The lessons for auditors and regulators from Enron fraud - Essay Example

?Describe and consider the lessons for auditors and regulators from the Enron fraud Introduction Auditing is simply defined as an investigative process performed to verify the reliability and accuracy of a company’s state of affairs for the last fiscal period. A comprehensive and authentic audit report adds to shareholder values and assists the company’s stakeholders to analyse how the management has responded to their financial interests. In addition, business decisions of third party stakeholders such as banks, other lending institutions, and investors are centred on the company’s annual audit report (IFAC, n.d). It seems that even a well structured audit programme may fail to provide desired outcomes unless the whole audit team pays special attention to each and every phase of the audit process. The past decade witnessed a series of corporate scandals including Lernout & Hauspie, Arthur Anderson, Enron, WorldCom, Parmalat, Peregrine Systems, Rite Aid, and Homestore.com. Subsequent investigations have proven that majority of those failures were attributable to accounting fraud. However, these incidents greatly increased the significance of audit work and firms nowadays allot more money for developing internal control systems. Many of the economists argue that weaker corporate governance structure also greatly contributed to those corporate failures. As a result, organisations are vehemently trying to improve their corporate governance framework. Evidently, audit firms have made strategic amendments to their processes and procedures to detect frauds and errors in the account books of the client on time. This paper will analyse the lessons that auditors and regulators must learn from Enron Fraud. Enron Scandal: Overview In 1985, The Huston Natural Gas integrated its natural gas pipeline companies with those of InterNorth under the supervision of Kenneth Lay to form Enron. The Enron became the North America’s largest natural gas dealer by 1992 and the company’s gas contracts trading operations significantly contributed to its market dominance. The firm’s stock rose by 311% during the period 1990-1998 and its market capitalisation went over $60 billion by the end of the year 2000. This unimaginable growth assisted the company to be rated as the most innovative huge company in Fortune’s Most Admired Companies survey. Unlike other corporate giants, the Enron had not published its balance sheet along with statement of earnings and this practice persuaded financial analysts to explore the company’s sources of income. Despite the explanations given by the company officials, Enron’ stocks started to fall in 2001 mainly due to its indecipherable nature of business and vague accounting practices. Following the stock level declines, the company faced a series of challenges including restructuring losses, the US Securities and Exchange Commission (SEC) investigation, liquidity issues, and credit rating downgrade. The Enron scandal was revealed in October 2001 and it gradually led to bankruptcy. Reports indicated that Enron scandal was the biggest audit failure at that time. Jeffrey Skilling, the former President, CEO, and COO of the Enron Corporation, misled the company’s stakeholders through special purpose entities, accounting loopholes, and unsupported financial reporting practices and therefore they (stakeholders) were unable to identify debts resulted from failed deals and projects. These deceitful practices assisted the company to exaggerate its profit figures and thereby unfairly retain the trust of its shareholders. Andrew Fastow, the Chief Financial Officer, and other executives misled the Enron’s board of directors and also forced Andersen to neglect the issues. As per reports, the Enron shareholders lost nearly $11 billion when the company’s stock price fell from US$90 per share in mid-2000 to less than $1 in late-2001 (World News Inc, 2012). Following this issue, the U.S Securities and Exchange Commission commenced an investigation to bring out the actual reasons behind this unnatural stock price declines. Although Enron’s rival Dynegy had offered to buy the company at a sale price, the deal failed. Subsequent to this, