Accounting Fraud: Enron Accounting Scandal - Term Paper Example

? Accounting Fraud: Enron Accounting Scandal Inserts His/Her Inserts Grade Inserts 4 May Accounting scandals can be easily prevented. The research focuses on the study of the Enron accounting scandal. The research delved into Enron’s window-dressing of its financial statements to present a more favorable balance sheet and income statement. The research also focuses on the liability of the Enron external auditor, Arthur Andersen. The research is divided into investigation, resolution, and prevention. Accounting fraud can be prevented. Investigation. Paul Clikeman (9) emphasized some accounting scandals took place when it should not have happened. The organizational officers should show and act as trustworthy persons at all times. The investigations show one of Enron’s Accounting Staff, Margaret Ceconi, discovered huge discrepancies in the numbers presented in the financial statements. The biggest losers of the Enron financial statement fraud were the stockholders (investors) and the employees, who lost their nice comfortable jobs. Clikeman (7) reiterated the investigation found that the scandal –tainted officers presented a deceitful illusion of a company that was generating huge profits through the use of several factors. First, the Enron officers implemented smart and scrupulous management tactics to pursue their evil deeds. Next, the board of directors backed the sinister plans of the Enron officers. As discussed, Arthur Andersen failed in its duty report the fraudulent transactions of the Enron officers. One of the judges in the Enron investigation stated “Enron robbed the bank and Arthur Andersen provided the getaway car.” Here, the judge emphasized that Enron fraud could not have prospered if the external auditor exerted its sworn duty as certified public accountants to avoid issuing audit reports stating that the financial statements are fairly presented even though the external auditors know that the financial statements are fraudulently prepared and presented to the current and prospective stakeholders. The United States Congress’ Joint Committee on Taxation (71) found in its Enron investigation that the Enron officers used off-balance sheet accounts to fraudulently present a better picture of the company. Off balance sheet accounts means that the company hid from the public some of the accounts. For example: the basic accounting equation is: assets = liabilities + stockholders equity. Using this equation, the company’s total assets can easily be computed by adding the total liabilities (for example $1 million) and the total stockholders’ equity of $4.5 million). Thus, the company’s total assets are $4.5 million. With the introduction of off balance sheet accounting, one fraudulent practice would be the liabilities as assets or stockholders’ equity items. Consequently, the assets and the stockholder’s equity accounts will fraudulently increase. Specifically, the investigation discovered that Enron had incurred large amounts of liabilities in its plan to invest in capital expenditure amounts. The capital expenditure amounts were distributed among power plants, pipelines, water, electronic commerce, metals, and broadband technologies. Most of Enron’s growth businesses required large amounts of cash inflows or investments. The investments placed an insurmountable pressure on the Enron management 2000 financial statement targets. The targets included $1 billion of net income for the year 2000 alone, 15 percent average compound annual growth, and double digit growth in each individual year, and cash inflows to pay for its ballooning liabilities. Likewise, the Enron Company had to enter into credit transactions to ensure the company had enough means to pay energy contracts being traded on its online trading market. Enron suffered unnerving fluctuations in its credit ratings due to its failure to comply with all debts obligations on time. The Enron poor credit rating increased Enron’s to obtain new long term loans. Likewise, the decline in the company’s credit ratings caused the company’s unpopularity in terms of new investments from current and prospective investors. The United States Congress’ Joint Committee on Taxation (73) states the Enron Company fraudulently used a series of financing, operational, and accounting strategies to accomplish its financial objectives. The Enron objectives included: (1) using energy contracts called prepays that gave Enron a large advance payment to deliver natural gas or other energy products; (2) the crafting of hedges to lessen the risk of long-term energy delivery products; (3) pooling and securitizing energy contracts; (4) making the company ‘asset light’ by removing capital –intensive energy projects, such as power plants, that were historically related to low returns and mounting debts in the Enron accounting records. Some of Enron’s strategies, such as included the use of accounting hedges, were implemented to lessen the effect of investment value declines affecting the Enron’s financial statements. The strategies were implemented to effectively change Enron’s economic risk. United States Congress’ Joint Committee on Taxation (75) opined: to resolve the above capital investment and other financial statement hurdles, Enron used special purpose entities. The entities were composed of Enron’s officers and employees. The entities would enter into dummy transactions with Enron. Instead of selling the Enron assets to or entering into hedging transactions with independent outside parties, Enron engaged in business transactions with off-balance accounts. The off-balance sheet accounts are the Enron- established special purpose entities. Enron did not record transactions with entities in the financial records (off-balance sheet accounts). Enron entered in transactions with its special purpose entities in its synthetic lease business transactions. The lease transactions were classified as asset and leaseback of asset