01The_Enron

Managerial FinanceEmerald Article: The Enron fallout: Was Enron an accounting failure?C. Richard Baker, Rick HayesArticle information:To cite this document: C. Richard Baker, Rick Hayes, (2005),"The Enron fallout: Was Enron an accounting failure?", Managerial Finance, Vol. 31 Iss: 9 pp. 5 - 28Permanent link to this document:/10.1108/03074350510769839Downloaded on: 22-09-2012Citations: This document has been cited by 2 other documentsTo copy this document: permissions@This document has been downloaded 4767 times since 2006. *Users who downloaded this Article also downloaded: *Gerald Vinten, (2002),"The corporate governance lessons of Enron", Corporate Governance, Vol. 2 Iss: 4 pp. 4 - 9/10.1108/14720700210447632(2003),"Enron: the ultimate lesson in irresponsibility: CSR left reeling from the biggest failure in US corporate history",Strategic Direction, Vol. 19 Iss: 6 pp. 10 - 13/10.1108/02580540310794660Gerald Zandstra, (2002),"Enron, board governance and moral failings", Corporate Governance, Vol. 2 Iss: 2 pp. 16 - 19/10.1108/14720700210430333Access to this document was granted through an Emerald subscription provided by UNIVERSITY OF SYDNEYFor Authors:If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service.Information about how to choose which publication to write for and submission guidelines are available for all. 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The organization is a partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.*Related content and download information correct at time of download.The En r on Fall o ut: Was En r on an Ac c ount i ngFail u re?by C.Rich ard Baker,Ac c ount i ng, Finance and Economics, Adelphi Uni v er s ity, New York and Rick Hayes, De part ment of Ac count ing,Col lege of Busi ness and Eco nom ics,Cal i for-nia State Uni v er s ity, Los An g eles.Ab s tractThis pa p er traces the de v el o p m ent of En r on Corp. from a regu l ated natu r al gas dis t ri b u t ion com p any to a world w ide en e rgy trad i ng com p any to its ul t i m ate de m ise in bank r uptcy in De c em b er 2001. The pa p er ex a m i nes whether En r on should be viewed as an ac c ount i ng fail u re, with in v es t ors and credi t ors be i ng se v erely mis l ed by false fi n an c ial state m ents, or whether it was a busi n ess fail u re that was ob s cured by ac c ount i ng prac t ices that strained the lim i ts of credi b il i ty. It is the con t en t ion of this pa p er that as t ute fi n an c ial analy s is would have re v ealed the in s ta b il i ty of the En r on busi n ess model, thereby alert i ng in v es t ors and credi t ors to the lack of cred i t w or t hi n ess of the com p any. At the same time, the pa p er ar g ues that had there been an ap p ro p ri a te level of trans p ar e ncy in the fi n an c ial state m ents, in v es t ors and credi t ors would have been pro v ided with a more re a l i s t ic view of the com p a -ny’s fi n an c ial po s i t ion and its re s ults of op e ra t ions, thereby fa c ili t at i ng their abil i ty to as -sess the vi a bil i ty of the com p any and avoid their bank r uptcy losses.Keywords:Credit w orthi ness,trans par ency,de reg u la tion,fi nan cial anal y sis,SPEs1.In tro duc tionThis pa p er traces the de v el o p m ent of En r on Corp from a regu l ated natu r al gas dis tri bu tion com p any to a world w ide en e rgy trad i ng com p any to its ul t i m ate de m ise in bank ruptcy in De c em b er 2001. The pa p er dis c usses whether the En r on bank r uptcy should be viewed as an ac c ount i ng fail u re, with in v es t ors and credi t ors be i ng mis l ed by false fi n an c ial state -ments, or whether it was a busi n ess fail u re that was ob s cured by ac c ount i ng prac t ices that strained the lim i ts of credi b il i ty. It is the con t en t ion of this pa p er that as t ute fi n an c ial analy s is would have re v ealed the in s ta b il i ty of the