The Enron Scandal, and a Look at the Accounting Practices that Permitted it to Happen - Case Study Example

The Enron Scandal, and a Look at the Accounting Practices that Permitted it to Happen Introduction …………………………………..………………..-….………………… 2 Enron, The Circumstantial Variables ……………………………………………... 3 The Company - Enron ……………………………………………………………… 4 The Path to Greed ……………………………………………………………...….... 5 Conclusion …………………………………………………………………………… 7 Bibliography .………………………….…………………………………….…….... 10 Introduction The collapse of Enron in 2001 represented the largest failure of a publicly traded company in the United States, with the foundation of the fall resting squarely on fraud, and deception in its accounting practices that misstated revenue earnings and contracts (Fox, 2003, p. 247). Enron’s bankruptcy marked a period of large public company failures that were all linking to financial reporting and accounting areas that included Tyco International, WorldCom, Xerox, the accounting firm of Arthur Anderson, and others (Patsuris, 2002). The reason why Enron stands above the other corporate scandals, is the magnitude as well as scope of Enron’s misconduct, and financial fallout that rocked the United States financial markets with the brazeness of running up of the stock price through deals, and reporting measures that were either non-existant or fraudulent (Longnecker, 2004). The preceding was further compounded by the company’s accounting firm, Arthur Andersen, essentially turning a blind eye to the events, and reporting measures through failing to perform its fiduary duties in a manner consistent with good accounting, and auditing practices (Longnecker, 2004). The fallout did not just end with American based companies. The Italian food giant Parmalat became the subject of investigation by authorities in Italy “…after discrepancies were revealed in its accounting practices to the tune of more than $5,000,000,000”, one of which represented the fact that money being held in a Cayman Island subsidiary was indeed false (Longnecker, 2004). These events led to the passage in the United States of the Sarbanes-Oxley Act of 2002 that represented the United States Congress introduction of “…a series of corporate governance initiatives into the federal securities laws …” (Romano, 2003). The Act, is also known as SOX as well as the Public Company Accounting Reform and Investor Protection Act of 2002 (McCauley-Parles et al, 2007). It, the Sarbanes-Oxley Act, was enacted to restore public trust in accounting as well as corporate reporting practices after the public comopany scandals and “…has been described as the most sweeping and significant change in securities law since the 1930s.” (McCauley-Parles et al, 2007). The fall of Enron represented the event that pushed the creation and passage of the Sarbanes-Oxley Act, even though prior scadals of corporate reporting and misdoings had occurred. The significance of Enron’s fall thus represents the focus of this examination, which shall delve into the events that comprised this scandal, along with the accounting practices that caused it to occur. As the Sarbanes-Oxley Act of 2002 represents the legislative answer to the abuse of accounting standards, consistent reference shall be made to the Act as a means of illustrating the scope, extent and ramifications of the Enron example. Enron, The Circumstantial Variables In understanding the motivational factors that helped to drive the accounting malpractices in the Enron failure, one needs to be cognizant of the financial, reward, shareholder and public stock trading facets that are intertwined with the preceding. Under the Anglo-American concept management monitoring is primarily based upon rewards and penalties that are market based, whereby the capital as well as labour that is utilised by the company is used as the means (Dore, 2000). The foregoing refers to a company is performing below projections and or expectations as observed by shareholders, then capital can be withdrawn, moved, from one company to one whereby the expected returns are indicated and or presumed to be higher (Dore, 2000). The preceding is also manifested through what is termed as stock market capitalism (Dore, 2000). The indicated example represents the rise and or fall of stock market prices based upon the economic performance of a company in meeting or not meeting projected expectations for growth and profits. The performance and or lack of performance by a company is attributed to its executives and thus the profits generated, along with the value of stock can fuel a takeover attempt, hostile or friendly thereby threatening the tenure of executives (Dore, 2000). Good stock performance means bonuses and increases in salaries for executives, whereas poor company performance, and thus retreating stock prices represent grounds for replacement, takeovers and negative reactions by shareholders. Fuelling this process, to an extent, is the performance of a company’s stock that is