Enron Scandal - Lessons from Enron for British Business - Essay Example

Running Head: Lessons from Enron for British Business. Lessons from Enron for British Business s Description of Enron Scandal: The Enron scandal has given a new dimension to the corporate scandals in the history of United States. Due to the collapse of the Enron Corporation the notion of the off-balance financing or external funding not recognised on the issuing company's financial statements has gained much importance. The SPE was the form of the off balance sheet finance which was used by the Management of the Enron Corporation. It is thought that the management used the SPE to hide the external liabilities from the investors and regulators. The plan was so wisely crafted that the professional accounting analysts could not found the proper position of the company till the explosion of the bankruptcy bomb. Off balance sheet financing and Enron Scandal: The Enron Scandal in Numbers: Enron's stock price at its January 2001 peak: $83 Enron's stock price at its January 21, 2002: $0.67 Total shareholder value last: $63,101,519000 NO. Of Employees: 20,600 Enron's rank in size before the drop: 7th largest. Enron's reported net income in 2000: $979 million Federal Income tax paid in 2000: $0 Profit restated over four years: nearly $ 600 million. No. Have outside partnership: more than 3000 Partner ship based offshore: about 900 Total debts listed on the books, based on its bankruptcy filing: $13.12 billion Source U.S.A Today 1/21/02 Reinstein & Weirich, (2002) write in their article: Many unconsolidated SPEs were found on the Enron's balance sheet. Another accounting gap, which was discovered from the Enron's balance sheet, was the recording of the note receivable as an asset. These were the promises to pay the equity claim in the limited partnerships, which Enron recorded as assets even though GAAP requires subscribed equity to be reported as a contra-stockholders' equity account, rather than as a note receivable. Once it was accused of GAAP violations, Enron announced it would restate the previous 4 As years of financial statements by recording a $1.2 billion reduction in stockholders' equity, adjusting its income statements and balance sheets for the unconsolidated SPEs, and making prior-period proposed audit adjustments and reclassifications that had originally been considered as immaterial. Enron's restatement reduced previously reported net income by $569 million and reduced shareholders' equity by $1.2 billion. Shortly after these announcements, several rating agencies lowered Enron's long-term debt to below-investment grade, and Dynegy terminated its proposed merger agreement with Enron. In December 2001, Enron filed for Chapter 11 bankruptcy protection. Off Balance Sheet Financing: 2nd aspect: Charles Mulford, co-author of The Financial Numbers Game, says, "the accounting model isn't broken, financial reporting just needs some tweaks." The Enron used the most common off balance sheet financing technique. Enron conducted much of its business in these entities that they controlled. They transacted with themselves. That kind of self-dealing allowed them to report profits when they weren't traditionally making a profit." (Cited in Kelcher, 2002) Definition: Off balance sheet usually means an asset or debt or financing activity not on the company's balance sheet. It could involve a lease or a separate subsidiary or a contingent liability such as a letter of credit. (Wikipedia, 2005) Can be explained as the different methods of acquiring capital by a company, which is not stated, on the financial statement of the company. The most commonly used methods of raising money which does not appear on the balance sheet is in the shape of the research and development partnerships, different kinds of lease, and Joint ventures etc. are the common methods used. Most of the companies obtain funds by using their product idea on intelligence and knowledge about any specific field and acquiring the capital from the partner. Since the partner who is providing the capital can just invest money and do not have much knowledge related to the product therefore the person having the main idea retains the significant control over the project. In this way the company can purchase the joint venture through lease and by using a joint venture instead of funding the project out of its own funds, the company can accomplish an important objective while preserving its cash for other purposes. Although there are many significant variations which can be made in the notion to use it positively. But as a matter of fact in the case of Enron Corporation the transparency was avoided intentionally in order to get personal benefits. Many companies use the off balance sheet financing in a proper way to finance their projects. Continental Airlines and other carriers have used a type of off-balance-sheet financing to buy planes, while truck rental company Ryder creates partnerships that fund the purchase of fleets that Ryder leases from the partnerships. Enron used the Off balance sheet finance techniques in most troubling and complex manner. In