The Enron Collapse By: Jeff Porter Kevin Clark ... - Franklin College

The Enron Collapse
By: Jeff Porter
Kevin Clark
Jared Sabelhaus
February 18, 2005

Introduction
Companies have mission statements that often read like inspirational leaflets.
Enron’s mission was at first to be the world’s greatest energy company then later revised
in early 2001 to be the “world’s greatest company”. In the late 1990’s, Enron seemed to
have accomplished their mission accumulating vast amounts of assets, had the
intellectually elite at the helm, a political climate in their favor and numerous
opportunities to expand. Enron gave all appearances of a vastly superior company that
could do no wrong. The thing about king of the mountain is that the ones on top never
seem to stay there for very long and in Enron’s case the fall from corporate mountain was
spectacular and felt all over the world. Over the course of three short years Enron went
from the seventh largest company in the U.S. to financial ruin. However deep and
impressive their intelligent managerial pool was; internal flaws led to a slide of epic
standards. In our report, we will analyze these internal flaws that include inadequate
control measures, a hostile environment and flawed accounting and financing methods.
Because of the financial severity which the company was in we concluded that Filing
Chapter 11 bankruptcy was the only option for Enron and therefore will be assumed in
our report. When we asked Rich Kidwell if there was anything Enron could have done to
keep from filing Chapter 11 he said “I don’t know if there was anything that they could
do. Enron was like a house of cards and it was only a matter of time before they were
blown down.” We examined different ideas on how to transform these flaws and then
suggest which idea we feel is best suited to the needs of this company.

Assumptions
While writing this paper we assumed the following points:
• Enron has already filed for Chapter 11 bankruptcy.
• Enron is unique in regards to size and operations (accounting methods and
actions) compared to other regulated commodity companies.
• Due to Enron’s aggressive accounting we understand the financial ratios that are
Brief History
computed using Enron’s financial statements are more than likely not going to
give an accurate or clear picture of the company’s current status.
• 1985- Enron is formed by merger of Houston Natural Gas and InterNorth
creating the largest company owned natural gas pipeline.
• 1989- Enron opens its Gas Bank, where consumers can buy long-term
supplies of natural gas at a fixed price, setting the stage to become a
commodity trading company.
• 1990-1998- Enron expands its holdings in the U.K., Europe, South
America, and India. Enron in this time moved away from natural gas and
pipeline operations instead focusing more on marketing other energy-
related commodities.
• 1999- Enron launches its broadband services and Enron Online.
• August 2000- Enron’s share price reaches an all time high of $90, ranking
it the seventh largest energy company in the world.

S.W.O.T. Analysis
Strengths
• October 2001- Enron post its first quarterly loss in four years, $618
million and a reduction in shareholder equity by over $1 billion dollars.
• December 2, 2001- Enron files for bankruptcy protection.
Enron is the largest company-owned natural gas pipeline system in the United
States and is ranked seventh on the Fortune 500 giving it an established name with
credibility. Another strength of the company would be its reputation and public
perception. Enron has a competitive and almost monopolistic advantage over its
competitors because they are the largest energy provider. They also have market-making
abilities that result in price and service advantages (26).
Weaknesses
It is easy to target Enron’s weaknesses in the company. They have a lack of
ethical and moral behavior among employees and auditors by engaging in deceitful and
wrongful acts. Management has a lack of control and conflicts of interest occur in
numerous transactions. The culture of Enron was all about results therefore, expectations
of financial statements were high and employees were told to make up for losses.
Opportunities
Name recognition is an opportunity for Enron. Society recognizes Enron as a high
quality energy provider. There are many opportunities for Enron to expand or use to their
advantage the many assets they have such as pipeline. Deregulation of the energy
industry in the 1970s allowed Enron the opportunity to grow and begin trading.

Threats
There are many threats Enron faces. Competitors could come in and steal some
partners Enron does business with potentially taking away profits from Enron. Threats
exist that newer technology will provide alternative energy sources to oil and gas,
Enron’s two major sources of energy. A possible threat would also be if the energy
market became regulated again and trading could not occur.
Internal Flaws
Accounting
Another problem Enron faced was the aggressive accounting style used to inflate many
figures on their financial statements. Many complicated partnerships with special purpose
entities and other subsidiaries made the accounting even more confusing. These methods
helped Enron manipulate their revenue and earnings.
“Mark to Market” Accounting
Enron used “mark to market” accounting, which allowed them to adjust the value of a
security or asset to reflect the current market value (20). This procedure allows
companies to book as current earnings their expected future revenue from certain assets
(7). The introduction of volumetric production payments opened the door for this type of
accounting. These payments were contracts that had a predictable future cash flow and
could be treated as merchant assets meaning the assets held on Enron’s books could be
traded at any time if they received a suitable offer (20). The SEC granted Enron
permission to mark these assets to market in 1991 and was supposed to be on a temporary