En r on Corp. busi n ess model, thereby alert ing in ves tors and credi t ors to the lack of cred i t w or t hi n ess of the com p any. At the same time, the pa p er ar g ues that had there been an ap p ro p ri a te level of trans p ar e ncy in the fi n an -cial state m ents, in v es t ors and credi t ors would have been pro v ided with a more re a l i s t ic view of the com p a n y’s fi n an c ial po si tion and its re sults of op era tions,thereby fa cili tat ing their abil i ty to as s ess the vi a bil i ty of the com p any and avoid their bank r uptcy losses.The re m ain d er of the pa p er pro c eeds as fol l ows. The first sec t ion dis c usses how de -regu l a t ion in the elec t ric power in d us t ry in the 1980s served as a prel u de to the crea t ion of En ron Corp.The sec ond sec tion ex am ines de regu la tion in the natu ral gas dis tri bu tion in-dus try and dis c usses how En r on was de s igned to take ad v an t age of busi n ess op p or t u n i t ies that arose dur i ng the de r egu l a t ory pro c ess. The third sec t ion ex p lains how En r on changed its busi n ess strat e gy from be i ng the larg e st pro d ucer of whole s ale elec t ric power and natu -ral gas in the coun t ry to be c om i ng the larg e st trader of en e rgy prod u cts and it as s esses whether this change in busi n ess strat e gy was suc c ess f ul. The fourth sec t ion dis c usses how En r on used of off- b alance sheet fi n anc i ng to hide its lack of cred i t w or t hi n ess. The fifth sec t ion dis c usses En r on use of mis lead ing ac count ing prac tices in re la tion to capi tal stocktrans ac tions,reve nue rec og ni tion and foot note dis clo sure.A fi nal sec tion con cludes the pa per.2. De r egu l a t ion of the Elec t ric Power In d us t ryUp un t il re c ently, the elec t ric power in d us t ry in the United States con s isted pri m ar i ly of reg u l ated elec t ric util i ty com p a n ies. The struc t ure of the elec t ric power in d us t ry was the re sult of fed e ral leg i s l a t ion that had been en a cted dur i ng the 1930s, the pur p ose of which was to pre v ent abuses that had arisen prior to the Great De p res s ion. In es s ence, the laws pro hib ited reg u lated elec t ric util i t ies from op e r a t i ng in more than one state and sub j ected such com p a n ies to rate of re t urn reg u l a t ion, whereby prices were set as a func t ion of a fixed al l ow a ble rate of re t urn on share h old e rs’ eq u ity. The en e rgy cri s es of the 1970s, pro -moted the US Con g ress to pass a num b er of laws that were in t ended to re d uce Amer i ca’s de p end e nce on crude oil from the Mid d le East, in c lud i ng cer t ain laws that par t ially de r eg -u l ated the elec t ric power in d us t ry. As the en e rgy cri s es sub s ided dur i ng the 1980s, many of the de reg u la tion ini tia tives w ere not fully im p le m ented. How e ver, these laws did not dis ap pear;in stead,in di vid u als and com pa nies w ho saw ad v an t ages to be gained from the en ergy ini tia tives con tin ued plan ning and lob by ing and w ork i ng to w ards their goals. Enron was one of the com p a n ies that was cre a ted in the wake of the US gov ern ment’s en-ergy ini t ia t ives of the late 1970s and 1980s.2.1The Reg u la tory/Le gal Frame work of De reg u lated Elec tric ity Pro duc tion in the USThe Pub l ic Util i ty Reg u l a t ory Pol i c ies Act of 1978 (PURPA) was en a cted by Con g ress to en cour age en ergy con ser va tion and in creased elec tric ity pro duc tion.Ti tle IT of PURP A re quired the US Fed eral En ergy Reg u la tory Com mis sion(FERC)to is sue reg u la tions to en c our a ge small power pro d uc t ion (i.e. al t er n a t ive en e rgy) and cogeneration (i.e. the si -mul t a n eous gen e r a t ion of elec t ric i ty and use f ul ther m al en e rgy). As a part of its gen e ral frame w ork, FERC stip u l ated that reg u l ated elec t