Enron

Enron was formed in 1985 following a merger between Houston Natural Gas and Omaha-
based InterNorth. Kenneth Lay, who had been the chief executive officer (CEO) of Houston
Natural Gas, became Enron’s CEO and chairman, and quickly rebranded Enron into an
energy trader and supplier. Deregulation of the energy markets allowed companies to place
bets on future prices, and Enron was poised to take advantage.
By 1993, Enron had set up a number of limited liability special purpose entities that allowed
Enron to hide its liabilities, growing its stock price. Analysts were already criticizing Enron
for ‘swimming in debt’, but the company continued to grow developing a large network of
natural gas pipelines, and eventually moving into the pulp and paper and water sectors.
Enron was named ‘America’s Most Innovative Company’ by Fortune for six consecutive
years between 1996 and 2001.
Creative accounting allowed Enron to appear more powerful on paper than it really was.
Special purpose entities – subsidiaries that have a single purpose and that did not need to
be included in Enron’s balance sheet – were used to hide risky investment activities and
financial losses. Forensic accounting later determined that many of Enron’s recorded assets
and profits were inflated, and in some cases, completely fraudulent and non-existent. Some
of the company’s debts and losses were recorded in offshore entities, remaining absent from
Enron’s financial statements.
During the late 1990s and into the early 2000s, more and more special purpose vehicles
were created that allowed the company to keep debts off the books and inflate assets. These
entities, along with other accounting loopholes and poor financial reporting, let Enron
ultimately hide billions in debt from special deals and projects.
In August of 2001, shortly after the company achieved $100 billion in revenues, then-CEO
Jeff Skilling unexpectedly resigned, prompting Wall Street to question the health of the
company. Kenneth Lay once again took the helm, and both Lay and Skilling, in addition to
other Enron executives, began selling large amounts of Enron stocks prices continued to
drop – from a high of about $90.00 per share earlier in the year, to less than a dollar. The
U.S. Securities and Exchange Commission (SEC) opened an investigation.
Dec. 2, 2001 Less than a week after a white knight takeover bid from Dynegy was called off,
Enron filed for bankruptcy protection. The company had more than $38 billion in outstanding
debts. In the following months, the U.S. Justice Department initiated a criminal investigation
into Enron’s bankruptcy. Several Enron executives and Enron’s auditor firm, Arthur
Andersen, have since been indicted for a variety of charges including obstruction of justice
for shredding documents and conspiracy to commit wire and securities fraud, and some
have been sentenced to prison.
Questions
A Identify the ways in which Enron was out of control.
B What are the most important causal factors of this control problem? To what extent would
you consider this a problem of management control? What level of control was dysfunctional
according to the cascading idea of management control?
C Could appropriate management control have avoided this problem?
A. Ways in Which Enron Was Out of Control:
 1. Lack of Transparency and Misleading Financial Reporting: Enron’s use of special
purpose entities (SPEs) allowed it to keep liabilities off the balance sheet, creating
the illusion of profitability while hiding debt. This lack of transparency was a key
element of Enron being out of control as it misled investors, regulators, and
stakeholders about the company’s true financial health.
2. Creative Accounting and Fraudulent Practices: Enron engaged in “creative
accounting” practices that inflated profits and hid debts through complex accounting
loopholes. Many of its recorded assets and profits were either exaggerated or
completely fabricated. This manipulation of accounting data was a clear example of
the company being out of control.
3. Weak Ethical Standards and Governance: The top leadership at Enron, including
CEO Jeff Skilling and Chairman Kenneth Lay, was directly involved in selling large
amounts of Enron stock while the company was collapsing. This demonstrates a
breakdown in ethical management and corporate governance.
4. Inadequate Oversight by Auditors and the Board: Arthur Andersen, Enron’s
auditing firm, failed to provide appropriate oversight and instead facilitated the fraud
by shredding documents. The lack of effective checks and balances, both from the
auditors and Enron's board of directors, contributed to the company’s out-of-control
environment.
B. Most Important Causal Factors of the Control Problem:
1. Incentive Structure and Results Control:
o Enron’s focus on short-term stock price growth motivated executives to
engage in unethical behavior. The company's reliance on results controls
(such as stock-based incentives) without balancing them with ethical and
financial safeguards led to risk-taking and manipulation of financial reports.
This represents a misalignment of incentives, where the desire to increase
stock price took precedence over long-term company sustainability and ethical
behavior.
2. Management’s Role in Fostering a Culture of Deception:
o Enron’s leadership, particularly Kenneth Lay and Jeff Skilling, played a key
role in fostering a culture of deception and risk-taking. Instead of focusing
on sound business practices, they encouraged the use of SPEs and
aggressive financial tactics to artificially inflate stock prices.
3. Weak Internal and External Controls:
o Internally, there was a lack of effective control systems to ensure that
employees behaved in ways consistent with Enron’s long-term goals.
Externally, the company’s auditors, Arthur Andersen, failed to enforce proper
accounting controls, allowing fraudulent activities to continue without scrutiny.
Extent of the Problem as a Management Control Issue:
This was fundamentally a problem of management control at all levels. The cascading
failure occurred from the top-down:
  Strategic Control: Top executives pursued unsustainable and unethical strategies
aimed at artificially boosting stock prices rather than ensuring the long-term health of
the company.
 Operational Control: The use of SPEs and fraudulent accounting practices at the
operational level allowed the company to manipulate its financial data without
oversight.
 Cultural Control: Enron’s corporate culture was toxic, promoting excessive risk-
taking and rewarding short-term gains, which undermined the long-term stability of
the company.
According to the cascading idea of management control, the problem originated at the
highest level (strategic management) and cascaded down to the operational and cultural
levels. This dysfunctional control system affected both the top management decisions and
day-to-day operations, leading to widespread fraud and eventual collapse.
C. Could Appropriate Management Control Have Avoided This Problem?
Yes, appropriate management control systems could have prevented or at least mitigated
the collapse of Enron. Here’s how:
1. Stronger Results Controls with Ethical Safeguards:
o Results controls that align incentives with long-term goals rather than short-
term stock price gains would have helped. For instance, compensating
executives based on long-term performance metrics such as sustained
profitability and risk management would reduce the motivation for unethical
financial manipulation.
2. Improved Action Controls:
o Introducing stronger action controls through enhanced governance
mechanisms could have prevented risky and unethical actions. For example,
tighter restrictions on the creation of special purpose entities (SPEs) and
closer monitoring of financial reporting practices would have reduced
opportunities for fraud.
3. Enhanced Internal and External Audit Functions:
o If Enron’s auditors, Arthur Andersen, had properly followed accounting and
auditing standards, they could have flagged the discrepancies in Enron’s
financial reports. Strengthening both internal controls and external oversight
could have caught the fraudulent activities earlier. Independent pre-action
reviews could have also identified the risks associated with aggressive
accounting practices before they spiraled out of control(management control).
4. Cultural and Personnel Controls:
o Enron lacked a strong ethical culture. Implementing cultural controls that
promote ethics, transparency, and responsibility would have fostered a more
accountable environment. Personnel controls, such as training programs on
ethical decision-making, could have helped employees and managers resist
the pressure to engage in unethical behavior.