asis, but the SEC has not introduced this topic since. To create a merchant asset deal, the
trader would forecast the future price curve for the underlying product, calculate the
future cash flows and apply a discount rate to compute the net present value which could
either be sold to a special purpose entity (SPE) created for that purpose or kept on
Enron’s books as a merchant asset (20). Market prices for gas futures could be obtained
from the New York Mercantile Exchange (NYMEX) but for a limited time range, usually
four years. Enron extended this principle to longer contracts, for which it had to derive its
own price curves (20). For example, a 20-year deal where the energy company’s
generation unit builds and sells the output of a multi-million dollar power plant. There is
no NYMEX for power prices going out 20 years so an estimate must be made.
Accounting standards allow management to use its discretion to determine future income
and cost. If it is determined that the company must sell the power for 4.8 c/KWH (cents
per kilowatt hour) while realizing an estimated cost of 4.5 c/KWH, all these less than
certain future profits are recognized in the present earnings. If in future quarters, when
the real numbers come in and profits do not meet expectations, the energy company can
offset the losses by entering into additional deals. The best way to cover up a bad deal is
to make two more (15). Enron used “mark to market” accounting involving two specific
companies, Blockbuster and Quaker. In 2000, Enron entered into an agreement with
Blockbuster to deliver movies on demand to viewers’ homes over Enron’s broadband
network. This venture fell apart within months, but Enron still booked $110 million in
profits in late 2000 and early 2001, based on the anticipated value of the partnership over
20 years (7). “Mark to market” gains accounted for over half of Enron’s reported pretax
earnings in 2000. Another deal created to use “mark to market” accounting involved

Quaker Oats in 2001. Enron agreed to supply 15 Quaker plants with their energy needs,
from natural gas and electricity to workers who would maintain boilers and pipes. Enron
guaranteed it could save Quaker $4.4 million from its energy bill (16). Enron then
forecast a $36.8 million profit over the 10-year deal and under “mark to market”
accounting booked $23.4 million of that before they had ever turned on Quaker’s lights
(16). The rules permit this to occur for commodities like natural gas and electricity, but
when it comes to services, the rules are more restrictive. Profits from service activities are
to be booked on an accrual basis, in which a fraction of the profit is realized each year.
The Quaker deal projected profits from services, not commodities causing a major
problem. Enron used a method called revenue allocation designed to redefine as
commodities some of the money Quaker was paying for services and therefore create
more profits for Enron to book up front (16). Internal accountants created a new category
called allocated revenues which was based on figures Enron claimed reflected the open
market value of the commodities and services, not what Quaker had historically paid for
energy commodities (16). “Mark to market” accounting is very aggressive and
overlooked by the SEC, especially in Enron’s case.
Sham Swaps
Enron and telecommunications giant Qwest Communications struck a deal in 2001 to
swap fiber-optic network capacity and services. Qwest agreed to pay Enron $308 million
for assets that included dark fiber, strands that require additional investment before they
can be put into service, along a route from Salt Lake City to New Orleans. Enron agreed
to pay Qwest $195.5 million for active fiber-optic cable services over a 25-year period.

This enabled Enron to avoid recording a loss on dark fiber assets, whose value in the
open market dropped below the price on Enron’s books, by booking a sale (17, 7).
Prudence Accounts
Enron used prudence accounts to make their revenue stream appear less volatile than it
actually was. Enron traders split profits from deals into two categories. The first would
allow profits to be added directly to the company’s financial statements, and the other
category would allow profits to be added to a reserve fund. According to Frank Partnoy,
an expert in finance who testified before the U.S. Senate Committee on Governmental
Affairs, the prudence accounts served as a slush fund that could be used to smooth out
profits and losses over time (7). An example would be a trader who earned a profit of $10
million. Of that $10 million, the trader might record $9 million as profit today, and enter
$1 million into a prudence account (18). In other words, traders were saving for a rainy
day. Enron was misstating the volatility and current valuation of its trading businesses,
and misleading its investors.
Off Balance Sheet Transactions
Chewco
Chewco was the first deal with an Enron employee and a special purpose entity to cause
controversy. The SPE could be treated as if it were an independent, outside entity for
accounting purposes if two conditions were met: an owner independent of the company
must make a substantive equity investment of at least 3% of the SPEs assets, and that 3%
must remain at risk, that is, not guaranteed by someone else, throughout the transaction;