transactions. Enron entered into contract with the special purpose entities to repurchase the assets at a future data and to enter in a fake sale to hedging of Enron stocks as well as stock rights to offer credit support Enron’s hedge transactions. Consequently, Enron reported in its financial statements the gains and losses on its portfolio market investments on a mark to market concept. The concept states that the increase or decreases in the market value of the Enron’s portfolio investments had increased or decreased Enron’s financial statement earnings. Enron fraudulently used the concocted hedging structures to try to offset its portfolio investment losses by taking that position that the underlying capital investment portfolio was hedged. Enron presented a fraudulent picture that it has offsetting gains on the purported hedging positions. The October 2000 investigation further found that Enron had an estimated $60 billion in assets. Of these assets, $27 billion had been listed under Enron’s unconsolidated affiliates. The use of unconsolidated entities had fraudulently permitted Enron to include its share of the affiliates’ revenues in its profit and loss statements where excluding related debts from the consolidated financial statements. Because of the off-balance sheet transactions, Enron was able to increase its return on investment and other financial statement analysis ratios to attract more victims. The United States investigation team concluded that Enron had used its off-balance financial transactions for other goals. The other goals included the receiving of beneficiary regulatory treatment from the company’s California wind farms under the auspices of the Public Utility Holding Company Act. Three of Enron’s off balance sheet transactions were Chewco partnership, LJM2 partnership, and LJM1 partnership. On January 15, 2002, the New York Stock Exchange announced that the organization will remove Enron as one of companies offering shares of stocks to current and prospective investors. On October 12, 2002, the Powers investigation report showed the Enron assets were not enough to pay the outstanding debts of the The managers of Enron implemented the profit –priority motive in the preparation of its fraudulent financial statements. The managers instructed their line and staff personnel to prioritize presenting a more favorable financial statement in order to ensure the continued trust and confidence of its stakeholders. Enron implemented the profit motive as exemplified by Enron’s Chief Operating Officer’s business transactions. Skilling felt that money was the prime mover (driving force and motivator) of the company’s preparation of financial reports indicating its assets, liabilities, stockholders’ equity, revenues, expenses, and profits (Williams 28). The profit motive complemented the company’s rational managerial tools. The fraudulent tools included the generation of break even analysis, current ratio, quick ratio, debt to equity ratio, gross profit ratio, net profit ratio, inventory turnover, and receivables turnover grounded on the false financial reports victimize more investors. In this regard, the Enron employees must either implement the preparation of the fraudulent profit-priority financial statements or resign from the Enron Company. However, there are conflicting subcultures within the major profit-priority culture. The initial findings on the Enron cash’s reporting transactions violated United States financial accounting standards board policies and processes in the company’s presentation of the financial statements. The corporate social responsibility culture runs counter to the company’s profit-priority scheme in the preparation of the company’s financial reports (210). To present a profitable business, the company must have diverse themes or values implemented by all Enron line and staff personnel. In the Enron Case, officers and staff of Enron were unanimous in enticing the external auditors, Arthur Andersen, to present an audit report stating that the financial statements are fairly present. Consequently, the Enron officers were successful in convincing the external auditors to comply with their dastardly deed because one of the Enron officers was a former Arthur Andersen external auditor. Enron’s downfall is grounded on the discovery of its fraudulent financial statements. Resolution. After the discovery of the fraud and true financial performance, Enron filed for bankruptcy in 2001. In the same manner, the Enron external auditor, Arthur Andersen closed shop because its name as an unbiased auditing firm had been tarnished by a handful of fraudulent auditing staff. The Arthur Anderson auditing firm was one of the top five auditing firms within the United States and around the world before its name was tarnished by a few scrupulous auditing staff assigned to the Enron Company. The Enron case is one of the biggest audit fraud events in United States history. The officers of Enron were convicted by the courts and meted jail terms for their participation in the fraudulent scheme to present falsified financial statements (Williams 2008). Michael Holt (176) theorized the Sarbanes Oxley Act of 2002 was created in response to several accounting and corporate management scandals that tarnished the public’s impression in terms of the fairness of the representations listed in the audited financial statements. Enron was able to victimize several current and prospective investors to funnel their cash and other assets into Enron. The unsuspecting investor victims trusted the external auditor’s report stating the financial statements of Enron were fairly presented. The Sarbanes Oxley Act of 2002 was implemented to avoid a recurrence of an increasing cased the recurrence of accounting scandals. According to Debra de Vay (27) the Sarbanes Oxley Act of 2002 is an important piece of legal document. The law was created by United States Senator Paul Sarbanes (D –MD) and United States Representative Michael Oxley (R –OH). The law was approved and implemented in 2002. The accounting scandals that included WorldCom and Enron that rocked the United States precipitated to the compulsory creation of a law that would bring back the public’s trust in the financial statements, the external auditors, and the corporations. The law only focuses on companies offering their stocks within the United States stock exchanges. The Sarbanes –Oxley Act of 2002 does not cover private companies not offering their stocks in the stock exchanges. According to Theodore Plette (105), the 2002 law established the Public Company Accounting Oversight Board or PCAOB. The board monitors external auditors, inspects, and determines if the companies are implementing all the provisions of the Sarbanes-Oxley Act of 2002. Likewise, the Act makes it a required for senior managers of the corporations to be held directly responsible for any fraudulent misrepresentation in the organization’s financial statements. The Sarbanes-Oxley Act of 2002 puts into place the penalty for auditing firms and corporation known to violate any section of the 2002 Act. The 2002 law punishes any person (corporate officers or external auditing staff) found burning, hiding, or damaging records that will prove the financial statements are fraudulent. In addition, the United States Congress’ Joint Committee on Taxation’s investigation showed Enron entered into other types of fraudulent accounting transactions. In August, 2001, Ms. Sherron Watkins, Vice President for Corporate Development, sent a message focusing on irregularities entered into between Enron and its special purpose entity, LJM partnership as well as Raptor and Condor. The focus of the message was on the related-party transactions issue. Accounting theory dictates that Enron must indicate in its financial statements all its related party transactions. However, Enron hid the truth regarding its creation of the dummy special purpose entities to improve its financial condition. Ms Watkins requested that the financial statement of Enron be audited by another auditing firm because Arthur Andersen was conniving with Enron. Likewise, Ms Watkins requested that Enron’s current counsel, Vinson & Elkins, be replaced with a new set of legal counsels. The current Enron counsel, Vinson & Elkins, replied to Ms Watkins’ request with its own investigation. The investigation showed that there were badges of fraud in: (1) the apparent conflict of interest involving Enron’s Chief Financial Officer, Andrew Fastow, and LJM Partnership, one of the Enron special purpose entities; (2) the accounting treatment of Condor in Raptor in the Enron financial statements; (3) the adequacy of public disclosures of the Condor and Raptor business transactions; and (4) the potential impact of the Condor and Raptor organization on the Enron financial statements. The counsels stated that a wider investigation be conducted to determine the true depth, effects, and coverage of the Enron’s financial statements with the hiring of new legal counsels and new auditors to replace Arthur Andersen. Due to the investigation, Enron filed prepared a net loss financial statement for the first time, after several years of presenting fraudulent net profits on October 16, 2001. The company filed for a $618 million net loss for the quarter ending 30 September 2001. The net loss was arrived at after incorporating a $1 billion after tax non-recurring charges. The non-recurring expenses included $287 million write –off of asset impairments related to Enron’s transactions with Azurix. Azurix was Enron’s United Kingdom water company business partner. Likewise, Enron included in its financial statements a $180 million expense used to restructure Enron’s broadband business and a $544 million loss principally relating to Enron’s interest in The New Power Company organization. Likewise, the Securities and Exchange Commission explained that the $544 million expense was connected to a pretax expense of $710 million in connection with Enron’s ending its Raptor business relationship. Further, Enron recorded in its books a decrease of $1.2 billion to correct its financial records. The correction was related to Enron’s improper recording of its Raptor partnership as an investment instead of the proper reduction to the company’s stockholders’ equity accounts. In addition, Enron used its $ 3 billion bank credit line to pay its maturing obligations on October 25, 2001. On October 31, 2001, Enron’s officers announced to its board of directors that the company had appointed a new set of legal counsels. The counsels will investigate and prosecute erring Enron officers, especially those connected with the off-balance sheet transactions with its special purpose entities. The new Enron counsel was Mr. William Powers, Dean of the University Of Texas Law School. The stock market price of Enron dropped further to $13.90. On November 8, 2001, Enron announced the company will be presenting a new set of financial statements for the period 1997 to 2000. The new set of financials statements will present the true financial condition of the company. In accounting parlance, all accounting personnel, especially the external auditors, are required to avoid off-balance sheet accounts. The accounting personnel, accounting officers, and external auditors are required to eliminate off-balance sheet accounts in order to avoid presenting false financial statements. In addition, Bernhard Kuschnik (15) emphasized the law focuses on curtailing the fraudulent preparation of fraudulent financial statements. The law focuses on the prevention of companies listed in the stock exchanges from presenting intentionally misleading financial statements. The law includes the implementation of legally sound penalties on the officers of the corporations and the auditing firms found guilty of intentionally conniving to present false financial reports. Prevention. Richard Riley (237) reiterated fraud prevention methods should be designed and employed