Introduction
Enron’s brief but spectacular history is an example of how greed, desperation, and overly aggressive accounting practices can cause lasting damage to a company and initiate a ripple effect of change throughout all of corporate America. Laws and regulations were slow to keep pace with innovations in derivatives trading that constituted the main source of Enron’s income. Because of this, unethical traders and accountants at Enron were able to take advantage of this lack of understanding and oversight to hide deficiencies in the company’s balance sheet. As a result, the company imploded, causing thousands to lose their jobs, millions to lose their investments, and initiating a major change in the way that corporations practice accounting.
Early Years
Enron was created in 1985 as the result of a merger between Houston Natural Gas and InterNorth, a pipeline company. Soon after, the US government passed legislation to deregulate the gas industry meaning that Enron no longer had exclusive access to its own pipelines. Since transporting gas was a major source of Enron’s income, Kenneth Lay, the CEO of Enron, was desperate to find a new strategy to keep the company in business. He hired McKinsey & Co., a well-regarded consulting firm, to assist in the creation of a new strategy. McKinsey consultant Jeffrey Skilling, who would later become a key figure in the accounting scandal, came up with a brilliant solution that would become the source of Enron’s meteoric rise and subsequent crash.
Derivatives Trading
Skilling’s solution was to create a “gas bank.” In effect, Enron would serve as a middleman connecting gas producers to gas customers. Enron would buy the gas from producers when prices were low and sell to consumers at a higher price. Enron guaranteed the supply and price of gas to its customers insulating the customers from fluctuations in the market. In doing this, Enron created a new product called the energy derivative.
In 1990, after initial success with this new strategy, Lay decided to expand the derivatives business and hired Skilling to run the Enron Finance Corp. Enron Finance Corp was a new division dedicated exclusively to energy derivatives. Under Skilling’s guidance, the new division grew and continued to buy natural gas companies across the country. By the mid 90’s Enron dominated the gas derivatives business and was able to predict with great accuracy the rise and fall of the price of natural gas. In 1996, Skilling was promoted to Chief Operating Officer of Enron and with his new clout was able to convince Lay to expand the derivatives business into electricity. Like gas before it, Enron soon became the dominant player in electricity