At a minimum, we see our market opportunities company-wide tripling over the next five years. Enron’s excessive amount of leverage magnified its poor financial performance. Related: Watch the video below to learn how to employ long-term thinking like Jeff Bezos. Arthur Levitt SEC Chairman, 1993-2001. These calls are when executives discuss ongoing corporate events and financial performance with analysts and sometimes large shareholders. In the past, investors had to pay for expensive subscriptions to access quarterly conference call transcripts. Enron’s risky, profit-driven derivative activities were encouraged by the economic climate of that time period. In fact, high debt levels can be used to fuel growth for businesses with very stable business models. This paper will analyse the lessons that auditors and regulators must learn from Enron Fraud. In some ways, Enron’s business was similar to an Exxon Mobil (XOM) or Chevron (CVX). Yet there were Navy intelligence reports and executive officers who knew the Japanese were capable of mounting a strike against US naval vessels in the Pacific. A famous example of this is Berkshire Hathaway (BRK.B) (BRK.A). These quotes from two of the best businessmen of our time are in stark contrast with statements made in Enron investor communications. With that said, high debt levels are not always a bad thing. Thus, investors should be quite wary of any observations that lead them to doubt the accuracy of a company’s financial statements. Enron owned and operated assets in the oil and gas industry such as pipelines, refineries, and electricity generation stations. These write-downs would lower the company’s GAAP earnings-per-share – Wall Street’s favorite yardstick of corporate performance. This is exactly what happened at Enron. Conversely, bad managers produce unsurprisingly bad results. 3 lessons from Enron There are still several important lessons for investors to take from the Enron scandal. Just don't look too hard at Washington to find them. still being investigated. We have heard about the role of the auditors and the Audit Committee; differences between the UK principle based and USA’s Enron’s bankruptcy also came directly after the dot-com bust, when overvalued Internet stocks came crashing down from peak valuations and resulted in a widespread market recession. The previous CEO Kenneth Lay resumed his post as CEO. An excerpt from this call can be seen below: Operator: Richard Grubman of Highfield Capital. What  Swartz and Watkins describe is how Enron prioritized how profitable it had become and it was probably not surprising that along the way, they lost their moral compass. But the bigger lessons that Enron offers for accounting and corporate governance have long been familiar from previous scandals, in America and elsewhere. At Enron, this inevitably happened. Discounted cash flow valuations are very tricky because they rely heavily on the quality & accuracy of assumptions about future cash flow, discount rates, and growth rates. On June 15, 2002 – roughly six months after Enron originally declared bankruptcy – Arthur Anderson was convicted of  obstruction of justice. The last source that investors can use to monitor the executives of their investees is the broader news media. The shareholders were overly optimistic. Not next quarter. At the time of its bankruptcy, Enron was the seventh-largest company in the United States. Trust is important in all economic transactions. Having the natural gas and electricity come from 93% of the revenues, 4% of the energy wholesome income, and 3% of exploration and services (Ferrell and Thorne, pg. The following is an excerpt from the company’s 2000 Annual Report (the last annual report published by Enron before it declared bankruptcy). But what I’m thinking to myself is – those quarterly results were actually pretty much fully baked about 3 years ago. “Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them.”. The Enron scandal which disclosed in October 2001, led to the bankruptcy of the Enron Corporation. Lessons Learned from the Byword of Corporate Fraud: Enron. This plan was to make disclosures in financial statements more informative and in the management’s letter of representation. Having studied social psychology for many years, this dynamic is reminiscent of the concept of “groupthink” which was introduced by Irving Janis in the mid 1970’s. … I mean, you have a trading desk with a $21 million matched book that’s two times your book value, and you cannot tell us what the balances are? In fact, vanilla investor presentations should be welcomed by investors because they save money on investor relations and media expenses. The Enron scandal which disclosed in October 2001, led to the bankruptcy of the Enron Corporation. Enron stock prices) became Priority #1 above all other considerations. It was supposed to be the scandal that changed everything, yet it taught us nothing. Finally, the lessons that can be learned form Enron’s failure is learn to be satisfied with what you have legitimately earned, as greed is a vicious vice that can destroy you. Some additional quick math shows that Enron had a debt-to-equity ratio of 4.7x (computed as $54 billion of total liabilities divided by $11.5 billion of total shareholders’ equity). Enron Scandal as a Learning Lesson Enron was a company that transported natural gas through pipelines and distributing electricity to the northwest of the United States. 