Enron 101

The fall of a global corporation is a textbook case of management failure—and business professors are hurrying to incorporate the lessons of Enron into their own classrooms. Here, professors from three management disciplines analyze what went wrong.
Enron 101

What brought about the sudden collapse of energy giant Enron? Along with many other interested observers, management professors have been consumed by that question. Was Enron a failure of strategic management and organizational leadership? Harvard’s Christopher Bartlett thinks so. He believes that the company amassed and then squandered an unprecedented store of intellectual capital, and he warns other businesses that they must learn how to attract and cherish this valuable business commodity.

Or, was Enron brought down by ethical lapses? That’s the position of O.C. Ferrell of Colorado State University. Had Enron executives practiced ethically sound judgment, he says, they would not have struggled with the accounting systems and off-balance-sheet partnerships that ultimately caused the business to fail.

Yet, many believe that Enron’s demise can be traced to those very accounting woes. Mary Ellen Oliverio of Pace University examines generally accepted auditing and accounting principles— and how they were not applied by Enron’s auditors. All three professors examine how business schools might use the lessons of Enron in their classrooms, and what students and executives might learn from Enron’s mistakes.

Enron is a remarkable story of the creation and destruction of value in a company. It starts with Ken Lay merging two regional gas pipeline companies and evolving them into one of the largest and most successful companies in the global energy field. He and his top team transformed a $5 billion company into one with a market capitalization of $65 billion in little more than a decade.

Then, in just a few months, Lay and his associates destroyed all they had built. They took their extraordinary creation of intellectual capital and undermined it by the way they mismanaged financial capital. It’s a story that business school students need to understand before they enter the world of business.

In the 1990s, deregulation and privatization were changing the energy industry around the world. Lay backed two of his up-and-coming stars, each of whom was making a different strategic bet. One key Enron manager, Rebecca Mark, felt that Enron should take advantage of deregulation by acquiring the infrastructure that would allow it to become a truly global energy company. She led the initiative whereby Enron bought up gas pipelines and power generation operations around the world, from the United Kingdom to Latin America to India. This capital-intensive, heavy-infrastructure bet made Enron a driver of change as the energy industry deregulated and went global.

Lay also backed Jeff Skilling, who joined Enron in 1990 and predicted that, as the industry became deregulated, Enron could essentially disaggregate the parts of the value chain. No longer would there be a monopoly from wellhead to consumer, in which a single company controlled all the gas that flowed. Skilling saw that deregulation would allow companies to decouple all the various transactions of drilling and piping and distribution, and he thought that Enron would no longer need to own these assets to be a major industry player. He created a notion called a gas bank that eventually evolved into a full-blown trading function, allowing Enron to buy and sell supply contracts and production contracts.

Skilling developed his trading organization around a highly innovative and entrepreneurial culture that helped it become the driving force in Enron’s growth. One key entrepreneurial initiative began in 1999 when the chief gas trader in the United Kingdom, Louise Kitchen, decided that trading had to migrate to an online function. Concerned that there was insufficient liquidity to support a stable Internet-based auction, Enron had been wary of going online. There were also concerns that profits would shrink as spreads became visible on the screen.

Nonetheless, Kitchen put together a group of several hundred people within the company—lawyers, traders, accountants, and IT experts—and proposed solutions to the problems. Liquidity could be provided by having Enron act as the principal in every buy or sell transaction. The shrinking spread would be offset by volume, they argued. In just nine months, this team created EnronOnline, and Skilling gave the nod to it. Within 12 months, it became the biggest dollar volume trading site on the Web.

Eventually people with Enron started saying, “If we can do online trading for gas, why not for electricity and metals and broadband and weather futures?” Soon they were trading all these commodities and more, and EnronOnline grew very, very fast. It was at this stage that the company started creating off-balance-sheet private companies to provide the liquidity it needed to fuel the rapid growth of the trading operations. Enron wanted to be valued not as an asset-heavy energy company, but as a new-age online trading company.

The transformation was rapid and dramatic. During the 1990s, Enron went from being a company managed by buttoned-down engineers in a low-risk environment to an entrepreneurial, innovative corporate culture where people were creating new products, new markets, and whole new business models. When Lay first took over the company, 90 percent of the business was generated from drilling for oil and gas and delivering energy. By the end of the ’90s, trading accounted for more than 90 percent of the business.

However, the high-powered, incentive-driven culture Skilling had created also had a dark side. A certain hubris began to pervade Enron. As company leaders articulated, then achieved, successive strategic visions of the company, confidence became arrogance. First they wanted to be the United States’ first major gas utility, and then the world’s largest energy company. By 2001, Skilling said that his new vision was for Enron to be the largest company in the world. Quite an ambition!