ric com p a n ies had to pur c hase pow er from “qual i f ied fa c il i t ies” (QFs). QFs were de f ined as “small power pro d uc t ion fa c il i t ies”and “cogeneration” fa c il i t ies. A small power pro d uc t ion fa c il i ty was de f ined as a power plant pro d uc i ng less than 80 mega w atts of elec t ric i ty that was fu e led by an al t er n a t ive en -ergy source, such as w a t er, w ind, so l ar, bio m ass, w ood, mu n ic i p al w aste, other solid w aste, or geo t her m al en e rgy. A qual i f ied cogeneration fa c il i ty w as de f ined as a pow er plant that pro d uced both elec t ric i ty and use f ul ther m al en e rgy, such as steam or heat. A qual i f ied cogeneration fa c il i ty could be of any size as long as the per c ent of ther m al en e rgy pro d uced was not less than 5% of the to t al en e rgy out p ut (Baker, 1992).To be c ome a QF, a de v el o per had to file an ap p li c a t ion with the FERC. The im p or -tance of be c om i ng a QF was ob v i o us in that reg u l ated elec t ric util i t ies were not re q uired to pur c hase elec t ric i ty from other than QFs, and in most states the reg u l ated com p a n ies would not agree to pur c hase elec t ric i ty un l ess a pro j ect was a QF. Prior to the pas s age of PURPA there had been some power sales agree m ents ne g o t i a ted on an arm’s length ba s is be t ween in d us t rial com p a n ies and reg u l ated elec t ric util i t ies. This was com m on in the Gulf Coast of Texas where there are large pet r o c hem i c al fa c il i t ies fu e led by nat u r al gas. Hous -ton Nat u r al Gas Com p any (the orig i n al name of Enron Corp.) was one of the pri m ary sup -pli e rs of nat u r al gas to both pet r o c hem i c al and cogeneration fa c il i t ies in the 1980s (Baker, 1992).2.2 Pro j ect Fi n anc i ng of In d e p endent Power Pro j ectsIn the 1980s, in d e p end e nt power proj e cts were fi n anced pri m ar i ly through proj e ct fi n anc -ing. In a proj e ct fi n anc i ng, the lender looks to the cash flows and the as s ets of the proj e ct as col l at e ral for the loan. There f ore, it is im p or t ant that there be a long- t erm con t ract for the sale of the facili t y’s out p ut (i.e. elec t ric i ty), and the long- t erm con t ract had to be with a cred it w or thy en tity(i.e.a regu lated elec tric util ity com pany).Pro ject fi nanc ing of in de-pend e nt power proj e cts de v el o ped slowly dur i ng the ini t ial years af t er the pas s age of the PURPA law in 1978. Few fi n an c ial in s ti t u t ions took an in t er e st in pro v id i ng fi n anc i ng for such proj e cts. There were sev e ral rea s ons for this re l uc t ance, in c lud i ng lack of ex p e r i e nce on the part of de v el o p e rs, un f a m ili a r i ty with proj e ct fi n anc i ng on the part of lend e rs, and the use of new and un p roven tech n olo g ies. As the ex p e r i e nce of both de v el o p e rs and lend -ers in c reased, the number of banks and other fi n an c ial in s ti t u t ions ac t ive in the field of proj ect fi nanc ing also in creased.In the1980s,the pri mary fi nan cial in sti tu tions pro vid ing loans to in d e p end e nt power proj e cts were banks with ex p e r i e nce in proj e ct fi n anc i ng in ar -eas such as min i ng, pipe l ines, and oil and gas ex p lo r a t ion. Among these banks were Ci t i -bank, Bar c lays, Mor g an Guar a nty and Chase Man h at t an Bank. These banks sub s e q uently be c ame the pri m ary lend e rs to En r on Corp. (Baker, 1992).At the in c ep t ion of the in d e p end e nt power in d us t ry, lend e rs re f used to lend more than sev e nty- five per c ent of the to t al costs of a proj e ct. Since de v el o p e rs of in d e p end e nt power proj e cts were of t en thinly capi t al i zed, there was a need for eq u ity capi t al or sub o r d i -nated debt. In the early 1980s, eq u ity capi t al for in d e p end e nt power proj e cts