Enron Accounting Scandal - Assignment Example

Enron Case Study Name Institution Course Tutor Date Abstract The Enron scandal represents one of the worst accounting scandals in American history. This is an example of an accounting fraud whereby complex accounting procedures are used to falsify financial statements by a corporation and to conceal the true facts of the entity’s financial situation. Enron Corporation was created after Internorth (Omaha) and Houston Natural Gas Company merged becoming the United States largest gas pipeline business. The approach used in researching additional resources for the case was searching various journal databases and texts with the words ‘Enron accounting scandal’. The events leading to the collapse of Enron Corporation started in 1980s when the energy sector was deregulated. The management of Enron changed its strategy and started using mark-to-market accounting as well as creating Special Purpose Entities. The accounting professionals did not perform their work as required and this created problems for the company. The executives of the company used creative accounting techniques in keeping their share price high. It also used manipulative accounting practices to have favourable financial statements. Andersen, Enron’s external auditor did not report these anomalies in their reports to the board of directors. The lesson that I have learned from Enron case is that the management of a company should not have any material conflicts of interests. I have also learn that there is a need for accounting firms to have a separate firm that audits it and one which offer consulting activities Introduction Enron was an American corporation that specialised in energy trading, electric utilities and natural gas. The company was founded in 1985, and its operations were based in Houston, Texas. Enron rise meteorically and it was soon to become listed as Fortune’s best 100 companies. It expanded its operations all over the world into South America, India, and London among other places. The energy sector was deregulated in early 1980s which led Enron to rise as the giant energy company in the United States. In 1989, Enron started trading in the futures markets and it heavily benefited from the gas contracts that were carried out between consumers and suppliers. Enron slowly began to be a dominant player in the energy market in 1990s by controlling a sizeable percentage of the gas business. Due to success the company had been realising, it created markets in various energy-related products. For example, it offered companies an opportunity to hedge against certain risks such as weather and adverse price movements. In early 2000, Enron began an ambitious plan of venturing into broadband internet networks. It traded in bandwidth capacity and the business prospered. This dynamic idea together with the stable energy business, the company was appealing to the investors leading Enron’s share price to rise. Since it began its operations, Enron had been having a profitable business reflected by the rise in its annual revenues to more than $100 billion in 2000 from just $9 billion in 1995 (Li 2010, p. 37). Its share price also soared to $90 per share in the middle of the year 2000 before the scandal began. This was to be the highest point in the company’s history as Enron became bankrupt in 2001 and it subsequently collapsed. Enron accounting scandal is one of the America’s worst corporate scandals in history. The events that led to the Enron scandal started with the deregulation of the energy sector in 1980s. The executives of the Enron Corporation were now able to retain agency over the reported earnings that were given to the company’s investors and employees. This agency made it possible for the reported earnings of the company to be out of ordinary and very much skewed. In fact, illustration of losses was entirely absent in the financial books of the company. This prompted investors to increase their investments in what appeared to be a very profitable corporation. Misrepresentation of the facts resulted in the embezzlement of investors funds by the Enron’s executives while at the same time reporting falsified earnings to them. This resulted in proliferation of more investments by these shareholders and new investors were also attracted. In 2000, there were signs that something was wrong with the company. Subsequently, Enron made a public statement by admitting that a critical circumstance exists in California regarding natural gas supply. Nevertheless, after retroactive review, it was suspected that the company created this crisis in its bid to prepare for fraud discovery it had committed. The fraud was later discovered leading to the bankruptcy of the company and it consequently collapsed. The major players in Enron’s scandal are the chairman and Chief Executive Officer Kenneth Lay, Jeffrey Skilling, Rebecca Mark- head of Enron’s failed international businesses and its Chief Financial Officer, Andrew Fastow. Jeffrey Skilling was responsible for implementation of mark-to-market accounting in the company. During his tenure, Enron started EnronOnline where trading of energy commodities contracts with Enron was carried out in this internet-based service. At long last, the company was not able to cover its transactional capital costs, and this was among the reasons for Enron’s bankruptcy. On the other hand, Andrew Fastow, Enron’s CFO masterminded Special Purpose Entities at the company. He was responsible for making complicated