Driven by their overstretched ambition, Enron executives began engaging in complex financial engineering. The huge growth required funding that would have hurt the quality of the company’s balance sheet. As a result, the company began to create increasingly questionable off-balance-sheet partnerships. The complex and opaque financial reports were difficult for analysts to penetrate and eventually led these analysts to ask some challenging questions. But Enron’s management was unwilling to elaborate on the published data, and Skilling became increasingly confrontational with those who wanted more detailed information.

Within weeks the company’s invaluable customer goodwill and employee intellectual capital had been  by management’s lack of openness and honesty in its dealings with its stakeholders.

Ultimately, this is a story about loss of trust. First, Enron lost the trust of the analysts who were acting as intermediaries for shareholders. As shareholders became nervous and the stock price began to fall, Enron lost the trust of the buyers and sellers who started worrying about whether or not the company had the resources to back the transactions. Finally, it lost the trust of its employees, who had large amounts of their compensation tied to Enron stock, and who began to feel as if they had been misled. By December, Enron’s traders were simply walking away from their terminals with trades left in mid-transaction. Within weeks the company’s invaluable customer goodwill and employee intellectual capital had been destroyed by management’s lack of openness and honesty in its dealings with its stakeholders.

Financial capital—the machines that were once the scarce resource in companies—could be bolted to the ground and kept there overnight. As we move into an information age— a knowledge-based, service-intensive economy where human capital is the source of competitive advantage—the way we develop, treat, attract, motivate, and retain people becomes critical. Those relationships are based on trust, and that’s what was undermined at Enron.

Today’s corporate leaders are being compelled to learn how to manage intellectual assets as a scarce resource. That requirement is behind all the downsizing, de-layering, restructuring, and empowerment that’s been going on through the 1990s. Companies are stripping out the layers of management that were necessary to control and manage financial resources from the top. Instead, management is trying to get as close as possible to the scarce resource, the intellectual capital that resides deep in the organization.

Like companies, business schools are in the process of evolution. I think business schools have been reasonably effective in following the new economy, capturing the innovations created by Amazon, Microsoft, and the other companies built around intellectual capital. And they have done a fair job of bringing the challenges facing traditional companies into the classroom. The career of Jack Welch at GE—his concepts of “workout” and “boundarylessness”—epitomizes this transformation from managing financial capital to managing intellectual capital. So business schools have been capturing this transformation as it occurs.

But we must also learn from failures like Enron’s. In fact, that’s often a more powerful and dramatic way to learn. To me the central lesson of this case is how long it took management to build competitive advantage based on superior intellectual capital, yet how quickly it was destroyed when those at the top lost the trust of the key stakeholders. It’s a lesson our MBAs should take to heart.

Christopher Bartlett is faculty chairman of the international executive program called Program for Global Leadership at Harvard Business School, Boston, Massachusetts.

Enron is a classic textbook case of an organization with a highly unethical corporate culture. All you have to do is pick up recent issues of Fortune, BusinessWeek, and The Wall Street Journal to see that basic ethical principles were not important to top executives at Enron. I really believe that the root of the problem with Enron is going to be missed by some people who will see it as an accounting/auditing problem. In reality, the company’s downfall was caused by a poor ethical climate in which unethical rule-bending of almost every dimension of business practice was accepted.

The real issue was a corporate culture that encouraged a focus on the balance sheet—or, in some cases, off-balancesheet partnerships. Enron converted business into a technical science of manipulation involving computer information systems, software, and financial analysis that did not consider social or ethical consequences. Enron learned to manipulate earnings and stock prices by wielding its culture of arrogance. It even learned to manipulate its auditor, Arthur Andersen. The company also developed a reputation for ruthlessness with all of its stakeholders and became far more focused on short-run earnings than the effect its actions would have in the long run on its employees, stockholders, and society. 

Like most Fortune 500 companies, Enron may have had a code of ethics, but it was only

Like most Fortune 500 companies, Enron may have had a code of ethics, but it was only window dressing. The role these codes play in daily business activities varies tremendously from company to company. Lockheed Martin, for example, has an incredibly well-documented code of ethics. But for some companies, the code of ethics is nothing more than “be honest, be truthful,” accompanied by generalizations about personal morality. In such cases, the companies have not developed a thoughtful process of identifying areas of risk and then providing guidelines to address those areas of risk. Without ethics statements that are implemented and communicated throughout the company, the standard of ethical behavior is compromised.