512). There are many different types of counterparties that suffered financial losses after the Enron scandal. The ethical challenge facing us in the wake of the Enron scandal is not one of analysis. For example, Warren Buffett – likely one of the most shareholder-friendly executives in history – donates a portion of his Berkshire Hathaway stock to charity each year. In some cases, transactions simply do not take place. Businesses seldom operate in a tranquil, no-surprise environment, and earnings simply don’t advance smoothly (except, of course, in the offering books of investment bankers). The Enron scandal, give out in October 2 001, Enron Top officials abused their privileges and power, manipulated information put their ow n interests above those of their employees and the public and Enron made extensive use of commodity derivatives to make money. Skilling resigned in August, Lay resumed the CEO post, and Enron eventually declared bankruptcy in December. When other executives like Watkins had expressed concerns of financial irregularities she was accused of not being an Enron “team player”. Here’s what the math looks like. The Enron scandal provides a fascinating case study on corporate governance and board room management. So the first lesson of Enron is, like Jerry Maguire said, “show me the money”. Just because the parent Enron company was not reporting these losses did not mean they did not occur in reality. Arthur Anderson was forced to stop auditing public companies (its major source of revenue) and dissolved as an accounting firm. Enron incurred interest expenses of $876 million in fiscal 2000. Charlie and I not only don’t know today what our businesses will earn next year – we don’t even know what they will earn next quarter. The devastation of the Enron scandal can also be seen at the security level. The most widely used – and dangerous – technique used by Enron accountants is called mark to market accounting. Enron’s total debt of $10.3 billion and total liabilities of $54 billion means that a significant number of large investors saw their debt holdings take a haircut in December of 2001. Moving on, the next sections will discuss 5 actionable lessons that investors can learn from the Enron scandal to improve their personal investment strategy. From all the facts we have about the Enron bankruptcy, the most important lesson is this: buy high-quality businesses with management teams that have both character & competence. Notably, Enron’s then-CEO Jeffrey Skilling sold a significant portion of his Enron stake in August of 2001 – about four months before the company declared bankruptcy. But until we put all of that together, we just cannot give you that. First, it's critical not to have too much of your portfolio invested in a single stock. It'd become one of America's largest in just a decade with accolades like "America's most innovative company." Enron was the dress rehearsal for the banking crisis which propelled the economic crisis we now find ourselves mired in. Enron allowed its chief financial officer, Andrew Fastow, to set up a fund called LJM and engage in suspect deals that made Enron's books look better, Levin said. Accountability and Trust. That’s nonsense. Enron’s shareholders were not the only ones who were significantly harmed by the Enron scandal. Source: Enron 2000 Annual Report, page 33. Lay was indicted for more than 10 counts of securities and wire fraud after the Enron accounting fraud was exposed. The second media-sourced clue that investors could have used was Skilling’s surprising resignation in August 2001, roughly 4 months before the company declared bankruptcy. Michael W. Maher. In one of the company’s last quarterly earnings releases before bankruptcy, its fledgling telecommunications segment reported an operating loss of $137 million. Would anyone care to argue that the recording of the expense in years two through ten would be simply a bookkeeping formality?”. In truth, depreciation is a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Enron allowed its chief financial officer, Andrew Fastow, to set up a fund called LJM and engage in suspect deals that made Enron's books look better, Levin said. If Warren Buffett – someone with decades of experience reading financial statements – does not completely understand Enron’s financial statements, then it is highly likely that the majority of the company’s investors were also oblivious to the company’s true business model. It was a period of deregulation in the financial markets, which allowed companies like Enron to place large, risky bets on the future prices of various commodities. The result, according to Salter, was "emotional contagion and the normalization of deviancy." Lessons Learnt from Enron Scandal. So financial specialists need to guarantee that they comprehend the united reports … For a company with a large amount of money invested in fixed assets (think railroads, telecommunications providers, utilities, and energy infrastructure companies) depreciation is a very real expense, and ignoring it is not likely a wise decision. The Lessons Learned from Enron’s Collapse What are lessons learned from Enron’s collapse, and how do we prevent another Enron, and prevent situations greed in companies? Four Lessons from Enron . Enron Corporation was an American energy company which was established in Houston, Texas… Download full paper File format:.doc, available for editing ... We still need to ask whether we have learned the right lessons from the debacle. Another dynamic is one of moral superiority that takes the form of , “we are superior and righteous, therefore we will prevail”. The merger was primarily facilitated by Kenneth Lay, who was Houston Natural Gas’ CEO before the merger was completed. The second lesson stems from Enron’s use of special purpose entities (SPEs). 