the first place the investments were made in the forms of equity stakes in companies and even stock options rather than in hard assets. There was a conflict of interest in the leadership of the organisation. Third and the most important the leader ship was reluctant to disclose the details of the financial position of the investors and analysts. In the beginning the company used the simple form of the off balance sheet finance activities. The conditions became complex when the company management decided to expand the growth of the company. Although the fishy thing was getting smelled from years before the Enron's bankruptcy but there was not any hard proof available. (Kurtz, 2002) Major Short Comings: There are several weaknesses in the relating to the corporate governance, internal and auditing which are leading to an increase in the corporate scandals in United States. The degree of disclosure of financial information is also a main reason. Mostly the corporate running bodies do not find them answerable in front of any one therefore they keep on trying 'innovative' ideas for which others have to pay. (Maclean, 2005) Financial information in the form of audited accounts can prevent the system slipping into corruption (Sunlight is the best detergent), but it is not clear why, for example, a superior US financial reporting infrastructure did not help us detect Enron. The corporation could come out the crises situation by selling its hard assets but the top management kept on transforming finance into a merchant organisation, one engaged in the intermediation of both commodity and capital risk positions." SPEs are a fairly common but complex financial instrument used to isolate and contain financial risk. They typically work like this: A business wants to perform a specialised task; for example, an airline wants to buy a fleet of planes. It sets up an SPE, a sort of joint venture, into which it and one or more partners put some funds. The SPE buys the planes, financing the purchase with bonds or other debt. The planes secure the debt; at least in theory, the parent company has no responsibility for the repayment of this debt. The parent company gets the use of the asset, perhaps by leasing it from the SPE; then the SPE's revenues from the lease are used to pay back the creditors. (Info trac Article). The company, now in bankruptcy but once the world's dominant energy trader, was an aggressive user of partnerships separated from the parent but for which the parent's shareholders remained on the hook. Perhaps worse, it also committed the ultimate sin of omission - it failed to disclose the extent of its contingent liabilities related to those partnerships. Under federal securities laws, those details should probably have been listed in at least the footnotes to the company's financial statements. In itself, off-balance-sheet financing is no vice. Companies can use it in perfectly legitimate ways that carry little risk to shareholders. The trouble is that while more companies are relying on off-balance-sheet methods to finance their operations, investors are usually unaware that a company with a clean balance sheet may be loaded with debt - until it is too late. (Morgenson, 2001) 4. Differences between the UK and the US accounting and business environments. Difference between Accounting practices in the U.K and the U.S: Business combinations Both UK and US GAAP require purchase consideration relating to a business combination to be allocated to the net assets acquired at their fair value on the date of acquisition. Intangible assets: Under UK GAAP fair values are assigned to identifiable intangible assets only if the identifiable intangibles are capable of being disposed of or settled separately, without disposing of a business of the entity. Under US GAAP, identifiable assets are separately valued and amortised over their useful lives. The separately identifiable intangible assets included in the US GAAP balance sheet are principally comprised of brand rights, which are being amortised over periods between 25 to 30 years. Derivative financial instruments: Under UK GAAP, derivative financial instruments that reduce exposures on anticipated future transactions might be accounted for using hedge accounting. US GAAP requires the Group to record all derivatives on the balance sheet at fair value. The Group has decided not to satisfy the SFAS No. 133 "Accounting for Derivative Instruments and Hedging Activities" (SFAS 133) requirements to achieve hedge accounting for its derivatives, where permitted, and accordingly movements in the fair value of derivatives are recorded in the profit and loss account. (Annual Report and Accounting, 2005) There has historically been a considerable difference between U.S. and U.K. owned corporations in their management and organisation. U.S. corporations have typically been more centralised, more professionally managed and [have had] more formalised bureaucracy. They have generally been seen as more aggressive and results-oriented. U.K. corporations placed more emphasis on relationships rather than formal controls, and appeared "amateurish" compared