financial structures that enabled Enron to hide its debts and losses. The chairman of Enron, Kenneth Lay contributed to Enron’s bankruptcy after he embezzled the assets of the company. Moreover, Lay played a part in conspiring to hide the fraud that was taking place in the company and its imminent downfall. Auditing of Enron’s financial information was carried out by a reputable audit firm, Arthur Andersen. Enron used aggressive accounting practices that resulted in the removal of liabilities from its statement of financial position, improved profitability position, and reduction of profit volatility (Tan & Yeo 2006, p. 643). These were achieved after the company structured various transactions in a complex and “innovative” manner. The majority of these transactions pertained to the creation of special purpose entities by the company resulting in hiding of losses and fabrication of earnings. In theory, Enron was having a remarkable range of corporate governance mechanisms in place prior to bankruptcy. The individuals that governed the company were highly qualified and well respected in various fields such as law, finance and accounting. Its Board of Directors was composed of several committees that were tasked with reviewing aspects of Enron’s policies and operations (Tan & Yeo 2006, p. 643). The culture and ethical foundations of Enron had a solid background. Cash and stock options were given as bonuses and incentives to the most hardworking and motivated employees. This led Enron to be an admired company and a competitive place of work. Employees rushed to finish projects because they know they will receive bonuses notwithstanding the project outcome. Performance review committee was established by the management to make employees become aggressive in their work. This resulted in the creation of culture within Enron whereby cooperation was replaced by competition (Healy & Palepu 2003, p. 13-14). The culture around Enron was influenced to a large extent by competition and large bonuses motivated employees. Moreover, if employees did not perform to the required standards, they get scared because they were likely to be laid off. This caused unhealthy competition among employees. It led to a bad working environment as money became a strong incentive that would not rule out illegal and immoral things from happening. These are some of the specific issues within Enron Corporation. Q 1: While describing the context of Enron, illustrate why was Enron an admired company prior to 2000? The collapse of Enron Corporation is a perfect example of executive piracy that has happened in the United States history. A company cannot be just admired because it is largest company in a given sector or control majority of undertakings in a given industry. There must be things that it does well that appeals to many people including employees, other stakeholders and the general public. At its infant stage of operation, Enron was not an admired company. However, Enron slowly changed its vision. In early 1990s, Enron evolved as a company that buys, sells and exploit markets such as futures and commodities. It exploited deregulation and build its existing domestic infrastructure to consolidate its market position. Furthermore, under the leadership of Rebecca Mark, head of international operations, Enron carried massive investments in energy assets. For example, it set up a power plant in India. All these undertakings contributed immensely to making Enron an admired company. Enron had a competitive working environment. The bonuses and incentives that were given to its employees as a way of motivating them appeal to many people. Every potential employee dreamed of working for Enron. Enron had a retirement plan for its employees’ which was a very lucrative deal. The revenues of the company were increasing year after year meaning that the retirement package also increase as employees were paid based on performance through bonuses which was more in comparison with the industry norms (Healy 2013, p. 04). This greatly contributed to Enron being an admired company. In fact, it was at one stage voted as a company that was the most innovative in the Fortune’s “most admired companies (Healy & Palepu 2003, p. 03). The brightest minds in the accounting and auditing sectors in America worked for Enron and this led the company to be praised by financial analysts, business reporters, as well as renowned business school professors. This increased the admiration that people had of Enron Corporation. Q2: What led to the rise and fall of Enron? Your discussion should revolve around the role of accounting professionals only (direct or indirect). Several factors can be identified that contributed to the rise and fall of Enron. Specifically, accounting professionals such has financial analysts, accountants, auditors and investment banks played a major part in Enron’s rise and demise. Jeff Skilling is an accounting professional that took advantage of the deregulated energy sector to steer Enron into a successful company. Deregulation led to volatility in gas prices to increase (Healy & Palepu 2003, p. 06). Moreover, it increased the supply of gas and lowered its prices. Through Skilling visionary skills, Enron’s gas trading business was very successful. Although it was a successful venture, Skilling further refined this trading model. The company started divesting “heavy” assets by involving itself in an “asset light” business model. Consequently, Enron’s gas financial transactions significantly