2 8 LESSONS LEARNED FROM THE CASE STUDY OF ENRON 1) First lesson is that the part of SPE's was the key in Enron's extortion. Pearl Harbor and the Bay of Pigs invasion are two notable examples where groupthink dynamics seem to take over in the decision-making process. Fundamentally, the American style of capitalism depends on trust. We are unlikely to ever meet these executives in person, so our assessment of their character & competence must be done at arm’s length. There are many views about Enron and the lessons to be learned. Most seasoned CEOs exceed this requirement by a wide margin. “Creative accounting is an absolute curse to a civilization. Lessons from the Enron Scandal On March 5, 2002, Kirk Hanson, executive director of the Markkula Center for Applied Ethics, was interviewed about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper Nikkei. The Enron scandal is … In 1985, Enron was born. The topic is a new addition to the “Lessons of Enron” curriculum: the practice first surfaced earlier this year. The problem at Enron, as with the problems that emerged at Tyco, Parmalat, Adelphia, Worldcom and other prominent corporations, was not one of isolated bad judgement. What Watkins describes happening at Enron was that the focus on profits (i.e. The government reacted aggressively when they became aware of the Enron scandal, and a flurry of legislation and proposals emanated from Congress and the SEC about how best to deal with this situation.President Bush even announced one post-Enron plan. Here’s Warren Buffett’s opinion on leverage: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. Amazingly, Enron was the counterparty to every transaction made on Enron Online. WASHINGTON (CBS.MW) -- There are lots of lessons to be learned from the Enron scandal. It was supposed to be the scandal that changed everything, yet it … Managers that always promise to “make the numbers” will at some point be tempted to make up the numbers.”, – Warren Buffett in the 2002 Berkshire Hathaway Annual Report. For obvious reasons, Enron executives were incentivized to avoid asset write-downs – and earnings declines – whenever possible. If any of these assumptions prove wildly inaccurate (which is often the case; even the best accountants cannot predict the future), then a discounted cash flow model becomes useless. Enron’s heyday has long ended. In 2001, everything began to fall apart for Enron executives and shareholders. Ken Lay, the CEO of Enron had developed deep political connections to the George H.W. This observation can be generalized to other common stock investments. As mentioned in the first section of this analysis, what was particularly dangerous about Enron’s use of derivatives is that they relied on these speculative contracts to generate earnings for their businesses. We have heard about the role of the auditors and the Audit Committee; differences between the UK principle based and USA’s This raises important questions regarding instances when employees with conscientious feels compelled to raise questions regarding unethical business practices and how the organization responds to those concerns. Trust is important in all economic transactions. Company insiders – including CEOs, board members, and other important executives – are required to disclose any insider trading activities by filing a Form 4 – Statement of Changes in Beneficial Ownership of Securities – with the U.S. Securities & Exchange Commission. Joseph Berardino CEO, Andersen Worldwide, 2001-02. The lessons learned from Enron, had they been fully understood and respected, may have helped avoid the financial crisis of 2008. The easiest way to demonstrate Enron’s excessive leverage pre-bankruptcy is to compare its current balance sheet composition to today’s energy giants (whose balanced sheets are presently stretched thanks to prolonged low oil prices). Enron Scandal: Overview In 1985, The Huston Natural Gas integrated its natural gas pipeline companies with those of InterNorth under the supervision of Kenneth Lay to form Enron. However, Berkshire has not used debt in the traditional sense. All said, Enron’s complicated business model and excessive growth forecasting contributed to the company’s eventual downfall. For context, Enron’s entire business had only ~$60 billion in assets. That makes it … So what are the lessons to be learned from the Enron scandal. There are many lessons that can be learned from the collapse of Enron. Under legal accounting policies, Enron would be required to report an asset write-down on any asset that become less valuable due to variances from previous