Prepared by

Simpson Dsouza

In 1985 after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and Inter North, a Nebraska pipeline company. Enron incurred massive debt and no longer had exclusive rights to its pipelines. Needed new and innovative business strategy Kenneth Lay, CEO, hired McKinsey & Company to assist in developing business strategy. They assigned a young consultant named Jeffrey Skilling. His background was in banking and asset and liability management.
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Created Energy derivative

Lay created a new division in 1990 called Enron Finance Corp. and hired Skilling to run it

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
Created Performance Review Committee (PRC) that became known as the harshest employee ranking system in the country---based on earnings generated, creating fierce internal competition

Was devoid of any boundary system

Enrons core business was losing moneyshifted its business to trading of derivatives

During 2000, Enrons derivatives-related assets increased from $2.2 billion to $12 billion and derivates-related liabilities increased from $1.8 billion to $10.5 billion
Enrons top management gave its managers a blank order to just do it Deals in unrelated areas such as weather derivatives, water services, metals trading, broadband supply and power plant.
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 Created by the merging of two pipeline

companies in the mid-1980s

Moved slowly away from its hard-assets

roots
From pipelines and energy plants

To transmission and energy trading

To innovative commodities trader (energy, bandwidth,

advertising time/space)
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Because Enron believed it was leading a revolution, it pushed the rules. Employees attempted to crush not just outsiders but each other. Competition was fierce among Enron traders, to the extent that they were afraid to go to the bathroom and leave their computer screen unattended and available for perusal by other traders.

Enrons banner in lobby: Changed from The Worlds Leading Energy Company to THE WORLDS LEADING COMPANY

Accounting: Special Purpose Entities (SPEs) Non-compliance with FAS 57 Used for hedging transactions Used to accomplish asset sales Leveraging the Company To finance operations Guaranteeing Obligations of SPEs Enrons Culture (Advancement and Incentive Plans) Promoted Greed Culture Encouraged employees to hide problems
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Traditionally used securitization

by

finance

companies

for

Also used to isolate risky asset ( aircraft leasing ,real estate development)

In late 1990 many companies used SPEs to accelerate revenue recognization

Really a joint venture between sponsoring company and a group of outside investors Cash flows from the SPE operations are used to pay investors
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Governed by Financial Accounting Standard 57 Allows SPEs to be kept off the balance sheet if: Outside owner invests equity capital for a 3% or greater share of the SPE Outside owner exercises control over the SPE

If both criteria are met, gains and losses from transactions with the SPE can be recorded Assets and liabilities of the SPE are not consolidated
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To hide bad investments and poor-performing assets Declines in value of assets would not be recognized by Enron
Quick execution of related-party transactions at desired prices. (LJM1 and LJM2) To report over $1 billion of false income To hide debt

To manipulate cash flows, especially in 4th quarters

Many SPE transactions were timed (or illegally back-dated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations
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Example Joint Energy Development Investment (JEDI) (formed in 1993) Properly established with CalPERS as controlling 50% partner Enron records gains from transactions with JEDI but does not consolidate JEDIs debt on its balance sheet 1997 CalPERs wants to cash out Enron needs a new partner to avoid consolidating JEDI on it balance sheet Enron executives form Chewco Chewco invests borrowed capital (Enron guarantees Chewco debt)

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Success of JEDI and Chewco inspire additional SPEs New SPEs used to: Sell hard assets to increase income Engage in hedging transactions

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2000 Annual report shows a debt load of $37 billion (up from $14 billion in 1999)
Many lending agreements reduction triggers containing debt

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Enron made promises to lenders to secure capital for itself and SPEs Loans and credit facilities contained credit rating payment clauses If Enrons credit rating fell below a set level payment would become due immediately Pledged stock and options to secure borrowings for SPEs

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Accounting and reporting standards for marketable securities, derivatives and financial contracts are found in FAS 115 and FAS 133.
Changes in market values are reported in the income statement Gains often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and prices Enron often recognized revenue at the time contracts (even private) were signed based on net present value of all future estimated revenues and costs.
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Incentive Plans Cultivating Greed compensation plans tightly geared to stock price incentive to promote earnings growth and stock price
Employees focused on earnings growth instead of

business lines or products

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Advancement Practices Corporate Culture Promoted Self-Interest Bottom 20% of performers forced out Incentives based on Enrons earnings per share (rewarded with stock options)

