some other
prohibitions to maintain good governance are self-dealing transactions, off-the-books
activity to make the company’s financial condition appear better than it is, excessive
executive compensation, and company’s outside auditor from also providing internal
auditing or consulting services to the company and from auditing its own work for the
company. Finally, board should understand the transactions relating to the company ---
the economic rationale, the consequences, and risks involved.
ENHANCE CONFLICT OF INTEREST REGULATIONS
SEPARATION OF CEO AND CHAIRMAN ROLE
ENSURE AUDITOR INDEPENDENCE
CONDUCT CORPORATE PROFILING FOR POTENTIAL SPE ABUSE
ESTABLISH A PROGRESSIVE-ADOPTIVE CULTURE
 POLYTECHNICUNIVERSITY OF THE PHILIPPINES

REFERENCES
Permanent Subcommittee on Investigations of the Committee on Governmental Affairs
United States Senate (2002). The Role of the Board of Directors in Enron’s Collapse
United States Senate. https://www.govinfo.gov/content/pkg/CPRT-
107SPRT80393/pdf/CPRT-107SPRT80393.pdf
Hayes A. (2021). Accrual Accounting.
https://www.investopedia.com/terms/a/accrualaccounting.asp
ENRON Corporate Responsiblity. (2021). Csus.Edu.
https://www.csus.edu/indiv/m/merlinos/enron.html#:%7E:text=Enron’s%20vision%20is
%20to%20become,and%20a%20better%20environment%20worldwide.&text=Respect
%3A%20We%20treat%20others%20as,tolerate%20abusive%20or%20disrespectful
%20treatment.
Enron scandal | Summary, Explained, History, & Facts. (2021, July 19). Encyclopedia
Britannica. https://www.britannica.com/event/Enron-scandal
History.com Editors. (2020, December 1). Enron files for bankruptcy. HISTORY.
https://www.history.com/this-day-in-history/enron-files-for-bankruptcy
Meredith, C. (2010, June 18). Enron Corporation Accomplishments & Achievements.
Enron Online: The Enron Blog. https://caraellison.wordpress.com/2010/06/18/enron-
corporation-accomplishments-achievements/
Segal, T. (2021, June 1). Enron Scandal: The Fall of a Wall Street Darling.
Investopedia. https://www.investopedia.com/updates/enron-scandal-summary/
Smith, R. (2018, December 10). The Enron Scandal. Large.Stanford.Edu.
http://large.stanford.edu/courses/2018/ph240/smith1/
Wikipedia contributors. (2021, August 13). Enron. Wikipedia.
https://en.wikipedia.org/wiki/Enron
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