dependent upon the information transmitted to the public. The preceding represents the infamous case of Enron, and foundational reasons behind the collapse of the company and rounds of legislation that grew from this and similar instances. The understanding of the preceding and associated instances is importance in equating the events that transpired before, and after the collapse of this company. The Company - Enron Enron was formed in 1985 as a result of the vision of Kenneth Lay who used the proceeds generated by junks bonds in his company Houston Natural Gas to combine with another natural gas pipeline firm to create Enron (Fusaro and Miller, 2002, p. 9). It is important to understand some of the historical facets behind Enron in order to understand the reasons and factors behind its actions and collapse in 2001. During the late 1980s oil prices fell dramatically, thus prompting the buyers of natural gas in the United States to switch to cheaper fuel oil (Fusaro and Miller, 2002, p. 3). Enron led a consortium of gas producers to lobby for deregulation to help stabilise gas prices, which began the core new business of Enron, the marketing of futures contracts that guaranteed a delivery price sometime in the future (Fusaro and Miller, 2002, p. 37). The company also lobbied for deregulated electricity markets thus creating another opportunity to trade in futures contracts (Fox, 2003, p. 33). That foundation, futures trading, lead to the company’s formation of a new division, Enron Finance Corporation, headed by new addition Jeffrey Skilling, formerly of McKinsey & Company (Fox, 2003, p. 27). To understand the house of cards that represented the gradual unraveling of Enron, one needs to be cognizant of its operational framework. A key to the foregoing is what is known as a “gas bank” (Fox, 2003, p. 31). Under Killing’s leadership, “… Enron Finance Corp. soon dominated the market for natural gas contracts, with more contacts, more access to supplies, and more customers than any of its competitors” (Thomas, 2002). That positioning provided the company with the ability to predict futures prices with higher efficiency and accuracy thus further enhancing its positioning as well as market dominance, and resulted in the generation of superior profits (Thomas, 2002). That success began a change in the corporate culture as well as manner in which Enron did business as the superior returns were having an extremely positive impact on the company’s stock prices as a result of earnings. The foregoing represented a track record the company would need to maintain in order to keep its growth rate and positioning. However, the more the company grew and generated more revenues, increasing those returns on a percentage basis became exceedingly difficult as a result of simple mathematics in that a 10% increase on $100 million is easier to generate than a 10% increase on $1 billion in revenues. The Path to Greed The preceding marked the beginning of the internal pressures that came to produce this historical study in corporate malfeasance and greed. This changed Enron’s corporate culture as the company sought to match its trading business profile that was generating the profits (Thomas, 2002). New perks, bonuses and compensation rewards were tied to gaining increased business and new ways of generating profits, which led to the hiring of Andrew Fastow, a leveraged buyout MBA (Thomas, 2002). The more the company grew, the more complex as well as complicated the deals became, and thus the financing and accounting measures used to underwrite them (Thomas, 2002). That culture of results fostered a climate of increased internal pressures and a personnel policy of a high rate of firing for not meeting the demanding profits and deal oriented structure. The following summarises the internal climate, which represented the foundational failure system that led to the company’s downfall (Thomas, 2002) “Skilling instituted the performance review committee (PRC), which became known as the harshest employee-ranking system in the country” Thomas (2002) continues be advising us that “It was known as the "360-degree review" based on the values of Enron - respect, integrity, communication and excellence (RICE).” The seeds of Enron’s unraveling culture are found in the fact its “… associates came to feel that the only real performance measure was the amount of profits they could produce… (and) … In order to achieve top ratings, everyone in the organization became instantly motivated to "do deals" and post earnings.” Thomas (2002) tells us that this promoted a climate whereby “Paranoia flourished and trading contracts began to contain highly restrictive confidentiality clauses…. Secrecy became the order of the day for many of the companys trading contracts, as well as its disclosures.” The financial mismanagement began in the preceding environment of operations, and was a part of the internal bookkeeping and profits at any cost structure that had no checks and