by the victim (entity) that could have prevented this type of fraud from occurring. Fraud prevention should prioritize the materiality of the financial statement accounts. Materiality entails focusing on accounting entries that will affect the decision-making activities of the financial statement users. The financial statement users include the investors, creditors, employees, customers, board of directors, community, state, labor unions, environmental protection agencies, government regulating agencies, labor law agencies, and the managers. First, the company should allow the officers of the organization to take a compulsory leave, generally one week to a month. The replacement officers will conduct an operations audit to determine if the officer does not enter into fraudulent transactions. Likewise, the company should rotate the external auditors. In the Enron case, there was a close relationship between the officers of Enron and the external auditor staff of Arthur Andersen. In addition, the company should hire an honest, morally upright, and intelligent internal auditor. The internal auditors will help the external auditors accomplish their responsibility to present fairly presented financial statements. Further, Richard Riley (237) proposed the company should hire an expert financial statement analyst. The financial analyst should have a strong background in economics. The financial analyst can easily spot if irregularities in the financial statements by relating the reports to economic conditions during the preparation of the financial statements. For example, the current economic depression enveloping the United States and some parts of Europe will affect the increase and decrease of the company’s revenues, expenses, and profits. The company should also hire accountants, accounting officers, and accounting staff having strong corporate social responsibility backgrounds. With such backgrounds, the accounting officers and staff will think twice or thrice before engaging in fraudulent activities. It took the likes of a person imbued with corporate socially responsibility and ethics background to inform the federal authorities of the currently perpetrated fraudulent financial statements. The hiring of ethics-driven accounting staff and accounting officers, the officers of Enron and other organizations will think twice or thrice before implementing fraud-related recording of business transactions. Furthermore, Robert Ingram (224) emphasized the company should offer salaries, wages, and benefits to prevent the company’s officers and employees from being tempted or given the opportunity to engage in fraudulent activities. Low salaries may give some employees the temptation to violate company policies for their own personal gain. The Enron officers resorted to fraud to ensure the continued payment of their high salaries, wages, and other benefits. The company should remove any opportunity for the employees and officers to indulge in fraud-laden activities. One of such activities is to separate the possession of cash and other assets from the recording function as well as the business transaction- approving functions. In terms of internal control, Richard Riley (237) proposed the external auditors of the company should implement a company policy where the accounting officers are not allowed to enter into a close relationship with the external auditors. Specifically, the company’s internal auditor should focus one’s attention on accounts that present badges fraud. The transactions between Enron’s special purpose entities and Enron send a strong signal that a possible fraud is hiding. Thus, the internal auditor must focus on financial statement accounts where the officers and staff of Enron or any other organization have financial interests. Based on the above discussion, accounting scandals can be easily prevented. The study of the Enron accounting scandal indicates that the problem of fraud had been in place since 1997. The research indicates that the Enron officers went out of their way to persuade the Arthur Andersen auditing staff to give in to the Enron officer’s fraudulent preparation of the company’s financial statements. The research indicates that Enron delved into off-balance sheet accounts to perpetrate its fraudulent activities. The Enron Company set up special purpose entities to perpetrate the preparation of window-dressed financial statements. Likewise, the research indicates the effect of the Enron, WorldCom, and other fraud-laden accounting scandals has reduced the public’s trust in the financial statements prepared by the companies listed in the stock exchange. In addition, the research shows that some external auditors are persons susceptible to temptation. The research shows that the liability of the Enron external auditor, Arthur Andersen, should not go unpunished. The Sarbanes –Oxley Act 2002 imposes stiff penalties to fraud-tainted corporation officers and external auditors. The research is divided into investigation, resolution, and prevention. Accounting fraud can be prevented. Cited Works De_Vay, D. The Effectiveness of the Sarbanes-Oxey Act of 2002 in Preventing and Detecting Fraud in the Financial Statements. New York, University Press (2006). Clikeman, P. Called to Account: Fourteen Financial Frauds that Shaped the American Accounting Profession. New York (2009) Holt, M. The Sarbanes-Oxley Act: Costs, Benefits and Business Impact. New York, Butterworth Heinemann Press (2008). Ingram, R. Financial Accounting: Information for Decisions, Cengage Learning.New York, Cengage Learning Press (2006). Kuschnik, B. The U.S. Sarbanes Oxley Act of 2002 Corporate Governance. New York, Grin Press (2007). Riley, R. Financial Statement Fraud: Prevention and Detection. New York, J. Wiley & Sons (2009). U.S. Congress, Joint Committee on Taxation. Report of Investigation of Enron Corporation and Related Entities . retrieved April 21, 2011, from Williams, C. Management . New York, Wiley & Sons (2008). Read More