to their U.S. counterparts. Recent years have seen a considerable convergence of U.K. management styles with those of the U.S. Many of the largest British multinationals, such as GlaxoSmithKline and BP, have merged with or acquired large U.S. firms, and almost all leading U.K. companies derive substantial proportions of their revenues from the U.S. The differences in management style and culture have become far more nuanced. Large British multinationals probably remain more international and cosmopolitan in their outlooks than their U.S. counterparts, slower to act and less inclined to adopt the latest management fads, and less ruthless in dealing with failure and under-performance. However, there is vast industry and firm differences. Recommendations: It was, of course, this policy on 'off balance sheet' reporting which contributed to the downfall of the company with $40 billion of debt because the financial effect and the accompanying risk of these partnership deals was in reality highly material to presenting a true and fair view of the company's financial prospects. Those types of off-balance sheet financing arrangements are not permitted under International Accounting Standards which are being adopted in Europe and much of the rest of the world, A change is required in the regulations. The accounting firm should not perform the consulting and auditing services both. The Companies should be required by the Government to increase their degrees of disclosure. The top-level management should be held more responsible by tightening up the regulations. They should also be held responsible in case of any frauds and regulatory violations of their subordinates. This in turn will give rise to the sense of responsibility in the people related at all levels. (Hanson, 2002) In the UK the lessons learned in the early 1990s when we had a series of major corporate collapses. The most famous one you might have heard of was Robert Maxwell who misappropriated hundreds of millions of pounds from his public companies and their pension plans to finance his private corporate expansion. That and other collapses at the time helped to cause a revolution in the UK in how companies and the accountancy profession were governed. Today, there are any number of codes of governance around the world but they are all based on the three principles I have already mentioned - those of transparency, integrity and accountability. The corporation accountants should really understand what the risks and opportunities of the company are and what it does in respect of them to enhance performance, and second, They should inform the outside world about what the company has been doing in a transparent and trustworthy manner. In order to avoid scandals like Enron the Government should introduce the codes of financial ethics in order to improve sense of responsibility in the corporate employees and Management. A fair accountability should be undertaken so that the main responsible should pay the price of the fraud. One of the knock-on effects of Enron has been to finally persuade the US regulators to really look again at their own accounting standards - which they have always maintained are the best in the world - and look at the benefits of International Accounting Standards. Word Count: 2,163 Works cited Annual Report and Accounting, (2005). Summary of Differences between UK and US generally accepted accounting principles (GAAP), Retrieved 03/01/06 from http://www.imperial-tobacco.com/files/financial/reports/ar2005/index.asppageid=46 Hanson, K., (2002). Lessons from the Enron Scandal, interview about Enron by Atsushi Nakayama, a reporter for the Japanese newspaper Nikkei, March 5, 2002, Retrieved 04/01/06 from http://www.scu.edu/ethics/publications/ethicalperspectives/enronlessons.html InfoTrac Article # A82607012: SPEs: Off Balance-Sheet Ventures, retrieved 04/01/06 from http://www.swlearning.com/accounting/insidelook/february/022802_spe.html Kelcher, M., N., (2002). Creative Accounting: Prevention and Detection, SmartPros Editorial Staff, retrieved 04/01/06 from http://accounting.smartpros.com/x33125.xml Kurtz, H., (2002). The Enron Story That Waited To Be Told, by Washington Post Staff Writer, Friday, January 18, 2002; Page C01, Retrieved 04/01/06 from http://www.washingtonpost.com/wp-dyn/articles/A64769-2002Jan17.html Moregenson, G., (2001). Are New Woes Lurking in Financial Nether World The Associated Press, December 23, 2001, Retrieved 05/01/06 from http://pages.stern.nyu.edu/adamodar/New_Home_Page/articles/isthisdebt.htm Maclean, P., (2005). Power Play - Robert McCullough was interviewed for an article covering Enron's role in the California power crisis and its aftermath, Portland Monthly, May 2005, Retrieved 05/01/06 from http://www.mresearch.com/pdfs/102.pdf Reinstein A., & Weirich, Thomas R., (2002). Accounting Issues at Enron, The CPA Journal, Retrieved 04/01/06 from http://www.nysscpa.org/cpajournal/2002/1202/features/f122002.htm Wikipedia, (2005). Off-balance-sheet, Page last modified 15:24, October 10, 2005, Retrieved 03/01/06 from http://en.wikipedia.org/wiki/Off-balance-sheet Read More