balances, or reviews. The company utilised what is termed as “mark-to-market accounting” for its trading transactions (Thomas, 2002). Under the foregoing “…whenever companies have outstanding energy-related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealised gains or losses to the income statement of the period” (Thomas, 2002). The difficulty with the indicated method is that the application of these rules under accounting representing long-term futures contracts in commodities (gas, oil, etc.), is “…is that there are often no quoted prices upon which to base valuations” (Thomas, 2002). Thus, Enron utilised discretionary valuation models that were based upon the company’s own assumptions and methods (Thomas, 2002). As Enron’s competitors emulated its model, the company’s markets and revenue growth slowed, thus forcing management to seek new means and methods of attempting to maintain is growth record. Deals were entered into and structured (Thomas, 2002) “…without much regard to whether they aligned with the strategic goals of the company or whether they complied with the companys risk management policies. Thomas (2002) enlightens us further by telling us “As one knowledgeable Enron employee put it: "Good deal vs. bad deal? Didnt matter…. If it had a positive net present value (NPV) it could get done.” The foregoing summary of how Enron managed to work its way into a self-defeating situation that created a climate of questionable executive and employee action that lacked adherence to any internal checks and balances. That atmosphere saw more and more risky deals being made, and at the end of 2000 the house of cards started to unravel as the company’s share price dropped along with the sagging revenues. Alan Greenspan, the then Treasurer of the United States Federal Reserve System stated (Hake, 2005) “The rapidity of Enron’s decline is an effective illustration of the vulnerability of a firm whose market value largely rests on capitalized reputation ... The physical assets of such a firm comprise a small proportion of its asset base. Trust and reputation can vanish overnight. A factory cannot.” The bankruptcy filing of Enron in December of 2001 represented the largest in the history of the United States up to that time, which was made more alarming by the fact that the company had risen from a small gas pipeline operation to become the seventh largest company in the United States in just 18 years (Hake, 2005). Innovative financial techniques, along with major corporations heavily influencing account rules and standards represented a process that had controlled the U.S. landscape prior to Enron’s fall, bringing with it a climate of looseness in terms of financial oversight. In bringing the preceding into perspective. Champlin and Knoeder (1999, p. 43) tell us “Corporate interests have increasingly influenced the construction and passage of accounting rules and market regulations. Touted as the growth of freely competitive markets, the current drift of economic policy is more clearly caused by the growing influence of narrowly defined corporate interests”. In equating the case of Enron as the focal point for this examination of corporate governance issues, one needs to read beyond the statement of facts as presented above, and look at the deeper issues of influence, context, ethics. Conclusion The drive by Enron was the maximisation of shareholder value through revenue growth that rewarded employees for meeting, and or exceeding targets to drive further growth. That circular pattern as represented by the power of capital markets is exercised via “…the mechanism of equity finance and the stock market, the corporation is able to convert expectations of future profitability into contemporary purchasing power, purchasing power that can then be used to realize those expectations or simply to divert income” (Hake, 2005). The conditions for Enron’s failure have parallel developments in the regulatory system of the United States as well as global markets that have seen the battle for dominance extend to the corporate boardrooms in the fight for economic country stability and growth. During the 1990s in the United States, a period marked by the boom of the stock market that included the arrival of the Internet, new financial, valuation forms, and at the same time the Securities and Exchange Commission suffered from a shortage of funding (Hake, 2005). That development is important in this overall examination scenario as the SEC’s examination of the major securities filings of major corporations was reduced from every three years to seven as a result of short staffing (Labaton, 2002). The preceding represented a period when the integrity of both the review of filings with respect to the stock market as well as accounting practices spiraled downward. The rules under Section 404 of the Sarbanes-Oxley Act requires the company “…to file the registered public accounting firms attestation report as part of the annual report” (Securities