was eas i er to ob t ain than sub s e q uently be c ause of the ex i s t ence of tax in c en t ives pro v ided by the US gov e rn m ent, in c lud i ng a 10% in v est m ent tax credit, five year de p re c ia t ion write- o ffs, and ad d i t ional tax cred i ts of up to 15% for al t er n a t ive en e rgy. These tax in c en t ives were a form of pub l ic pri v ate part n er s hip, in that tax p ay e rs were sub s i d iz i ng the crea t ion of the in d e -pend ent pow er in dus try.These tax in cen tives al low ed in vest ments in in de pend ent pow er proj e cts to seem less risky from an in v es t or’s per s pec t ive. The risk was re d uced be c ause most of in v est m ent could be de d ucted as an ex p ense for fed e ral in c ome tax pur p oses or taken di r ectly as a credit against fed e ral in c ome taxes. These tax in c en t ives spawned a large sub in d us t ry of law y ers, in v est m ent bank e rs and ac c ount a nts who struc t ured proj e ct fi nanc ing ar range ments for in de pend ent pow er proj ects(Baker,1992).By the end of the 1980s all of the tax sub s i d ies for in d e p end e nt power proj e cts were elimi n ated by Con g ress be c ause of grow i ng fed e ral budget defi c its. Af t er w ards, in v est -ments in in d e p end e nt power proj e cts had to be evalu a ted based on cri t e r ia other than the tax sub s i d ies that the in v est m ents pro d uced. This caused a con s oli d a t ion in the in d e p end -ent power in d us t ry which fa v ored more ef f i c ient pro d uc e rs. Since the eco n om i cs of elec -tric pow er gen era tion fa vor natu ral gas com bus tion tur bines,de vel op ers w ho con trolled natu r al gas sup p lies were in a po s i t ion to be c ome domi n ant play e rs in the in d e p end e nt pow er in dus try.Rec og niz ing the po ten tial to be come domi nant play ers,both Hous ton Natu r al Gas Com p any and Inter- N orth (the origi n al prede c es s or com p a n ies of En r on Corp.) en t ered the in d e p end e nt power busi n ess in the mid 1980s.3. De r egu l a t ion of Natu r al Gas and the Crea t ion of En r onKen n eth Lay joined En r on Corp. in 1984 when it was still called Hous t on Natu r al Gas Com p any. Lay had a stra t e g ic vi s ion re g ard i ng the fu t ure of the natu r al gas dis t ri b u t ion in -dus t ry which fo c used on de r egu l a t ion and growth through merg e rs, ac q ui s i t ions and over -seas ex pan sion.This strat e gy in c luded a move into in d e p end e nt power pro d uc t ion, with natu r al gas as the cor n er s tone. In July 1985, Hous t on Natu r al Gas Com p any merged with North e rn Natu r al Gas Com p any to form En r on Corp. (En r on Corp., 2002). The pri m ary as s et of the com bined com pany w as an in ter state gas dis tri bu tion net w ork con sist ing of ap proxi mately 37,000 miles of pipe. Af t er lob b y i ng ef f orts by Ken Lay and oth e rs, in Oc t o b er 1985, the US Fed e ral En e rgy Regu l a t ory Com m is s ion (FERC) is s ued Or d er No. 436, al l ow i ng natu -ral gas pipe lines to be come open-access trans port ers.Pre vi ously,gas dis tri bu tion com pa-nies w ere regu lated and ver ti cally in te grated(Stra te gic Man age ment Whar ton,2002).The FERC or d er de r egu l ated the natu r al gas in d us t ry by sepa r at i ng the pro d uc t ion, long-distance trans mis sion and lo cal dis tri bu tion func tions,leav ing each func tion to a dif fer ent set of par tici pants.Ul ti mately,En ron re tained the in ter state pipe line dis tri bu tion net w ork w hile phas ing out its ex plo ra tion and lo cal dis tri bu tion ac tivi ties.Ken neth Lay be came the Chair m an of En r on Corp. in Feb r u a ry 1986 (Stra t e g ic Man a ge m ent Whar t on, 2002).3.1Trans form ing the Regu lated Gas Dis tri bu tion In dus tryBe t ween 1986 and 1996 En r on’s busi n ess strat e gy was fo c used on three pri m ary ar e as. The first area in v olved a trans