and the independent owner must exercise control of the SPE. If those conditions are met,
the company can record gains and losses on transactions with the SPE, and the assets and
liabilities of the SPE are not included in the company’s balance sheet (21). Enron used
SPEs to shift liabilities, its debt, off its books. Michael Kopper became the independent
investor in Chewco. He and a friend invested $125,000 of their own money, with Enron
providing collateral and received an $11 million loan from Barclays Bank. Enron
recorded its contractual share of gains and losses from the Joint Energy Development
Investment (JEDI) on its income statement and disclosed the gain or loss separately in its
financial statement footnotes, but did not show JEDI’s debt on its balance sheet (21). The
purpose of Chewco was to acquire the California Public Employees Retirement Scheme’s
(CalPERS) interest in an earlier joint venture with Enron called JEDI so CalPERS would
invest in another, larger partnership (7). The only way Enron could avoid consolidating
JEDI onto their financial statements were if Chewco had an independent owner with a
minimum of 3% of equity capital at risk. They could not find any outside investor so they
financed Chewco’s purchase of the JEDI interest almost entirely with debt, and Enron did
not consolidate Chewco into its consolidated financial statements disregarding
accounting requirements for non-consolidation (21). Under Enron’s Cod of Conduct of
Business Affairs, Kopper was prohibited from having a financial or managerial role in
Chewco unless the Chairman or CEO determined that his participation did not adversely
affect the best interest of the company, which we have no evidence of (21).

LJM Partnerships
In June of 1999, LJM 1, a Cayman Islands SPE, was formed. Fastow served as the
general partner and invested $1 million of his own money. He raised $15 million from
two limited partners, through an SPE, to get debt off the balance sheet by having Enron
purchase certain assets and associated liabilities the company wanted removed from its
balance sheet (20). The conflicts of interest prohibited Enron from having any dealings
with officers of the company according to their code of ethics. But, the board of directors
gave special permission to Fastow subject to certain checks put in place to protect
Enron’s assets. LJM 1 entered into numerous transactions with Enron. One example,
LJM 1 hedged Enron’s position with Rhythms NetConnections stock, which Enron
bought for $1.85 per share and rose to $69 at the end of the trading day (20). The
investment in Rhythms was worth about $300 million in May of 1999 so Enron wanted to
protect itself against future income volatility (21). By hedging, Enron could offset losses
on Rhythms if the price of Rhythms declined. LJM Swap Sub Limited Liability
Partnership, controlled by Fastow, issued a put option on the Rhythms shares in exchange
for a supply of restricted Enron stock and various notes. This option would entitle Enron
to recover any loss in the value of the Rhythms shares. LJM Swap Sub would pay for
such losses out of the value of the restricted Enron stock it received. Any “mark to
market” losses would be shifted from Enron to LJM Swap Sub (22). LJM 2 was formed
in October of 1999. Fastow raised $200 million of institutional private equity to purchase
assets that Enron wanted to syndicate. LJM 2 solicited prospective investors as limited
partners using a confidential Private Placement Memorandum (PPM) detailing the
"unusually attractive investment opportunity" resulting from the partnership's connection

to Enron (21). At the end of 1999, Enron sold interests in seven assets to LJM
partnerships. The LJM partnerships were shady because Enron bought back five of the
seven assets after the close of the financial reporting period allowing them to report the
gain on their financial statements. The LJM partnerships made a profit on every
transaction, even when the value of the asset declined and the transactions generated
earnings of $229 million in the second half of 1999 for Enron (20).
Raptor Partnerships
Four new SPEs were established in 1999 and 2000 known as the Raptor Partnerships.
These deals were extremely complicated with Enron funding it with its own stock to
hedge against declines in the value of Enron’s merchant investments (21). LJM 2
provided the outside equity to avoid consolidation of the Raptor SPEs. Talon was the
SPE set up for the Raptor partnerships to absorb Enron’s “mark to market” losses.
Harrier, an Enron subsidiary, invested $1,000 equity in Talon for “special interest limited
partnership equity,” entitling Enron/Harrier to execute equity swap transactions with
Talon, and, under certain circumstances, to all of Talon’s profits exceeding $41 million.
LJM 2 contributed $30 million of equity to Talon, with the understanding that it would
receive a return of $41 million on this investment before Enron/Harrier could proceed to
trade derivatives with Talon. To fund future hedge transactions, Enron/Harrier issued
Talon approximately 3.7 million restricted shares of Enron stock, and rights to an
additional 3.9 million shares to be issued under certain circumstances in future years. All
of these shares had a current face value of approximately $537 million. In exchange for
these shares and options, Enron received net notes from Talon worth $350 million. (22)