Many people, including some business faculty, do not fully understand the term “business ethics.” They believe it means developing personal morals and personal ethical behavior in the business environment. From an organizational perspective, business ethics means applying traditional ethical concepts of truthfulness, honesty, and fairness to a complex, culturally diverse organization. Top management must build an ethical climate by assessing risk and developing values at the very highest level of the organization, and then making sure that these values are accepted and shared by employees, regardless of their own personal ethical backgrounds. At a minimum employees must understand legal compliance, but encouraging a value system with behavior far above legal compliance is optimum.

What has happened in recent years is that companies have focused their ethical and legal attention on major crisis areas such as sexual harassment and anti-trust, instead of on developing true codes of ethics. The Enron case may be viewed from a narrow perspective of deficiencies in auditing and relationships between companies and their accounting firms, or it can be seen as a much broader issue. The Enron case should be a wakeup call to companies and colleges of business, signaling that teaching people about organizational ethics, organizational integrity, and social responsibility is good business. The most profitable companies do not end up on the front page of the paper accused of ethical violations.

In fact, research shows that good corporate citizenship equals long-term profitability. Many great corporations— including IBM, Hershey Foods, Cisco, General Electric, and Starbucks—have a track record of integrity even when their stocks are not doing particularly well. Starbucks, for example, works hard to interact with the community and be socially responsible. Not only does Starbucks provide a high-quality product to consumers, but it also works all the way down the supply chain to make sure farmers are paid a fair price for their coffee beans.

Enron did not have such a culture of corporate responsibility— and, apparently, neither did its auditor, Andersen. It seems ironic that, about ten years ago, Andersen contributed $5 million to teach colleges of business and business professors more about business ethics. It now appears that Andersen has a very questionable ethical climate itself. Its way of approaching ethics was to toss money out to business schools, rather than trying to apply ethical standards to its own behavior and become a role model for other companies.

An auditing company with poor ethical standards will lose business. Most companies with a great reputation and integrity might question whether they would want to have Andersen as an auditor right now. If I were a stockholder or board member, I would say, “No.”

Not only is Andersen enmeshed in the Enron crisis, but in 2001 the firm agreed to pay $110 million to settle an accounting fraud suit brought by Sunbeam Corp. Investors alleged the accounting firm ignored Sunbeam’s inflation of its earnings figures. The size of the settlement indicates that Andersen was willing to compensate Sunbeam investors who relied on its audit reports. We want our financial reporting to show high integrity. We don’t want it to be questioned because others may believe we’re relying on a questionable accounting firm.

No one wants to do business with a company that is not trustworthy. I hope colleges of business will look at the Enron case and assess how much time they devote to teaching students how to do things, as opposed to whether or not they should be doing these things.

I am deeply concerned that ethics and social responsibility are very low priorities in many colleges of business. Many colleges do not require courses on business ethics or business and society, and most colleges do not require a business ethics course for undergraduates. Some professors do cover ethical issues as they relate to the subject matter of their courses—that is, if they are teaching e-commerce, they might talk about privacy. Other schools might require courses on business law. However, students rarely are taught a comprehensive ethical framework that illustrates the consequences of integrity lapses in business. Colleges of business today believe that it is most important for them to teach the technical systems of business, such as software applications and the use of databases, to determine how to improve the bottom line. In reality, knowing how to use the tools of business responsibly is just as important as learning all the latest technical devices for success.

I do think that the Enron failure is causing many colleges of business to ask thoughtful questions. Are we sending out students who may be technically competent but deficient in understanding their responsibilities in managing a company and interacting with society? I feel that we need to make ethics a top priority over the next few years.

O.C. Ferrell is chair and professor of marketing and director of the e-center for business ethics in the College of Business at Colorado State University, Fort Collins, Colorado.

The Enron case is complex. Much careful analysis is needed to determine what was done and who was responsible. At this point, my tentative hypothesis about the case is that either by default or design there was an unbelievable level of collusion among the key executives, the board, the accountants, the lawyers, the investment bankers, and possibly governmental officials. Because an audit is an independent engagement, there can be an autonomous study of the auditors’ performance. A wise U.S. Congress should demand a serious, technically driven investigation of audits performed in the last two to three years by Arthur Andersen.

There is a precedent for a comprehensive investigation in the McKesson & Robbins fraud case of 1938. Unfortunately, although a number of alleged audit failures have been extensively discussed in the business press within the past five years, none of these audits was objectively investigated. Major public accounting firms have been willing to pay millions of dollars to settle cases without having to acknowledge whether or not there had been material deficiencies in their audits.

