Enron: Not Accounting for the Future

Introduction

If you are like most people, if you have ever heard of Enron, you would know that it is a case study on what not to do in almost every aspect of business. They had official values that no-one followed, they had performance reviews that were on the verge of unethical, and they urged their employees to seek out the “gray areas” of finance in order to further their pursuit of profit. The management of Enron, created an atmosphere of arrogance and deceit bolstered by almost non-existent checks and balances on much that it did.

Although it never explicitly promoted these “values”, they did absolutely everything they could to promote them through deed and non-verbal means. Enron was everything a business of today tries not to be.

Employee Performance

In the early years of Enron, when it was primarily a natural gas transporter and distributor, Ken Lay established its values as “Respect, Integrity, Communication, and Excellence”, or “RICE”, for all employees and customers.

His intent was to use this mantra in all interactions to ensure trust and transparency in all aspects of what the company and its employees did. In the beginning, this mantra served them well as they grew slowly with a small group of faithful clients served by a moderate sized sales group. Profits were meager but the business was stable and employees remained engaged and true to the values originally espoused by Ken Lay.

As time progressed and the business transformed into something new and innovative due to newly introduced federal deregulation of natural gas pipelines, something changed.

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With the formation of the Enron Finance Group, Jeffrey Skilling and new management came onboard and began to change the internal culture of this new entity. Although the company still technically followed RICE, Skilling began to emphasize “aggressive trading” and hired top candidates from MBA programs around the country. This reportedly created an intensely competitive environment within the company, in which the focus was on “closing as many cash generated deals as possible in the shortest amount of time”.

In conjunction with this culture change, Skilling also introduced the “360-degree review” which came to be known as “the harshest employee-ranking system in the country”. Under this new system which was called “rank and yank” internally, employees were reviewed every six months and given a score from one to five. The lower the score, the higher the employee was ranked within the company. The higher the score, the closer the employee came to unemployment. Under this performance rating program, the Finance Group reportedly replaced up to 15% of its workforce every year. Under increased pressure to perform, the sales group no longer regarded each other or the customers with any aspect of the values established by Ken Lay and it became a merciless environment where only the highest performers could thrive. Associates began to feel that the only real performance measures that mattered were the amount of profits they could produce. Within a short span of time, everyone in the entire organization became more motivated to complete any deal at any cost, simply to post earnings and gain rewards in the shape of merit-based bonuses with no cap.

Respect, integrity, and communication were pushed aside in favor of greed, profits, status, and favor in the eyes of Skilling who allowed them to “eat what they killed”. With near unlimited potential for income, and an apparent disregard for oversight by management and the Board of Directors, many once well regarded sales agents were transformed into sycophants, only motivated to create new deals, post earnings for their company, and please Skillings. To these employees, it did not matter how they arrived at a deal, only that it generated a profit.

Recommendation

On the issue of employee performance, I believe Enron’s fatal flaw was the push for performance, no matter the cost. While I agree that performance reviews are necessary, Enron strayed from Ken Lay’s original values of respect, integrity, communication, and excellence. I found no evidence of any reinforcement of these values from either management or the employees. In addition, Jeffrey Skilling’s propensity to allow his employees to “eat what they kill” sends a message that anything is acceptable as long as you generate a profit.

My recommendation would be to implement an ethics program within Enron with a specific Ethics Department, similar or attached to Human Resources, responsible for establishing codes of conduct, standards for employee behavior, and re-designing the 360-degree performance review to incorporate job specific measures for RICE and employee behavior into the employee’s performance appraisal. I would also increase the frequency for performance reviews to quarterly as well as institute monthly meetings for Managers with the Ethics Department to review overall performance and enforce the code of conduct and standards for behavior. My hope for this increased frequency would be to decrease the amount of time any individual is unobserved in their behavior as well as allow for performance improvement plans for any that may be either too aggressive or failing in any way. It would also serve to reinforce the code of ethics to both Manager and employees on a more frequent basis.

I would also institute monthly face-to-face meetings for employees with their direct managers to review RICE and reinforce the values and ethics established by the Ethics Department. As research has shown, repeated reinforcement of values from management strengthens the perception that management cares. It also allows for a regular dialogue with the employees to understand any issues there may be either with the employee or within the department. My hope would be to open communication to forestall any further issues.