f or m a t ion of the natu r al gas pipe l ine busi n ess from a regu -lated com p any to an open ac c ess, mer c hant trans p orter of natu r al gas. This trans f or m a t ion al l owed En r on to sell natu r al gas through o ut the United States at un r egu l ated prices. En -ron’s pipe l ine net w ork w as en l arged through ac q ui s i t ions of other pipe l ine sys t ems in Flor i da and the Pa c ific North w est. In 1989, En r on cre a ted Gas B ank, an en t ity who’s pur -pose was the whole s ale trad i ng of natu r al gas fu t ures con t racts. Gas B ank al l owed buy e rs and sell e rs of natu r al gas to en t er into for w ard com m it m ents to hedge the risk of vari a ble spot mar k et prices. As Gas B ank de v el o ped, En r on be c ame the larg e st natu r al gas mer c hant in North Amer i ca (En r on Corp., 2002).3.2 Ex p an s ion Out s ide of the United StatesThe sec o nd fo c us of the Enron busi n ess strat e gy was to be c ome a de v el o per of in d e p end -ent power plants out s ide the United States. One of Enron’s first over s eas pro j ects was the de v el o p m ent of a 1,875 mega w att (MW) power plant in Teesside, Eng l and. Upon com p le -tion in 1993, the Teesside pro j ect be c ame the world’s larg e st nat u r al gas-fired power plant. Af t er the Chan n el Tun n el, Teesside was the larg e st pro j ect fi n anc i ng ever com p leted in the UK (Enron Corp., 2002). Lord Wakeham, the for m er Sec r e t ary of State for En e rgy in the Con s er v a t ive Gov e rn m ent, played an im p or t ant role in the de v el o p m ent of the Teesside pro j ect. Sub s e q uently, Lord Wakeham be c ame a mem b er of Enron’s Board of Di r ec t ors. He was a mem b er of the Au d it Com m it t ee of the Board at the time of Enron’s bank r uptcy and was there f ore in a po s i t ion to know about Enron’s busi n ess strat e gy (BBC, 2002).Enron’s over s eas ex p an s ion strat e gy also en c om p assed the de v el o p m ent of a very large (2,450 MW) power pro j ect lo c ated near Mumbai, In d ia (the Dabhol pro j ect). The first phase of the Dabhol pro j ect be g an in late 1996 and it achieved com m er c ial op e r a t ion in May 1999. How e ver, by the be g in n ing of 2002, the pro j ect was not yet com p lete, and the In dian Gov ern ment w as con tem plat ing ter mi nat ing the pow er pur chase agree ment for the pro j ect (The Fi nan cial Ex press, 2002). Other Enron pro j ects in c luded the de v el o p m entof a 790 MW gas fired power plant at Sutton Bridge, Eng l and and the ac q ui s i t ion of Wes -sex Wa t er Com p any, also lo c ated in Eng l and (Enron Corp., 2002). This lat t er ac q ui s i t ion, along with the ac q ui s i t ion of a wind en e rgy com p any, Zond En e rgy, ap p eared to sig n al a di v er s i f i c a t ion away from Enron’s pri m ary fo c us on nat u r al gas-fired power plants.3.3In vest ing in In de pendent Power Pro duc tionThe third fo c us of En r on’s busi n ess strat e gy was to in v est in in d e p end e nt power proj e cts in the US, both as a sup p lier of natu r al gas to the proj e cts and as an eq u ity par t ici p ant. The US En e rgy Pol i cy Act of 1992 changed the struc t ure of the elec t ric power in d us t ry by cre -at i ng a com p eti t ive whole s ale mar k et for elec t ric i ty and grant i ng open ac c ess to trans m is -sion lines simi l ar to what had hap p ened in the natu r al gas in d us t ry (Bat t e l es, 1999). There was, how e ver, a re m ain i ng bar r ier to the rapid ex p an s ion of the in d e p end e nt power in d us -try, namely, the Pub l ic Utili t ies Hold i ng Com p any Act of 1935. This law had been en a cted dur i ng the Great De p res s ion to pre v ent abuses in the elec t ric power in d us t ry like those per -petu a ted by Sam u el In s ul. Dur i ng the 1920s, In s ul’s Chi c ago Edi s on hold i ng com p any was a multi- t iered cor p o r ate en t ity with