I am baffled by statements made by Andersen CEO Joseph Berardino during two appearances before the Committee on Financial Services of the U.S. House of Representatives. His comments do not reflect current auditing guidance as followed by auditors who accept their responsibility for the public interest. I shall just identify a few of his comments to illustrate this point:

Failure to get sufficient evidence: At one point in his testimony, Berardino stated that “it was not clear why the relevant information was not provided to us.” What needs to be made clear is why the auditors failed to use due professional care in assessing the adequacy of the information they received.

The auditing guidance is clear: Failure to obtain sufficient evidence leads to a scope limitation, which will require a qualified opinion or a disclaimer of opinion. Yet, the auditors’ report of February 23, 2001 (for the 2000 audit), included an unqualified “clean” opinion.

Assessment of adjustments: In his testimony, Berardino explained the basis used by the audit team in concluding that the proposed adjustments of $51 million were not material to the 1997 financial statements. The income that year was $105 million. If adjustments had been booked, the company’s net income for 1997 would have been reduced from $105 million to $54 million. Would an investor consider an income of $105 million to be materially different from $54 million? The auditors didn’t seem to answer that question. They used “normalized income”—an average of earnings during the preceding three years. Based on this computed average, the conclusion was that $51 million would represent only an eight percent adjustment, which was judged not to be material.

According to generally accepted accounting principles, a set of financial statements for a fiscal year must essentially reflect that year’s activity and status. While generally accepted accounting principles do not allow for smoothing of income or expenses, these auditors found a rationale for minimizing the impact of expenditures on earnings for 1997 and agreed with the client that no adjustments were required.

Complexity of transactions: Berardino, on occasion, noted the complexity of the transactions and the difficulty of understanding them. He pleaded for additional professional guidance.

Auditors currently have a hierarchy of sources for gaining an understanding of the appropriate basis for recording a transaction. Regardless of its complexity, a transaction is real, not hypothetical or metaphysical. Therefore, it can be plotted on a piece of paper; a flow chart can be drawn and reviewed to assure the auditors that they understand what happened. Our auditing students learn that if they cannot plot a transaction, they don’t understand it. And if they don’t understand it, they must seek more corroborating evidence. If that evidence is not provided and is determined to be material, the auditor has a scope limitation, and that precludes an unqualified opinion.

If the auditor was  during the performance of an audit, he must issue a disclaimer of opinion.

Premature conclusion: Berardino asserted that this case is a business failure, not an audit failure. Yet that is a premature conclusion. Many unreconciled points have been noted in the business press and in Congressional hearings. For example, while Berardino has said that the auditors merely reviewed Enron’s Special Purpose Entities, news stories have reported that minutes have been disclosed indicating that the auditors participated in the design of such entities.

The auditors also served as consultants to Enron. To what extent did their consulting lead to decisions that were then audited by the same individuals? This raises the question of independence. The guidance is clear: If the auditor was not independent during the performance of an audit, he must issue a disclaimer of opinion.

Other questions come to mind:

  • Audit partner David Duncan received a reported salary of at least $2 million, higher than average for partners in their early 40s. Was his salary determined by his high quality standards for auditing or by his skill as a rainmaker in relation to Enron?
  • Why was Enron’s audit committee so inept? Since 1985, the committee had been headed by a former accounting professor who served as dean of one of the most prestigious business schools in the United States. He admitted that the committee took the word of management. Why did he fail to probe? Where was the professional skepticism expected from those who are trained in accounting and auditing?
  • Why did the former CEO Jeff Skilling know so little about accounting and finance, as he insisted at the hearings? He stated that he was not aware of any financing arrangements designed to conceal liability or inflate profitability. Hadn’t the auditors informed him that management is responsible for the fair presentation of the financial statements in conformity with generally accepted accounting principles? In fact, before an audit is considered complete, the CEO and CFO must sign a management representation letter including such an acknowledgement. Did the auditors not get such a letter? Was it signed with indifference by the top executives?

The public accounting profession has skillfully suppressed criticism in recent years. They have gained supporters through lobbying, endowing chairs in some U.S. colleges and universities, and providing funds to the American Accounting Association, the major academic accounting organization. As noted in The Wall Street Journal, “…when outsiders are present at public hearings where standardsetting rules are proposed, they tend to be finance executives at corporations…or accounting professors whose endowed positions are financed by Big Five accounting firms.” Given such financial support, the Enron debacle is not surprising. When serious, thoughtful, good-faith criticism is stifled, the optimum standards and optimum behavior that assure professional quality cannot exist.

Mary Ellen Oliverio is a professor of accounting at Pace University, New York City.