1. Case Study: Enron Scandal Keywords: Mark-to market accounting, Off-balance items, Derivatives, CEO Compensation, Agency Problem 1

2. Overview  The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas Enron CorporationHouston, Texas  Enron shareholders filed a $40 billion lawsuit after the company's stock price, which achieved a high of $90.75 per share in mid-2000, plummeted to less than $1 by the end of November 2001. On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom's bankruptcy the next year.Chapter 11United States Bankruptcy CodeWorldCom  Many executives at Enron were indicted for a variety of charges and some were later sentenced to prison. Enron's auditor, Arthur Andersen, was found guilty in a United States District Court of illegally destroying documents relevant to the SEC investigation which voided its license to audit public companies, effectively closing the business. Arthur Andersen was one of the five largest audit and accountancy partnerships in the world. Arthur Andersenfive largestauditaccountancy 2

3. Human Failure: Enron Chairman  Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth.Kenneth LayHouston Natural GasInterNorth  He played a leading role in the corruption scandal that led to the downfall of Enron Corporation. Lay and Enron became synonymous with corporate abuse and accounting fraud when the scandal broke in 2001. Enron Corporationaccounting fraud  He earn his Ph.D. in economics from the University of Houston in 1970 and soon after went to work at Exxon Company, USA, the successor to Standard Oil of New Jersey, and a predecessor of ExxonMobil.Ph.D.University of HoustonExxon Company, USAStandard Oil of New JerseyExxonMobil 3

4. Human Failure: Enron CEO  Jeffrey Keith "Jeff" Skilling (born November 25, 1953) is the former CEO of the Enron Corporation. In 2006, he was convicted of federal felony charges relating to Enron's financial collapse and is currently serving a 24-year, four- month prison sentence.CEOEnron Corporationfelony  Earlier, Skilling received a full scholarship to Southern Methodist University in Dallas. After graduation, he went to work for a Houston bank, which sent him to Harvard Business School.Southern Methodist University DallasHarvard Business School  He stated that during his admissions interview for Harvard Business School, he was asked if he was smart, to which he replied, "I'm f_____ smart." Skilling earned the top 5% of his class as a Baker Scholar. He became a consultant at McKinsey & Company in the energy and chemical consulting practices. Skilling became one of the youngest partners in the history of McKinsey. McKinsey & Company 4

5. Human Failure: Enron VP  The former executive, J. Clifford Baxter, had complained to Enron's management team, including Jeffrey K. Skilling, then the chief executive, about questionable accounting measures used by the company. Later, he was discovered inside his Mercedes-Benz after he apparently killed himself.  Mr. Baxter was one of the 29 senior Enron executives named in a shareholder lawsuit seeking compensation for losses due to the collapse of the company into bankruptcy. He sold more than 577,000 shares, the lawsuit said, worth $35.2 million over a three-year period before the bankruptcy. By comparison, Mr. Lay sold 1.8 million shares for $101 million and Mr. Skilling sold 1.1 million shares for $66.9 million.  Mr. Baxter was born in Amityville, N.Y., received a bachelor's degree with honors from New York University and an M.B.A. from Columbia University. 5

6. Human Failure: Enron CFO  Fastow was initially charged with 78 counts of fraud, mostly connected to his central role in a web of off-balance sheet entities that did business with Enron, disguised the company’s financial condition, and made Fastow tens of millions. He ultimately pled guilty to two counts, forfeited $30 million, and agreed to testify against his former bosses as a government witness. Fastow served a six-year prison sentence for charges related to these acts.  In 2013, he works 9-to-5 as a document-review clerk at the law firm that represented him in civil litigation.  Fastow graduated from Tufts University in 1983 with B.A.s in economics and Chinese. earned MBAs at Northwestern University and worked for Continental Illinois National Bank and Trust Company in Chicago.Tufts UniversityB.A.sMBAsNorthwestern UniversityContinental Illinois National Bank and Trust CompanyChicago 6

7. “Enron: The Smartest Guys in the Room” 7

8. Enron History (and Story)  In 1985, after federal deregulation of natural gas pipelines, Enron was born from the merger of Houston Natural Gas and InterNorth, a Nebraska pipeline company. In the process of the merger, Enron incurred massive debt.  In 1997 Enron acquired electric utility company Portland General Electric Corp. for about $2 billion.  Skilling began to change the corporate culture of Enron to match the company’s transformed image as a trading business.  By the end of that year, Skilling had developed the division by then known as Enron Capital and Trade Resources into the nation’s largest wholesale buyer and seller of natural gas and electricity.  Revenue grew to $7 billion from $2 billion, and the number of employees in the division skyrocketed to more than 2,000 from 200.  Using the same concept that had been so successful with the gas bank, they were ready to create a market for anything that anyone was willing to trade: futures contracts in coal, paper, steel, water and even weather.  See more at: http://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html#sthash.t00h7sEZ.dpuf 8