own e r s hip in t er e sts in doz e ns of elec t ric i ty com p a -nies through o ut the US. Af t er the 1929 stock mar k et crash, the In s ul hold i ng com p any col -lapsed, much like En r on did in 2001. In 1993, af t er sig n ifi c ant lob b y i ng ef f orts with the fed e ral gov e rn m ent, En r on was granted an ex e mp t ion from the Pub l ic Utili t ies Hold i ng Com p any Act of 1935. This ex e mp t ion elimi n ated the re m ain i ng bar r ier to En r on’s rapid ex pan sion in the in de pend ent pow er in dus try(La ba ton,2002).Fur ther more,the ex emp-tion al l owed En r on to ac q uire an en t ire elec t ric power com p any, an ac t ion which would have been pro h ib i ted only a few years ear l ier (Kahn and Gerth, 2001).In late 1996, En r on an n ounced that it would ac q uire Port l and Gen e ral Elec t ric Com -pany. When this merger was com p leted in Janu a ry 1997, it com b ined En r on, which by then was the larg e st mar k eter of natu r al gas and whole s ale elec t ric i ty in North Amer i ca, with Port l and Gen e ral, a prof i t a ble elec t ric util i ty lo c ated in one of the fast e st grow i ng re -gions of the US. With own e r s hip of more than 5,900 mega w atts of elec t ric i ty gen e r a t i ng ca p ac i ty and more than 37,000 miles of natu r al gas pipe l ine, the com b ined com p any was well- p ositioned to be c ome a domi n ant player in the de r egu l ated natu r al gas and elec t ric power in d us t ries (En r on Corp., 1996). In the fol l ow i ng quo t a t ion from the press re l ease which an n ounced the merger, Ken n eth Lay ex p lained En r on’s busi n ess strat e gy:This pro posed merger w ith Port land Gen eral rep re sents an out stand ing op por tu nityfor us to cre a te the lead i ng en e rgy com p any of the fu t ure in the North Ameri c an en e rgymar k ets. By com b in i ng the natu r al gas and elec t ric i ty mar k et i ng and risk man a ge m entex p er t ise of En r on with the whole s ale and re t ail elec t ric i ty ex p er t ise of Port l and Gen -eral, along with its re l ated as s ets and skilled em p loy e es, we are uniquely po s i t ioned tobe the leader in the in c reas i ngly com p eti t ive natu r al gas and elec t ric i ty mar k et p lace.This stra t e g ic merger is ex p ected to be ac c re t ive to En r on’s earn i ngs per share be g in -ning in the first year af t er com p le t ion of the merger, and is thus con s is t ent with ourlong-term com pound an nual earn i ngs growth tar g et of at least 15 per c ent. The de r egu -la t ion of the elec t ric i ty mar k et in North Amer i ca rep r e s ents one of the most sig n ifi c antin d us t ry re s truc t ur i ngs ever. Just as coal was the pri m ary en e rgy source of the 19thCen t ury, and oil was the pri m ary fuel of the 20th Cen t ury, we be l ieve natu r al gas andelec t ric i ty will con v erge as the pri m ary sources of en e rgy in North Amer i ca and manyother mar k ets around the world for the 21st Cen t ury. Ten years ago, En r on suc c ess f ullyVolume 31 Number 11 200510 em b arked on a new strat e gy to com p ete in the newly de r egu l ated natu r al gas mar k et inNorth Amer i ca. Cus t omer choice and com p e t i t ion in natu r al gas, at the whole s ale leveland more re c ently at the re t ail level, have been a great suc c ess for con s um e rs and theAmeri c an econ o my. By ap p ly i ng the ex p e r i e nce gained in the natu r al gas mar k et, En -ron has be c ome, in a very short pe r iod of time, the larg e st in d e p end e nt mar k eter ofwhole s ale elec t ric i ty in North Amer i ca. As the move to w ard de r egu l a t ion in the re t ailsec t or pro l if e r a tes, En r on is poised to par t ici p ate as a leader in the evo l u t ion to w ard acon v erged gas and elec t ric i ty mar k et, with more prod u ct choices and com p eti t iveprices for all cus t om e rs, large and small, both whole s ale and