increased and it was twenty times more than its pipeline capacity (Healy & Palepu 2003, p. 07). In mid-1990s, through stewardship of the head of international operations Rebecca mark, Enron extended its gas trading model to international markets. Due to this strategy, the company increase their growth rate. The management of Enron used creative accounting techniques in order to keep their share price high and used manipulative accounting practices to register favourable financial statements. This situation was achieved through collusion between the firm and its auditing firm, Andersen LLP that failed to report any irregularities in the accounting books. The rating agencies also played some part in the rise of Enron Corporation as they highly rated the company which appeal to many investors. As fate would be, the reasons for Enron’s rise to success significantly contributed to its downfall. The accounting policies adopted by Enron, creation of special purpose entities and competitive working environment contributed to the fall of Enron. The management of Enron through its CEO, CFO and its chairman colluded to adopt mark-to-market accounting technique to hide the unhealthy financial situation in the company. The accounting system resulted in investors receiving misleading information about the company. Facts about the financial difficulties were concealed by its CFO Andrew Fastow. The management of Enron used special partnerships as a way of window-dressing its accounting figures hence seeking capital for the company on favourable terms (Nanda 2003, p. 02). The partnerships become unsustainable due to the huge debt burden and it collapses. Senior managers at Enron aggressively promoted the shares of Enron publicly while they unloaded personal stakes in the company at the same time. They did not give responsible leadership that accounting practice needed. The board of directors also contributed to the collapsing of Enron Corporation. It did not undertake proper oversight as required and allowed all the manipulations of accounting procedures despite being among the highest compensated boards in the world (Nanda 2003, p. 02). The role of external auditors is to assess the financial statements of the firm and find out whether it presented them according to the generally accepted accounting standards (GAAP). Andersen, Enron’s external auditor had a close working relationship with the company. The internal documents of Andersen indicated that the audit firm viewed Enron as a company that engages in high-risk accounting (Healy & Palepu 2003, p. 10). Despite this fact, Andersen never shared these concerns with the audit committee of Enron. In addition, the auditor fails to report many other accounting irregularities in the firm. Financial analysts also failed to detect any extraordinary events at Enron although they were generating earnings forecasts and stock recommendations through detailed research reports. Consultants, investments bankers and credit rating agencies helped Enron in its schemes hence leading the company towards to downfall. Q3: Why were Enron’s internal and external checks and balances system fail to prevent its demise? Your discussion should revolve around the role of auditors and the accounting regulations. Internal and external checks and balances system in a company when they are working properly has the capability of preventing a company from collapsing. This was not the case for Enron Corporation which they failed significantly due to a number of reasons. The sudden change of Enron’s accounting system to market-to-market accounting system strained the internal checks and balances system. This was because mark-to-market method is usually used by financial companies. The method corrupted Enron’s books of accounts which became very difficult to rectify. The audit committee of Enron had a habit of having short meetings while most of the company operations were covered (Healy & Palepu 2003, p. 14). In this case, they were unlikely to detect any irregularities in the company. Moreover, they rely to a large extent on information provided by the management and the auditors. This means that the audit committee would not detect any problem if auditors fail or if management is fraudulent. The regulatory framework was weak and it could not properly govern the highly skilful manipulation of accounts hence unable to prevent the demise of Enron. Q4: Would continuous auditing have prevented the Enron? Continuous auditing would have prevented Enron Corporation debacle. A continuous audit that is carried out in a correct manner is capable of detecting many operational problems in a company. If continuous auditing was being carried out, most of the operational problems of Enron would have been known much earlier. In fact, a continuous audit was capable of providing processes assurance that were not part of Enron’s final financial report. Continuous auditing would have prevented Enron’s mess because audit results that are produced are simultaneous with the relevant events. It uses online information technology in providing a variety of forms of assurance. It is sensitive to transactions that are extraordinary like those of Enron’s. Continuous auditing would have identified Enron’s related-party partnerships that were not reported. Furthermore, the abnormal transactions with special purposes entities would have been detectable since there is software that monitors transactions in a continuous manner and make a comparison between their characteristics