9. Enron in year 2000 - 2001  In January 2000 Enron announced an ambitious plan to build a high-speed broadband telecommunications network and to trade network capacity, or bandwidth, in the same way it traded electricity or natural gas.  In July of that year Enron and Blockbuster announced a deal to provide video on demand to customers throughout the world via high-speed Internet lines. As Enron poured hundreds of millions into broadband with very little return.  A very confusing footnote in Enron’s 2000 financial statements described the above transactions.  By April 2001 other skeptics arrived on the scene. A number of analysts questioned the lack of transparency of Enron’s disclosures.  See more at: http://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron. html#sthash.t00h7sEZ.dpuf 9

10. Enron in year 2000 - 2001  In February Skilling held the company’s annual conference with analysts, bragging that the stock (then valued around $80) should be trading at around $126 per share.  In March Enron and Blockbuster announced the cancellation of their video-on-demand deal. By that time the stock had fallen to the mid-$60s.  Also in August, in an internal memorandum to Lay, a company vice-president, Sherron Watkins, described her reservations about the lack of disclosure of the substance of the related party transactions with the SPEs run by Fastow.  On October 16 Enron announced its first quarterly loss in more than four years after taking charges of $1 billion on poorly performing businesses.  On October 17 the company announced it had changed plan administrators for its employees’ 401(k) pension plan, thus by law locking their investments for a period of 30 days and preventing workers from selling their Enron stock  See more at: http://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html#sthash.t00h7s EZ.dpuf 10

11. Enron in year 2000 - 2001  On October 22 Enron announced the SEC was looking into the related party transactions between Enron and the partnerships owned by Fastow, who was fired two days later.  On November 8 Enron announced a restatement of its financial statements back to 1997 to reflect consolidation of the SPEs it had omitted, as well as to book Andersen’s recommended adjustments from those years, which the company had previously “deemed immaterial.” This restatement resulted in another $591 million in losses over the four years as well as an additional $628 million in liabilities as of the end of 2000.  The equity markets immediately reacted to the restatement, driving the stock price to less than $10 a share. One analyst’s report stated the company had burned through $5 billion in cash in 50 days.  A week after his surprise Aug. 14 resignation, the media and public, however skeptically, had digested Skilling's claim and his colleagues' swift corroboration that the CEO was leaving the company for personal reasons.  Between January and August 2001, Skilling sold off about $20 million in Enron stock. He has tried to maintain a low profile—but the suicide by former Enron vice chairman Cliff Baxter brought reminders that, according to whistle-blower Sherron Watkins, Baxter had complained loudly to Skilling about Enron's shady bookkeeping.  See more at: http://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html#sthash.t00h7sEZ.dp uf 11

12. Accounting Fraud: “mark-to-market accounting”  Lay hires Jeffrey Skilling, a visionary who joins Enron on the condition that they utilize mark-to-market accounting, allowing the company to record potential profits on certain projects immediately after contracts were signed, regardless of the actual profits that the deal would generate. This gives Enron the ability to subjectively give the appearance of being a profitable company even if it isn't.Jeffrey Skillingmark-to-market accounting  Mark-to-market or fair value accounting refers to accounting for the "fair value" of an asset or liability based on the current market price, or for similar assets and liabilities, or based on another objectively assessed "fair" value. Fair value accounting has been a part of Generally Accepted Accounting Principles (GAAP) in the United States since the early 1990s.fair valuemarket priceGenerally Accepted Accounting Principles 12

13. “mark-to-market accounting”  In the accounting world, the numbers on a company's books are rarely indicative of market values. According to generally accepted accounting principles (GAAP), companies are supposed to record the value of assets at their.market valuesgenerally accepted accounting principles  In other words, if a bakery buys an oven for $10,000, the purchase is recorded as an asset on the company's balance sheet for $10,000 - even if it could be sold for more in the marketplace.asset  This all changed in the 1980s when companies started to adopt mark- to-market accounting. Just as the name implies, with mark-to-market accounting, certain assets are recorded at their fair market values, not at cost, as was previously the norm.fair market values 13

14. “mark-to-market accounting”  One of the biggest spurs for the change was the new way America did business; investing had become increasingly popular and accessible, and businesses had started thinking that padding their coffers with stocks and bonds was a lot more lucrative than hoarding cash.stocksbonds  It didn't make sense, they argued, to keep recording liquid assets like stocks and derivatives at their cost when investors wanted to learn the true value of what was on the books. The accountants capitulated - after all, the point was more transparency for investors.liquid assetsderivativestransparency 14