Interpretation issues

By his own admission, Andrew Fastow the former CFO of Enron, now realizes that he “was missing the point of the rules” when he was in charge of Accounting for Enron. While he observed the technical aspects of the law in all transactions and auditors approved them, he was concentrating on the letter, not the spirit of the law when he set up various off-book “special purpose entities” or “SPEs” to hide Enron’s less profitable business transactions. Fastow also stated many times that the deals he worked on to establish SPEs or move assets were blessed by attorneys and accountants but now realizes the transactions and his explanation for them were “misleading and fraudulent” Cohn, 2013.

Complicating these matters are Fastow’s oversight of “Mark-to-Market” or “MTM” accounting transactions that measure the fair market value of accounts and assets that can change over time. This MTM system tries to provide a realistic appraisal of an institution’s current financial situation based on projected profits for entities and transactions that are difficult to value. In essence, Fastow could create a value or profit projection for an entity as long as it was based on some measure of reality, then move it to one of the SPEs. This opened the door for Fastow, as an SPE manager, to create profits for Enron and the SPEs based on his own assessments, and then earn commission and bonuses on the values of the transactions he created as well as fees for managing the SPEs. Since the movements and values were technically legal and authorized by the accountants and lawyers, this gave Fastow access to an almost unlimited amount of income with little to no oversight.

During the investigation after the collapse of Enron, several of the “creative accounting practices” were exposed. In exchange for a lighter sentence, Fastow gave testimony useful to the prosecution and admitted that he “consistently lied to the banks about Enron’s true financial condition”. Although there were analysts on Wall Street that signaled the accounting was somewhat “murky”, they failed to raise the alarm because the accounting firm of Arthur Anderson had approved the transactions and had a very favorable reputation at the time, which lent validity to Fastow’s actions. All of these elements together created an environment where he could ignore checks and balances in favor of profit and greed.

Recommendation

Andrew Fastow had virtually no oversight in his creation of estimates for the MTM process or the management of the SPEs essentially letting him create his own rules and profits. Additionally, the rules around establishing fair market value for MTM’s is extremely complicated for anyone without a substantial finance background, allowing significant latitude in explaining the necessity for pricing. My recommendation would be to create oversight by separating the ability to create SPE’s from the accounting transactions created between them and the controlling entity. I would also suggest educating the Board of Directors extensively on the economics and accounting principles involved in SPE creation to give them more insight into any potential issues that could arise. These two actions should give a moderate amount of oversight for the creation and transactions for SPEs. It also introduces two more layers of oversight into the process, potentially limiting any malfeasance by any one party. As an additional measure, I would recommend quarterly reviews for all SPE’s by an independent/outside auditor, ensuring current assets and liabilities are recorded and transferred not only to the letter of the law, but to the spirit as well. This would not only give an added layer of oversight on the SPEs and their management, but would provide a level of transparency to dispel any notions of illegality.

I would also suggest separating any accounting audit firms from any consulting within the same company to eliminate the potential for a biased view or other impropriety. In addition, I would not allow any employees of either company to work for the other company for a specified period, possibly up to three years. This should remove the possibilities of collusion and co-employment that would normally have given these transactions another level of oversight. Along with this, I would ensure there was consistent classroom and reinforcement training to remind and ensure employees follow the spirit of the law as well as the letter of the law. By providing this training and reinforcement, it would leave no room for interpretation and remind employees what they should be doing.

Conclusion

On the surface, the motives and attitudes behind decisions and events leading to Enron’s eventual downfall appear simple enough: individual and collective greed, arrogance, invincibility, and superiority. Underlying these causes was simple dishonesty in the guise of superior intellect. Enron management created an atmosphere of extreme competitiveness and corporate arrogance either by not implementing proper controls or by being apathetic to the situation. The result of this was one of the largest corporate meltdowns in history coupled with some of the most punitive judgments ever handed out for white-collar crime.

Enron successfully violated almost every tenant of what a good employer should do for his or her company, employees, and customers. They violated every aspect of their stated values, bankrupted thousands of investors, drove well-established banks and other firms out of business, and ruined the lives of untold numbers of citizens who believed in them. When it was over, the largest effect was some of the most sweeping financial oversight legislation in history called Sarbanes-Oxley. The smaller effect was a case study in how not to run a business.

References

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