Two of the Raptor SPEs lacked credit capacity to pay Enron on the hedges. So Enron was
supposed to take a pre-tax charge against earnings of more than $500 million, but Enron
restructured the Raptor deals by having more than $800 million of contracts transferred to
receive its own stock before the quarter ended (21). The result of the Raptor deals was a
$544 million after-tax charge against earnings in 2001, which forced Enron to reduce
shareholders’ equity by $1.2 billion.
Financial Summary
To evaluate Enron fully, we need to look at their financial statements and ratios.
The results are from the year 2000 and we feel an assumption must be made about the
validity of these numbers. We used the financial statements provided by Enron for 2000,
but feel the numbers don’t fully represent the truth and analyzing them any further would
not provide us with a more accurate picture of the company. Profit margin tells us for
every dollar in sales it generates .0097 cents in profit, .97% (20). Another measure of
profitability is the return on equity, Return on equity is a measure of how the
stockholders did during the year (14). For every dollar in equity, Enron generated around
8.5 cents in profit, or 8.54% (20). Return on assets is a measure of the profit per dollar of
assets (14). For every dollar of total assets, Enron generated about 1.5 cents in profit, or
1.49% (20). Enron has so many assets that this number is going to be small. Some
liquidity ratios are the current ratio, quick ratio, and net working capital. The current ratio
is a measure of a company’s short-term liquidity (14). For every dollar in current
liabilities, Enron is covered 1.07 times over (20). The quick ratio is computed the same as
the current ratio except it omits inventory. Enron’s quick ratio was 1.036 times. Net

working capital is the ability to meet short-term obligations (14). The net working capital
for Enron is $1.975 billion with the net working capital ratio equal to around 3% (20).
The debt to equity ratio is a measure of a company’s financial leverage and the
proportion of debt and equity it is using to finance its assets (23). Enron has a debt to
equity ratio of .692 times, which is quite high (24). Enron is very asset heavy. Total
assets increased from $33,381,000 billion in 1999 to $65,503,000 billion in 2000, an
increase of over 96%.
The net income of Enron is a figure that needs some discussion. Although it has
increased from $703 million in 1998 to $893 million in 1999 to $979 million in 2000,
there are some discrepancies about its validity (20). The Chewco and LJM Partnerships
reported income, which should not have been booked. According to the Powers Report,
this would have reduced reported net income by $133 million in 1998, $248 million in
1999, and $99 million in 2000 (21). Enron’s net income cannot be credible until changes
are made to correct their “mark to market” accounting. The cash flow from investing
activities is a negative $4.264 billion. The biggest component of this is the acquisition of
subsidiary stock decreasing cash flow from investing by $485 million and a decrease of
$777 million from business acquisition (20). The financial situation of Enron by the
books is stable, but the use of “mark to market” accounting and off the balance sheet
transactions will distort the numbers and potentially provide insecurity to Enron.
Financial Ratios Enron
Profit Margin .97%
Return on Equity 8.54%
Return on Assets 1.49%

Current Ratio 1.07
Quick Ratio 1.036
Net Working Capital $1.975 billion
Debt to Equity 69.2%
Total Debt $10.229 billion
Total Equity $14.788 billion
International Institute of Management Development
(http://www.senate.gov/~gov_affairs/072302roach_a.pdf#search='enron%20total%20debt')
Total Equity is equal to Shareholders’ Equity, Company-Obligated Preferred Securities of Subsidiaries and Minority
Interests.
Millions of dollars
$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
Control Issues:
$0
Conflict of interest
1999 2000
Total Assets
Current
Assets
Total Debt
Long Term
Debt
Total Equity
Shareholders'
Equity
A company the size of Enron must maintain such a strict direction in which the
company otherwise, it is so easy to get off the beaten path when you’re a company of that
magnitude. Having complete control of what the company is and does is essential to its