15. “mark-to-market accounting”  Despite its benefits, not everyone is a fan of marking assets to market value. Detractors say that mark-to-market accounting is dangerous because it allows companies to use hypothetical numbers to account for hard-to-value financial instruments (like collateralized debt obligations). And indeed, with certain types of securities (like level-3 assets) discretion plays a big part in what you see on a company's books.collateralized debt obligationssecuritieslevel-3 assets  Conclusion Mark-to-market accounting isn't bad in and of itself. In fact, there are many times when marking assets to the market makes a company's books more accurate than leaving the items at cost. The easiest way to get a handle on how much of this accounting practice is going on is to read the footnotes attached to your stock's reports.footnotes 15

16. “mark-to-market accounting”  They must adjust them to fair market value, booking unrealized gains or losses to the income statement of the period.  For a company such as Enron, under continuous pressure to beat earnings estimates, it is possible that valuation estimates might have considerably overstated earnings  Furthermore, unrealized derivatives trading gains accounted for slightly more than half of the company’s $1.41 billion reported pretax profit for 2000 and about one-third of its reported pretax profit for 1999.  Derivatives such as energy futures contracts allows mark-to-market profits, which is unrealized yet. 16

17. Sarbanes-Oxley Act  One piece of legislation, the Sarbanes-Oxley Act, increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders.Sarbanes-Oxley Act  The act also increased the accountability of auditing firms to remain unbiased and independent of their clients. 17

18. Corporate America Scandals 18

19. Corporate America Scandals 19

20. Corporate America Scandals 20

21. Corporate America Scandals 21

22. Corporate America Scandals 22

23. “making its number”  Fastow, looking down, “I deserve it. It’s a very difficult thing to accept that about yourself. I didn’t set out to commit a crime. I certainly didn’t set out to hurt anyone. When I was working at Enron, you know, I was kind of a hero, because I helped the company make its numbers every quarter. And I thought I was doing a good thing. I thought I was smart. But I wasn’t.”  “in my opinion, the problem today is 10 times worse than when Enron had its implosion.” (A speech by Fastow in 2013 after he was released from prison) 23

24. Agency problem  In typical corporations, ownership can be spread over a huge number of stockholders.  Therefore, agency relationship exists when someone (the principal, or stockholders) hires another (the agent, or CEO, CFO, and other managers) to represent his or her interest.  Then, the separation of ownership and management creates agency problem, or Principal-Agent problem.  Agency problem: the possibility of conflict of interest between the owners and management of a firm. Mangers won’t work for the firm’s owners unless it’s in their best interest. 24

25. Two Key Groups in Corporation The agency problem: Mangers won’t work for the firm’s owners unless it’s in their best interest! 25

26. How are entrenched managers harmful to shareholders?  Management act in the best interest of themselves, not in the best interest of shareholders.  Management consume perks such as lavish offices and corporate jets, excessively large staffs, and memberships at country clubs.  More critically, management engages in non-value increasing activities.  Management accepts projects (or acquisitions) to make firm larger, even if its value after the event may go down. 26

27. CEO Stock Options  Why are the corporations willing to provide stock options to CEOs?  The separation of ownership and management creates conflicts (or agency cost) between managers and shareholders.  One way to mitigate conflicts is to offer stock options to mangers.  That is, in order to reduce agency cost, managerial compensation is closely tied to share value of the firm. 27

28. Stock Options in Compensation Plans  Gives owner of option the right to buy a share of the company’s stock at a specified price (called the exercise price) even if the actual stock price is higher.  Usually can’t exercise the option for several years (called the vesting period or the expiration). 28

29. A Hypothetical Example of CEO Stock Option 29 $20 $50 ($50 -$20)*100,000 shares = $3 million profit!

30. CEO Pays in Corporate America 30

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34. Sources:  https://en.wikipedia.org/wiki/Enron:_The_Smartest_Guys_in_the_Room https://en.wikipedia.org/wiki/Enron:_The_Smartest_Guys_in_the_Room  https://en.wikipedia.org/wiki/Enron_scandal https://en.wikipedia.org/wiki/Enron_scandal  http://content.time.com/time/magazine/article/0,9171,1101020204- 197668,00.html http://content.time.com/time/magazine/article/0,9171,1101020204- 197668,00.html  http://www.nytimes.com/2002/01/26/business/enron-s-many-strands- executive-s-death-critic-who-quit-top-enron-post-found- dead.html?pagewanted=all http://www.nytimes.com/2002/01/26/business/enron-s-many-strands- executive-s-death-critic-who-quit-top-enron-post-found- dead.html?pagewanted=all  http://www.investopedia.com/articles/financial-theory/08/mark-to-market- mayhem.asp http://www.investopedia.com/articles/financial-theory/08/mark-to-market- mayhem.asp  http://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenro n.html http://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenro n.html 34