and Exchange Commission, 2003). In addition, Section 404 also requires “…that management evaluate any change in the companys internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the companys internal control over financial reporting” (Securities and Exchange Commission, 2003). Interestingly the bad investments as well as debt that were hidden within Enron’s intricate accounting system were not addressed (cpa-cfa.com, 2007). However, these areas were strengthened under the Financial Accounting Board Standards (FASB) rule 46, and 46 that tightened the guidelines for financial sheet consolidations to prevent the hiding of intricate deals as occurred under Enron (cpa-cfa.com, 2007). The Sarbanes-Oxley Act represented a broad reaching as well as comprehensive and complex statute that amended U.S. securities laws in many significant ways (McCauley-Parles et al, 2007). The Act (McCauley-Parles et al, 2007) “… established new law, made changes to existing law, and effected Securities and Exchange Commission (hereinafter the "SEC") rule-making and stock market listing standards. SOXs provisions affect accountants, lawyers, and many others who deal with public companies or issuers. SOX included many "reforms aimed at improving and enhancing financial reporting and at regulating the accounting and audit professions". One of the central facets of the Sarbanes-Oxley Act was its revamping of the accounting profession, and system. As brought forth in the Enron scandal, “The lack of auditor independence is viewed as a significant contributor …” to the fall of this high flying company (McCauley-Parles et al, 2007). Section 201 of the Act clearly sets forth specifications to eliminate this type of occurance (Sarbanes-Oxley.com, 2007). This aspect represents one of the strongest provisions of the Act in that it overrode “…the long-standing objections of the accounting industry to the creation of an independent regulatory body that would set standards and discipline auditors” (Treaster, 2001). The preceding meant that the self-regulation of auditors had come to an end. The new Public Company Accounting Oversight Board would be under the oversight of the United States Securities and Exchange Commission (Treaster, 2001). Under this structure, the chairman as well as four members of the Board are chosen by the SEC (Treaster, 2001). The mismanagement, lack of reporting, masking of revenues, utilisation of empty contracts, and lack of fiscal oversight by Enron’s management, along with its accounting firm represented one of the most blatant examples of corporate accounting abuse ever recorded. This examination has sought to bring out the major issues that occurred in that scandal, as well as the regulatory measures that were enacted by the Sarbanes-Oxley Act that further explains the magnitude of the deception Bibliography Champlin, D., Knoedler, J. (1999) Restructuring by Design: Government’s Complicity in Corporate Restructuring. Vol. 33, No. 1. Journal of Economic Issues. P. 43 cpa-cfa.com. (2007) History and Analysis of the Sarbanes-Oxley Act. Retrieved on 10 November 2008 from http://www.cpa-cfa.com/Acc/SOX_History.html Dore, R. (2000) Stock Market Capitalism: Japan and Germany versus the Anglo-Saxons. Oxford University Press. Oxford, United Kingdom Fox, L. (2003) Enron: The Rise and Fall. John H. Wiley & Sons. Hoboken, N.J., United States. P. 27 Fusaro, P., Miller, R. (2002) What Went Wrong at Enron: Everyones Guide to the Largest Bankruptcy in U.S. History. John H. Wiley & Sons. Hoboken, N.J., United States. P. 3 Hake, E. (2005) Financial Illusion: Accounting for Profits in an Enron World. Vol. 39. Journal of Economic Issues Labaton, S. (2002) S.E.C is Suffering from Non-benign Neglect. 20 July 2002. New York Times Longnecker, B. (2004) The Sarbanes-Oxley Act: Altering the Fabric of American Business. Society for the Advancement of Education. Vol. 132, May 2004 McCauley-Parles L, O’Sullivan, S., Shannon, J. (2007) Sarbanes-Oxley: An Overview of Current Issues and Concerns. Review of Business. Vol. 27 Patsuris, P. (2002) The Corporate Scandal Sheet. 26 August 2007. Retrieved on 12 November 2008 from http://www.forbes.com/2002/07/25/accountingtracker.html Romano, R. (2003) The Sarbanes-Oxley Act and the Making of Quack Corporate Governance. Yale Law Journal. Vol. 114. Sarbanes-Oxley.com (2007) Section 201: Services Outside the Scope of Auditors. Retrieved on 10 November 2008 from http://www.sarbanes-oxley.com/displaysection.php?level=2&pub_id=Sarbanes-Oxley&chap_id=PCAOB2&message_id=4 Securities and Exchange Commission (2003) Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports. Retrieved on 11 November 2008 from http://www.sec.gov/rules/final/33-8238.htm Thomas, C. (2002) The Rise and Fall of Enron; When a Company Looks Too Good to Be True, It Usually Is. Vol. 193. Journal of Accountancy Treaster, J. (2001) Paul Volcker: The Making of a Financial Legend. Hoboken, N.J., United States. John H. Wiley & Sins, p. 22 Read More