survival. “For any corporation to be healthy and productive, it needs to be strong
in…social-spiritual capital in terms of ethics, relationships, meaning and purpose (13).”
The culture of the company must all have the same goal and all be working towards that
goal. One of the problems with Enron was all of its conflicts of interest in its
infrastructure, its financial transactions and its accounting practices.
Mark & Skilling
From the moment Kenneth Lay hired Jeff Skilling in 1989 there was a struggle in
upper management between he and colleague rival Rebecca Mark. Both wanted sole
control of the strategic direction which the company was to head and both directions were
extremely different. Skilling wanted Enron to go from being a generator and supplier of
different energy commodities to becoming a middleman by focusing directly on trading
in energy (7). He believed in an “asset light” company. Mark was more traditional and
had a reputation for pushing hard to seal deals (4). She wanted to focus on power
generating assets at home and abroad (7). As a result of this, the company would
continue to pursue different investing strategies until Skilling’s appointment as chief
operating officer in 1996.
Andersen
Arthur Andersen was an eighty-nine year old firm built on the reputation of strong
ethics, accounting and auditing guidelines. They were among what the industry calls “the
big five” accounting firms in the world. They were respected, law abiding, and above all
ethical. But when a firm like Enron comes along and pays you $51 million a year for

your accounting and consulting services an auditor wouldn’t dare “offend a big client
with uncomfortable scrutiny (10).” After a while hands start washing each other and a
new unwritten company policy is formed. Many thought the relationship was closer than
usual. Andersen’s auditors were in-house. Some Enron employees were quoted as
saying that “people just thought they were Enron employees (7).” Andersen’s own
infrastructure had conflicting views about the way difficult accounting issues should be
handled. Andersen had a professional standards group (PSG) at its corporate
headquarters whose job was to review these difficult issues shall they occur (7). PSG’s
are set at most big accounting firms, but unlike all the other firms Andersen’s PSG did
not have the authority to overrule its field auditors if one of these difficult issues were to
arise. On several occasions the Enron audit team proceeded with their accounting
procedures despite the objections of the PSG (7).
Fastow Deals
Andrew Fastow, Enron’s chief financial officer, formed many small offshoots of
Enron called Special Purpose Entities (SPEs). The only purpose proved to be building
his and other top executives wealth while mounting debt. Fastow originally started LJM
and formed many subsidiaries from this original SPE. By having Fastow play this dual
role Enron was violating one of its codes of ethics, which prohibited an officer from
owning or participating in “any other entity which does business with…the company
(6).” The only exception is if the participation was disclosed to the chairman and CEO
and was judged not to “adversely affect the best interests of the company (6).” As a

esult, the board reviewed and approved the LJM partnerships and voted to suspend its
code of ethics in this instance to permit Fastow to run the partnerships.
Ethics:
Disclosure of Info
Officials to employees and public
All markets are considered efficient. Stock prices are a reflection of all available
information to the public about any certain company and the price is a good indication of
whether or not a company is doing bad or good or going to do worse. There is no
predicting the market because it is perfectly efficient. That is why the fall of Enron had
such an impact on the business world, no one saw it coming. The financial statements
were looking good and the mainstay of the company Kenneth Lay was still stating that
the company is the strongest it has ever been just weeks before its demise. Stock prices
stayed steady because the market had no information to report otherwise. Insiders were
still ranking Enron’s stock as a “hold” the day they filed Chapter 11. The whole time Lay
talked up the company’s financial stance he and other top officials were dumping
millions of dollars worth of Enron’s stock. No one knew and no one could react until it
was too late.
Ethical Summary
In the weeks leading up to Enron’s demise CEO Kenneth Lay was still selling
Enron as being in perfect financial health. He told employees that the company was
financially stronger than it’s ever been, while he turned around and dumped the majority
of his stock. The company eventually lost millions, employees lost their retirement and
shareholders lost their investment. Enron kept accounting documents hidden and well

manipulated and while the auditing team at Andersen stood by and said nothing for fear
they would lose the account. These kinds of issues question the ethics in which Enron
and Arthur Andersen did business. When I asked Rich Kidwell, financial advisor for
Merrill Lynch and former CPA, if he could pinpoint one thing that directly led to the
downfall of Enron he said “fraud.” And when I asked Ken Flora, Team Leader of
Accounting Operations at Indianapolis Power and Light, the same question, I got almost
the same answer, “unethical accounting and operations.” Joe McGee, CLU and ChFC at
AUL Tower Agency, he gave a similar response. Three industry experts all agreed that
the leading cause of Enron’s collapse was the breakdown in moral and ethical business
practices.
Culture
A company’s culture is what determines in large degree how their employees act.
Organizational culture spurs from customs, traditions, and the general way things are
done that have evolved over time (12). As Enron transformed from an old regulated gas
company to a fast deal making powerhouse, the culture it developed was a major reason
of for its downfall. Touted throughout the nineties as the triumph of the new economy,
they believed that their culture was fast, adaptive and innovative (2). To get the whole
picture of what working at Enron is like an examination must begin with new employees.
Enron’s size and new innovative business plan attracted the top MBA talent from the best
business schools in the country, mostly new graduates. Enron emphasized risk-taking
and entrepreneurial thinking (2). As a result, Enron’s managers tended to be over
confident and cocky, as is the tendency of most young people. Enron had a typical

