The Case: Enron and Fraud

Enron, once America’s seventh largest corporation, soon became a byword for corporate greed, scandal and corruption.

Summary

Two smaller energy suppliers named Houston Natural Gas and InterNorth merged in 1985 to form Enron — which shifted its business model in the 1990s and became an energy trader, buying and selling gas and power. Enron created Enron Online (EOL) in Oct. 1999, an electronic commodities trading platform. Enron was the counterparty to every transaction on EOL; it was either the buyer or the seller. Fortune praised Enron for its expansions, naming it “America’s Most Innovative Company” for six consecutive years between 1996 and 2001.

Boom, then Bust

As Enron stock soared — reaching a high of $90.56 in August 2000 — Enron executives created off-balance sheet companies to hide debt and inflate profits. The scheme worked as follows: Enron would transfer some of its rapidly rising stock to the off-balance-sheet special purpose vehicles (SPV) in exchange for cash or a note. The SPV would subsequently use the stock to hedge an asset listed on Enron’s balance sheet. In turn, Enron would guarantee the SPV’s value to reduce apparent counterparty risk. Enron showed $352m in profits in 2000 from the sale of assets to its own subsidiaries. In August of 2001, an Enron vice-president sends an anonymous warning about questionable accounting practices that could lead the company to “implode in a wave of accounting scandals.”

Sarbanes-Oxley Act

In response to Enron and several other high-profile scandals, Congress passed what is known as the Sarbanes-Oxley Act (2002) to tighten internal controls and validate the work of auditors.

Section 404 of the SOX Act requires that management and auditors establish internal controls and reporting methods to ensure the adequacy of those controls. Section 802 of the SOX Act deals with destruction and falsification of records, the retention period for storing records and the specific business records that companies need to store, which includes electronic communications. The act had a profound effect on corporate governance, by making managers responsible for financial reporting and creating an audit trail or face serious criminal penalties. Internal audits play a critical role in a company’s operations and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements.

Accounting Lessons

Professor Mark Sheldon of the Boler College of Business, along with coauthors J. Gregory Jenkins and Velina Popova, explored the more recent impact of the Sarbanes-Oxley Act in their article “In Support of Public or Private Interests? An Examination of Sanctions Imposed Under the AICPA Code of Professional Conduct,” published in the Journal of Business Ethics. Specifically, the authors looked at the Public Company Accounting Oversight Board (PCAOB), one of the regulatory changes that followed the Enron scandal. They note the increased oversight begs a couple of questions: Have the misconduct and resultant punishment changed since SOX? And has the increased oversight added protections for the public? The authors find that increased outside oversight has produced three most common types of violations: (1) acts discreditable to the profession, (2) substandard professional service, and (3) criminal acts. The misdeeds are strikingly similar to those committed by public accountants during the 1990s, before the passage of SOX. But violators, the authors report, do face stronger sanctions and the punishment is targeted to protect public interest, versus misconduct that could hurt the private interests of the accounting profession. Such trends suggest that the government-mandated scrutiny provided by the PCAOB seems to have done what it was supposed to do: create an environment in which the accounting profession works to restore public trust.