Practices led to: Following the letter but not the spirit of FAS 57 (and sometimes not the letter) Sold assets to SPEs, transferred stock to SPEs to cover debts, and guaranteed loans to SPEs
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Headline: Enron Reports Recurring Third Quarter Earnings of $0.43 per diluted share
Projected recurring earnings for 2002 of $2.15

Enron actually lost $618 million or $0.84 per sharethey had mislabeled $1.01 billion of expenses and losses as nonrecurring.
Shockingly, there was no balance sheet or cash flow information with the release There was no mention of a $1.2 billion charge against shareholders equity, including what was described as a $1 billion correction to an accounting error
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stock price
$90 $80 $70 $60 $50 $40 $30

stock price

$20
$10 $0

01.08.2000

15.08.2001 $42

31.10.2001

$15

28.11.2001 $0.8

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drop of share price by 30% in the year 2000

Year 2001 :-Erratic cash flow and huge debt found by McLean Losses from different projects like logistic and dabhole as well as from India.

resignation of CEO,Mr.Skilling.

Selling of fixed assets and projects to different in the year of 2001 On Dec 2,Enron filled bankruptcy.

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Greed on a spectacular scale

Following resignation of Jeff Skilling, Enron and Arthur Andersen pulled the plug on certain SPEs originally deemed to satisfy the requirements for off-balance sheet treatment review led to recategorizing SPEs and restating income and debt

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The beginning of the end

October 16, 2001

$544 million after-tax change related to SPEs being consolidated reduced shareholder equity by $1.2 billion
November JEDI and Chewco arrangement exposed

forced consolidation of JEDI financials Enron financials for 1997-2001 restated increased reported debt by $711 million in 1997, $561 million in 1998, $685 million in 1999, and $628 million in 2000
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Increase in reported debt from JEDI and Chewco led to reexamination of Enrons debt rating by Moodys and S&P (downgraded to barely investment grade) Moodys and S&P further downgrade Enron's debt to junk Downgrading trips debt triggers in Enron loans ($4 billion becomes due immediately)

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Was paid $52 million in 2000, the majority for non-audit related consulting services.
Failed to spot many of Enrons losses

Should have assessed Enron managements internal controls on derivatives tradingexpressed approval of internal controls during 1998 through 2000
Enron was Andersens second largest client Provided both external and internal audits CFOs and controllers were former Andersen executives

Accused of document destructionwas criminally indicted

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Enron paid several hundred million in fees, including fees for derivatives transactions.
None of these firms alerted investors about derivatives problems at Enron. In October, 2001, 16 of 17 security analysts covering Enron still rated it a strong buy or buy.

Example: One investment advisor purchased 7,583,900 shares of Enron for a state retirement fund, much of it in September and October, 2001

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Enrons outside law firm was paid substantial fees and had previously employed Enrons general counsel Failed to correct or disclose problems related to derivatives and special purpose entities Helped draft the legal documentation for the SPEs

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The three major credit rating agenciesMoodys, Standard & Poors and Fitch/IBCAreceived substantial fees from Enron
Just weeks prior to Enrons bankruptcy filingafter most of the negative news was out and Enrons stock was trading for $3 per shareall three agencies still gave investment grade ratings to Enrons debt. These firms enjoy protection from outside competition and liability under U.S. securities laws. Being rated as investment grade was necessary to make SPEs work
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Individual and collective greed company, its employees, analysts, auditors, bankers, rating agencies and investors
Atmosphere of market euphoria and corporate arrogance

High risk deals that went sour

Deceptive reporting practiceslack of transparency in reporting financial affairs

Unduly aggressive earnings targets and management bonuses based on meeting targets
Excessive interest in maintaining stock prices
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Corporate Record keeping and Corporate Governance Accounting - FAS 57

Securities and Exchange Commission Rules Reporting Requirements Enforcement Authority Lending Practices - reporting of debt triggers
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THANK YOU

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