turnover for a large company and it placed great stress on having a young, intelligent,
high energy work force. For instance top management positions were filled by people
younger than 50; CEO Jeff Skilling was 46, CFO Andrew Fastow was 38 and top trader
John Arnold was 26.
Youth and arrogance lead Enron to push its employees to maximize revenue at
all costs. Executives were at the forefront, encouraging new ideas and initiatives that
might have looked good on paper but were drains when put into action. Their slogan in
the late 90’s became “We make Markets” expanding into broadband, paper, electricity,
weather, along with others all in the name of revenues. The problem with these ideas and
initiatives was that no one seemed to care if they were drains or not. They cared more
about making their “quota” to make the books look good. Bosses at Enron frequently
made “tweaks” to the numbers to squeeze out more of deals in efforts to make deals look
good. Enron was not only spending money expanding into new markets it also spent a
great deal trying to expand their influence into politics. Enron routinely requested and
was granted less government regulations (7). They spent millions lobbying government
officials and members of the SEC to get less government oversight. Their success in
getting several exemptions gave them a free range in several areas that they took
advantage. For instance, the last thorough examination of Enron’s annual reports was in
1997 (7).
With the insistence on growth, managers were constantly being rated on
performance. Every six months or so analysts in training would be ranked and the
bottom ten percent would be given their walking papers. These ranking were based on
different criteria but certain areas got more attention than others. More stress was put on

creativity than integrity. For instance, “intellectual curiosity” was one criterion that
counted as much as anything in the performance evaluation. This consisted of how many
ideas the person came up with and started up a new business or process, even if there
wasn’t a demand for the business (3). For example, Lynda Clemmons in 1997 launched
weather derivatives. Her start up, within two years, had written $1 billion in weather
hedges to protect against short-run spikes in power prices (3). Enron declared this as
another high-potential market for the company but the idea never panned out and was
scraped shortly after. Whether an idea was successful or not did not seem to matter, only
if employees kept coming up with new ideas to make sure that they survived the routine
purges. The pressure to come up with deals was enormous and lead to what became
called as “Friday night specials”. These deals were hastily put together and often with no
apparent planning on how to manage the deals. These “specials” were often done with
aggressive accounting that took ethical shortcuts, for illustration would be when they
would book huge amounts of revenue before the contracts were signed and they would
keep the revenue even if the deal fell through. Though most of these cases did knowingly
cross that ethical line, some might have just been because of young executives. In pursuit
of never-ending growth Enron expanded into unfamiliar areas and with executives
churning into new positions, sometimes as much as once a year, there is a possibility that
inexperience played a role in some mistakes. We would however not suggest that
Enron’s unethical behavior was caused by inexperience due to the wealth of information
coming out on the corruption.
The pressure to perform had its consequences but it also had its rewards. During
the period from 1998 to 2000 total compensation for the top 200 employees went up

more than 630% from $193 million to $1.4 billion. The majority of the gains were given
in stock options. These executives started to care only about keeping the stock price as
high as possible. Along with the compensation packages Enron routinely lent money to
top executives, which were forgiven if the terms of their contracts were fulfilled (7).
To complete the performance review a group of twenty people were selected to
rank more than 400 vice presidents, then all of the directors, then all Enron managers
(2). The reward for being a manager rated superior (top 5%) were bonuses of 66%
higher than those in the excellent group. This ranking policy had the effect of making
people incredibly careful not to offend any of the reviewers, thereby creating a culture of
“yes-men” (3). Skilling was very hands on when it came to ranking employees for
compensation. There were several people who cited that Skilling on several different
occasions held up a persons performance review because he was trying to get back at

them for criticizing or what they called stepping out of line (2). This led to a development
in the number of “yes men” that were afraid if they criticized or expressed disagreement
that their careers would be severely damaged when it came time for performance review.
The Enron environment bread a risk-taking culture that only cared about growth
at any cost. There was no manager to set the example on what to do or not to do.
Criticism and dissention were met with hostility and there was no counter balance to new
ideas that were presented. The emphasis on earnings lead employees to take ethical short
cuts to keep up since creativity was reward more than integrity (3). A definite agency
problem came to light between the managers and shareholders. With the compensation
packages and performance reviews, employees cared more about their own welfare and
not the welfare of the company.
Suggestions
Enron had a code of ethics in place but did not comply or enforce its own rules.
We feel that along with changes to accounting methods there also needs to be drastic
changes in the culture and operational control management.
Alternatives to current culture that Enron could adopt
• Progressive-adaptive- A culture which stresses openness to new ideas, adapts
quickly to shifting market conditions. Company is future-oriented and wants to
catch waves of change (13).