discounted cash flow assumptions. Thus, investors could have reasonably assumed that all was not well in Enron’s boardroom. This is somewhat similar to the mistaken perspective of the Iraqi Freedom invasion in which US troops were going to win over the “hearts and minds” of the oppressed Iraqis. What Swartz and Watkins describe in Power Failure is how the hubris and arrogance of Enron and its COO, Jeff Skilling essentially pushed their employees to either perform or get out. With that in mind, this article will describe 5 actionable investing lessons that can be learned from the Enron scandal. Markkula Center for Applied Ethics 3. Because of the company’s mark to market accounting scheme, these profits were recorded before the derivatives matured – which could result in profit clawbacks if the derivative’s underlying instruments moved against the company. Some learning what not to do with their business and what to do with some of their successes. They used "turbo incentives" but turbo incentives also require turbo controls. Few studies also evaluate the main lessons from the Enron scandal in perspective, by comparing its common causes with corporate scandals that emerged during the global financial crisis in 2007-2008. Similarly, Jeff Bezos sells a portion of his Amazon stock each year to fund his space exploration business Blue Origin. So the first lesson of Enron is, like Jerry Maguire said, “show me the money”. Before diving into some actionable lessons that can be taken away from Enron’s bankruptcy, it will be useful to understand the company’s complicated business model. ... We still need to ask whether we have learned the right lessons from the debacle. The lessons we could have learned from Enron. Accountability and Trust. Why are so many people drawn to conspiracy theories in times of crisis? The executives of Enron believed Enron was best at everything and jumped into any possible new arena. Next quarter for all practical purposes is done already and it has probably been done for a couple of years.”. Put Integrity First Finding the loophole may make something legal, but it doesnt necessarily make it right. Lynn Turner SEC Chief Accountant, 1998-2001. This was certainly the case in the Bay of Pigs invasion in which the United States backing of Cubans rebelling against the Communist dictator, Fidel Castro were viewed as morally righteous. Before diving into some actionable lessons that can be taken away from Enron’s bankruptcy, it will be useful to … But can general conclusions about good governance be drawn from Enron, or is it an isolated case, an exceptional scandal? This lack of forecasting stems – unsurprisingly – from Berkshire’s inability to predict future business results with any reliability. Grubman: You’re the only financial institution that cannot produce a balance sheet or cash flow statement with their earnings. Without trust, parties to transactions pay substantial costs to execute transactions. This is a belief that legendary investor also Peter Lynch held very strongly: “Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion, and so forth.” – Peter Lynch. The obvious lesson is that absolute power corrupts absolutely, but the Enron scandal goes far beyond just the faults and flaws of a powerful corporation. This created a problem for Enron accountants. The Enron executives were amateurs trying to play a professional sport, he said. Educators have a lot to learn from the Enron debacle, cautions Thomas R. Hoerr, especially the need for structures and systems that create … These two characteristics should be viewed as red flag in potential stock market investments. We are suspicious of those CEOs who regularly claim they do know the future – and we become downright incredulous if they consistently reach their declared targets. still being investigated. However, these types of isolated, terrible investment returns should not discourage market participants from continuing to invest moving forward. Warren Buffett extends this belief to all companies (not just the capital-intensive examples shown above). Accounting professor Cecil Jackson believes they will. 5.3 Lessons learnt from the Enron Case. These businesses — wholesale services, retail energy services, broadband services and transportation services — can be significantly expanded within their very large existing markets and extended to new markets with enormous growth potential. The most notable aspect of his darker side was his ability to bully others into getting his way. More specifically, prudent levels of cheap leverage can be used to improve risk-adjusted returns in a low-volatility investing strategy. Please send any feedback, corrections, or questions to support@suredividend.com. Introduction. Ms. Watkins had worked her way up the ranks in the male-dominated natural gas conglomerate to the ranks of one of the top executives in Enron’s Capital & Trade division. If you judge success in life by what you can accumulate, you will never be fully content, as someone will always have more, your children or others will always want more from you, and therefore, you will never have enough. Today’s investors can learn to watch for such red flags on future company conference calls. In conclusion, the Enron scandal became a learning lesson to many over the