and the expected results. Q5: Why did the Board of Directors fail to prevent Enron’s demise? And, what role the Board should have played in setting Enron’s accounting policies to prevent its demise? Enron’s board of directors would have prevented the company from collapsing, instead, it did not. This is due to a number of reasons. There were clear inappropriate conflicts of interest. Additionally, the board of directors’ exercised inadequate oversight hence could not protect shareholders of the company. They allowed Enron to engage in transactions that had an inappropriate conflict of interest. Furthermore, it did not prevent the company from engaging in high-risk accounting. It was privy to numerous questionable practices by the management of Enron for many years, but did not take any action. The board also lacked independence as some board members had financial ties with the company. In addition, it failed in ensuring that the company’s auditor is independent after it allowed Andersen to undertake internal audit as well as provide consulting services while at the same time being Enron’s outside auditor. The board should have reviewed overall business strategy in terms of setting up accounting policies that benefited the company. Q6: Describe in general terms the breaches of accounting and ethical conduct that occurred within Enron. Use the resources provided, identify accounting and ethical codes of conduct that would apply to the accounting profession. In any accounting scandal or corporate failure, there are breaches of accounting and ethical conduct. Generally, in a profession such as accounting, the conduct of those put in charge of an organisation should put the interests of their clients first. This code of conduct was breached by both Enron’s board of directors and the management. They partly pursue their self-interest over the interest of the shareholders. The management of Enron breached the duty of good faith and full disclosure (Li 2010, p. 37). For example, the company did not inform all the stakeholders about the financial health status of Enron. Management of Enron neglected their managerial integrity capacity by not demonstrating balance judgement in their decisions. Q7: Using the information provided in the case readings, describe the FOUR lessons you have learned as an accounting professional from Enron case. Enron accounting scandal is one of the worst corporate scandals in American history. Nevertheless, this case has valuable lessons that can be learned. As an accounting professional, the first lesson I have learned from Enron case is that the management of a company should not have any material conflicts of interests. This is because their business judgement is relied upon by private investors. Secondly, I have learn that there is a need for accounting firms to have a separate firm that audits it and one which offer consulting activities. Thirdly, ethical discipline should be instilled in all business organisations and board oversight should be strengthened. The fourth lesson is that accounting and corporate governance should be reformed in the United States as a way of updating the current regulation and rules to fit in the ever changing economy. Q8: Using the lessons learned from the Enron case; describe the effects of unethical business practices on society & community. The collapse of Enron Corporation led to many undesirable effects. Unethical business practices harm the society and community through loss of large amount of investors’ money. It leads to drop in stock prices consequently causing people to register losses. Furthermore, it negatively impacts on the profitability and survivability of a company in the long-term. It allows few individuals to get rich at the expense of others and the general population. Unethical business practices discourage entrepreneurship and people to invest their money in businesses. Conclusion Enron case represents one of the worst accounting scandals that occurred due to manipulation of accounting techniques. Due to morally questionable acts by the management of Enron and subsequent inaction by the board of directors, the company collapsed. Mark-to-market accounting technique seems unsuitable for Enron, but the company used it to give misleading information to the investors. The use of special purpose entities also played a part in Enron’s demise. The lessons learned from Enron case is that conflicts of interests should not be present in the side of management and separation of auditing and consulting services should be present. In avoiding similar challenges that were faced by Enron, corporations should careful select accounting approaches and financial structures to be used in their organisation. In addition, regulations should be further tightened and high standards of transparency, as well as disclosure in both audit and accounting professions, should be demanded. References Healy, P. M & Palepu, K 2003, “The fall of Enron”, Journal of Economic Perspectives, vol. 17, no. 2, pp. 3-26. Healy, P. M & Palepu, K 2013, The fall of Enron, Harvard Business Review, Boston. Li, Y 2010, “The case analysis of the scandal of Enron”, International Journal of Business and Management, vol. 5, no. 10, pp. 37-41. Nanda, A 2003, Broken Trust: Role of Professionals in the Enron Debacle, Harvard Business Review, Boston. Tan, P & Yeo, G 2006, ‘Accounting scandals and implications for directors: Lessons from Enron’, In C Lee & AC Lee (eds), Encyclopedia of Finance, Springer, New York. Read More