• Purpose-driven- Leadership effectively directs the company on a clear course. A
common purpose is defined that is shared by all employees who are committed to
the same set of core values (13).
• Community-oriented- A strong emphasis is placed on collectivity and cooperation.
Leadership builds a company in which people respect, support each other.
Employees express their ideas rather than try to just “fit in”. (13).
• People centered- A genuine caring for each worker by the company. Individual
employees are encouraged to develop their full potential, personally and
professionally (13).
Strengths and weaknesses of cultural system
Progressive-adaptive
culture
Strengths Weaknesses
• Open to new ideas
• Reacts quickly
• Future oriented
Purpose-driven • Clear Company direction
• Commitment to core
values
• Cares about more than
bottom line
Community-oriented • Team oriented
• Empowers employees
• Openness to ideas
People-oriented • Freedom to grow
• People oriented
• Risk taking
• Outcome Oriented
• Risk averse
• Outcome Oriented
• Less independence
• Possible conflicts of
interest

Type of control systems
• Market- Uses external mechanisms like market share, price competition. Under
this system a company’s divisions are evaluated by how much profits they
achieve for the company as a whole (12).
• Clan- Workers are regulated by shared values, traditions, rituals, and norms.
Behavior depends on identifying with a certain group and behaving in a way that
reflects on the group or team (12).
• Bureaucratic- Emphasizes an organizational authority. That authority has set up
an extensive set of rules, regulations, polices, and procedures (12).
Strengths and weaknesses of Control Systems
Market Control • Easy to monitor
• Flexible
Clan Control • Shared values
• Flexible
Bureaucratic control • Formal
• Extensive
Alternatives to Accounting and Finance
Strengths Weaknesses
• Profit driven
• Results oriented
• Informal
• Variations possible
• Slow
• Inflexible
• Transparency committee- Investors want adequate information to reliably assess
how a company is being run and what its risks are. An audit committee is only
there to assure that the firm is following GAAP as certified by the outside
auditors. A “transparency committee” would spend its time evaluating the
efficiency of the policies and decisions that have a greater impact on investors’

perceptions of the company. The goal should be to help investors and other
members of the board of directors understand the firm’s value proposition,
strategy, key success factors and risks (25).
• Auditing Business Model Reform- Auditors are to help investors identify stocks
that are good investments and those that are not. Auditors need to change their
strategy from minimizing the costs and legal risks of performing this task and
trying to increase profits in other areas like consulting, while instead focusing on
maximizing the value of audits. Auditor independence can be achieved when
auditors see audit committees as their real clients, not top management. Incentives
inside the audit firms need to encourage audit professionals to exercise judgment,
and walk away from clients that don’t deserve their certification, even when they
are big and important (25).
• Accrual Accounting- Companies need to use accrual accounting to provide a more
accurate description of a company’s value.
• SEC Review- A semi-annual review by the SEC would almost guarantee a more
accurate representation of a company’s statements. It could also prevent
executives from participating in transactions with a conflict of interest.
Strengths and weaknesses of Accounting and Finance
Strengths Weaknesses
Transparency Committee • Key business risks
transparent to investors
• Detail and attention to key
issues of importance
• Still violation of
accounting rules
• Reliance on external
auditors advice

Auditing Reform • Maximize audit value • Compliance still an
issue
Accrual Accounting • Revenue and expenses • Requires highly
recorded in period incurred skilled accountants
• Stable and accurate
statements
SEC Review • Restore confidence to • Too much
consumers and investors
government control
• More accurate financial
statements
Recommendations
• Accounting and Finance. We need better disclosure to public, board members and
employees. First, we want to go back to accrual accounting and stop the
aggressive accounting immediately. We feel accrual accounting gives a clear and
more accurate representation of earnings, financial statements and the overall
welfare of the company. To regain consumer confidence we will submit
ourselves to semi-annual review of our financial statements by the SEC. In our
new financial statements we plan to put footnotes describing transactions terms
and finance methods involved. This is in an effort to provide clarity on how we
do business. Also, auditors will no longer be permitted an office space in Enron’s
buildings. In addition, Enron will voluntarily rotate auditors every 5 years. An
effort will be made also to control the quality of trades. To simplify and control
small acquisitions and transactions we want to institute a payback period of 3
years, in which cash flows must result in a positive net present value using accrual
methods. For major project initiatives where a large initial investment will be
involved, a decision making panel will consult to decide whether to proceed or