years. In the initial years, trading volumes on Enron Online expanded exponentially; by mid-2000, Enron Online was on pace to execute $350 billion in trades per year. The content of this field is kept private and will not be shown publicly. Arthur Anderson is the foremost example that you do not need to be an investor to be harmed by a company’s poor financial management. Investors should avoid companies that rely on derivatives and other complicated financial instruments to generate earnings. In Janis’ book, Victims of Groupthink (1972), he provides some interesting examples of how groupthink dynamics resulted in defective decision-making similar to Enron’s financial decisions which eventually led to it’s demise and incarceration of several of its top executives. Basically, the reasoning behind groupthink was that in highly cohesive groups, an esprit de corps dynamic often develops in which everyone adheres to the party line and anything to the contrary is viewed by the group as being derisive and designed to diminish the group’s power. In a democracy, it often takes a scandal to trigger reform. More specifically, blatant vulgarity from the company’s CEO on an April 17, 2001 conference call was a sign to potentially avoid this stock. “Trumpeting EBITDA (earnings before interest, taxes, depreciation and amortization) is a particularly pernicious practice. Posted Monday, January 1, 2001. Thanks to its heavy involvement with commodity derivative trading and Enron Online, Enron had a very complicated business model that many investors did not fully understand. But, by the end of 2001, the Enron scandal's ethics quagmire shattered that illusion as $74 billion was lost and lives were destroyed in the aftermath. Several weeks ago, I had the opportunity of hearing Sherron Watkins speak at a special lecture she presented on Leadership Ethics that was sponsored by the Leon Hess Business School at Monmouth University. In other words, the Enron parent company reported only the beneficial consequences of this accounting scheme. You really don’t need leverage in this world much. Enron was an American energy company that formed in 1985 after the merger of Houston Natural Gas and InterNorth. “The risk to each party of a contract that the counterparty will not live up to its contractual obligations. A decade ago, as Enron slid toward bankruptcy, it seemed … Derivative counterparties and lenders aside, there is one notable Enron counterparty whose bankruptcy-related financial distress is still widely remembered to this day. Dividing the company’s total interest expense ($876 million) by its total debt level ($10.3 billion) gives a weighted average interest rate of 8.5%. Thanks to Enron’s high leverage levels, its debt was quite expensive. This study focuses in the ethics, which is considered as a preventer and a conservator of the occurrence of collapses and financial scandals. It was therefore assumed that once the invasion began, that other anti-Castro Cubans would join in the fight. It is hard to overstate the negative impact of Enron’s poor investments outside its circle of competence. That doesn't imply that all SPE's are shrewd, however these SPE's can without much of a stretch be utilized for abhorrence expectations and false money related reporting. Will the lessons from “Lessons of Enron” last 20 years out, when graduates are in a position to commit high-level fraud? Fraud and corruption can never give you the return which you want from an organization. I’m referring to the accounting firm Arthur Anderson, which was hired to be Enron’s official auditor. I covered some of this in Stan Hanks' answer to Why did Enron's bandwidth trading business fail? 45 per share value but fell down after declared as the Fraud, misleading and corrupt organization in 2002. Enron 2000 Annual Report, page 2 (emphasis mine). Lessons Learned From Enron: History Repeats Itself. However, Buffett’s leverage has two notable characteristics that are different from the leverage used by Enron (and most other companies). So how could reading conference call transcripts have helped prior to the Enron bankruptcy? Enron’s expensive debt combined with its highly volatile business model combined to create excessive losses for the company’s investors. I expect two consequences if these scandals continue. For context, the yield on the 10-year U.S. Treasury Bill was 5.1% on the last trading day of 2000. Truthfully, it can be difficult as an individual investor to gain any insight into the quality of corporate boardrooms. Berkshire Hathaway is, again, another notable example of this of the prudent employment of leverage. Jeff Bezos from Amazon shares a similar belief: “When somebody congratulates Amazon on a good quarter, I say thank you. Any organization has an obligation to all of its stakeholders, not just its shareholders, and those obligations were not met in this case. Enron Scandal Movie Review The Crooked E: The Unshredded Truth TV Movie about Enron Collapse and Key lessons learned from This Movie Enron Scandal Movie Review The Crooked E The Crooked E: The Unshredded Truth about Enron Scandal is a television movie that was broadcasted by CBS TV an American television broadcasting company in January 2003 (Cruver, 2003). 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