re t ail (En r on Corp.,1996).De s pite the en t hu s i a sm sur r ound i ng the merger be t ween Enron and Port l and Gen -eral, within three years, Enron tried to sell Port l and Gen e ral to an o ther com p any (Enron Corp., 2001). This was be c ause the busi n ess strat e gy of be c om i ng the dom i n ant player in the de reg u lated nat u ral gas and elec t ric power in d us t ries was prov i ng to be not as prof i t -able as Lay had hoped.Con s e q uently, Enron’s de r eg u l a t ion strat e gy was re p laced in the late 1990s with a new strat e gy which was to be c ome the dom i n ant bro k er in en e rgy re l ated prod u cts and other types of com mod i ties and ser vices,in clud ing met als and broad band com mu ni ca tion (Stra te gic Man a ge m ent Whar t on, 2002). This change of busi n ess strat e gy w ill be dis -cussed in the fol low ing sec tion.4. A Change in Enron’s Busi n ess Strat e gyIn 1985, when Enron was cre a ted, its pri m ary busi n ess strat e gy was to max i m ize the po -ten t ial of its in t er s tate gas pipe l ine net w ork. At that time, reg u l ated gas pipe l ine com p a n ies were ver t i c ally in t e g rated, con t rol l ing the nat u r al gas from well h ead to con s umer. The de -reg u la tion pro cess of the1990s sep a rated the pro duc tion,trans mis sion and lo cal dis tri bu-tion func t ions and forced the sur v iv i ng com p a n ies to op e r a te in a mar k et en v i r on m ent. This new en v i r on m ent al l ow ed in t er m e d i a r i es to cre a te con t racts for fu t ure de l iv e ry of nat u r al gas. Prior to de reg u la tion,large in dus trial us ers of nat u ral gas,in clud ing reg u lated elec t ric pow er com p a n ies, could re l i a bly fore c ast their fu t ure fuel costs by ref e r e nce to a reg u lated tar iff.Af ter de r eg u l a t ion, large us e rs of nat u r al gas had to pro t ect them s elves by en ter ing into con tracts for fu t ure de l iv e ry of nat u r al gas at agreed upon prices and quan t i -ties. Be t ween the con t ract date and the de l iv e ry date, the price of the gas could vary. The sup p lier of the nat u r al gas could dis c over that it had prom i sed to sell at a price that was lower than the cur r ent price, while the pur c haser might find that it could buy gas for less than it had agreed to pay. Con s e q uently, a mar k et for nat u r al gas de r iv a t ives con t racts (e.g. for w ards, fu t ures and op t ions) be g an to de v elop. In the late 1990s, Enron changed its busi n ess strat e gy to a fo c us on be c om i ng the dom i n ant player in the mar k et p lace for en -ergy de r iv a t ives. This change in Enron’s busi n ess strat e gy al l owed it to con t inue to be the larg e st mer c hant of nat u r al gas and elec t ric i ty in North Amer i ca with o ut main tain ing a large in v est m ent in tan g i b le fixed as s ets such as pipe l ines and pow er plants (Stra te gic Man age ment Whar ton,2002).4.1 Was the Change in Strat e gy Suc c ess f ul?Even though En r on’s share price rose stead i ly from 1996 through 2000, there was a sig -nifi c ant vari a nce its earn i ngs per share growth. The an n ual 15% growth tar g et for earn i ngs per share, set by Ken Lay in 1996, was not met. As Ta b le 1 in d i c ates, En r on’s di l uted earn -ings per share fell 4% in 1997, rose 16% in 1998, rose 26% in 1999, and fell 12% in 2000.The vola t il i ty of En r on’s EPS was ex p lained to the fi n an c ial com m u n ity by point i ng to non-recurring im p air m ent charges and the cu m u l a t ive ef f ect of ac c ount i ng changes. In the face of a strong bull mar k et, these ex p la n a t ions were taken at face value. En r on’s price earn ings mul ti ple rose from 23.7 in 1997 to 74.3 in 2000. En r on was counted as one of Ameri c a’s best com p a n ies. The ques t ion is whether there were prob l ems lurk i ng be h ind the num b ers.Volume 31 Number 9 2005 11。