not. The hope of this decision making panel is to get a wide variety of opinions.
Feedback will be collected through quarterly and annual internal audits of
financial statements. We will submit to SEC audits at their request and we will
hire an outside firm to do annual audits also of financial statements. Along the
same lines several former finance policies will be stopped such as, executive
loans and compensating top executives with huge chunks of stock options.
• Control Systems. As far as control issues are concerned we feel that enforcement
was extremely deficient. We suggest a change in the current control system to a
bureaucratic system. This will formalize rules, procedures and polices especially
in regards to integrity and ethics which will stop such behavior in employees.
The major fault of this system is that it will slow our business down and decrease
the number of transactions. We understand that this could hinder some of our
deals but feel that a bureaucratic system will be strong and able to deal with the
size of Enron especially when it comes to dealing with ethical issues. Included in
this control system will be several checks and balances that were not in place
before. First, during new hire orientation, employees will have to attend an ethics
workshop. Also, employees will be required to attend one ethics seminar a year.
In regards to advancement an effort will be made to keep people in their current
jobs for at least 6 months in order to gain operational experience. As a way to
insure quality trades the risk assessment and control division will be allowed more
people and time to analyze trades and projects. In regards to reporting unethical
activity, we propose an open door policy to report wrong doing. We also want to
establish a position or committee to have the power to investigate and enforce

company’s guidelines on ethics and values made up of employees from every
level of management where each has an equal vote. These changes are rather
large but we feel that they could take place immediately, within a few months.
• Culture. Enron’s culture is one where there is no clear direction with a dual role
of both an owner and trader of commodities. They stress a highly competitive,
arrogant, distrustful culture that made objecting to unethical behavior very
difficult. We want to change the current culture to a more purpose-driven culture
(13). We choose this culture because in this culture leadership will effectively
stress a clear purpose of the company. Since everyone has the same common goal
we feel that this will stop some of the bad investments while uplifting employees
unlike the old culture. We want to start the transition immediately. Meetings will
be held with management to discuss the focus and their role in this changing
culture. Human resources will be extremely important in getting the company’s
message across. They will post informative notices and answer any questions
about new polices. They will phase it in starting with new employee orientation.
Along with the ethics workshop mentioned in the control system, new hires will
also go through a session about Enron’s purpose and core values. The “rank or
yank” system of review will be scraped and a probationary system will be put in
its place. It will involve those that are below the 10% will be sent for more
training and given a period to show improvement before being let go. We believe
that this relieves pressure to perform that led to those unethical shortcuts. Along
the same lines, criteria for performance review will be weighted equally instead of
having highly weighted categories like “intellectual curiosity”. Top managers

should encourage criticism and alternative thinking by offering incentives to those
who come up with quality constructive opposing view points. Managers will also
be responsible for upholding the control system and not letting ethical standards
fall. It will be required of heads of departments to hold quarterly sessions to
reaffirm the Enron’s purpose and values. Feedback information will be gathered
on the efficiency of the new culture by annual surveys given to all employees to
rate different areas of Enron’s business practices, most notably the new control
and culture initiatives. In addition, a third will be contracted to do a cultural audit
every three years.
Enron is an example of what unethical business practices can do to even the seventh
largest corporation in the US. Ethical management control systems, aggressive
accounting methods, and the organizational culture were significant problems that
directly led to their demise. Though bankruptcy was inevitable we believe that with a
change to a bureaucratic purpose driven organization that follows all proper regulations,
such as the GAAP, they could once again be a mainstay in the energy industry and
corporate America.

Work Cited
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Ripe for Abuse’”. Business Week Online. 2/15/2002.
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Leader of Accounting Operations. IPL, PO BOX 1595, Indianapolis, IN 46221
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http://specials.ft.com/enron/FT3A5RP52XC.html
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New York, NY, McGraw-Hill Irwin 2005.
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Financial Advisor. Merrill Lynch , 111 Monument Circle, Indianapolis, IN 46221.
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ChFC. AUL Tower Agency, 12800 North Meridian St., Suite 490, Carmel, IN
46032
10. Pellegrini, Frank. “Andersen: The Whistle Not Blown”. Time.com.
www.time.com/time/nation/printout/0,8816,194573,00.html
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Jersey, Prentice Hall 2002.
13. Wong, Paul T.P., “Lessons from the Enron Debacle: Corporate Culture Matters”.
Psychjourney.com. 2004
http://psychjourney.com/Corporate%20Culture%20Matters.htm
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