Posted in Finance Articles, Total Reads: 3224
, Published on 28 July 2011
Enron, once a well known American energy company and a darling of investors had to eventually file for bankruptcy and wind up its operations across the globe. The rise of this company was meteoric and so was the downfall. Not only it went down but it also took along with it one of the top five auditing companies of the world. When it filed for Chapter 11 bankruptcy it was one of the biggest in corporate history which was bettered only by WorldCom a few months later. So we try to analyse the great rise and fall of this energy giant.
Enron was formed in 1985 by Kenneth Lay by merging Houston Natural Gas and InterNorth. The early rise of Enron can be attributed to selling electricity at Market prices and upon the US congress deregulating the sale of natural gas opened up a golden opportunity for companies like Enron which were basically into energy trading. Enron sold energy at higher prices and inspite of price variance and volatility concerns, lobbying on the part of Enron ensured that the free Market system was in place in US. However the company was not just happy with trading and pursued a strategy of diversification. They started owning and operating a variety of other enterprises such as gas pipelines, electricity plants and various other things with the idea of being the world’s largest commodity trading company.
This helped the company to increase the revenues by many times. It's stock increased by over 300% in a short period of around 7 years. The stock was growing better than the index on which it was trading. By end of 2000, the company's Market cap had reached close to around $60 Bn. The stock Market was very optimistic about the future growth of the company and its upward trend was irrational when looked in the hindsight. Also the company was adjudged as the most innovative companies but only after the scandal broke dud the world know that they were innovative in other things than in their core business. The company was accused of accounting scandals in collaboration with Arthur Anderson which was the main reason for pushing the company on the upward though there was nothing to write about the company actually.
So how did they go about showing everything rosy about the company when in reality it wasn't. The company adopted dubious accounting practices thereby inflating their revenues. One major way it inflated its revenues was the way in which recognised the revenues. Companies such as Enron which are into trading of energy are to recognise revenues which they accrue from trading and brokerage fees and not the full value of the transaction. However this was a conservative way of reporting whereas it was possible to actually show the full value of the transaction as revenues. The company did exactly that and it helped them in inflating the revenues.
Yet another way of inflating revenues was to make use of Mark to Market accounting practices. It was basically estimating the income at the present value of the net future cash flows. This method was a flawed one as even if a particular deal fell through the company continued recognizing it as profits even though in reality it is a loss making proposition. Creation of special purpose entities was another way of hiding the debts and at the same time inflating the profits of its sponsor. These methods ultimately led to the collapse of Enron.
Could this accounting madness have been detected earlier by the authorities and prevented the collapse. To a certain extent yes but then the company was following the practices which was legal but was actually taking advantage of the loopholes prevalent in the system. So the greed of a few individuals led to the collapse of the company and along with that the money of thousands of investors as the shares had become useless when the end came. There are many such examples across the world that uses loophole in the system to inflate the profits. So the need of the hour is to ensure that the competent authorities plug all such loopholes so that we don't have many more cases like Enron going forward.
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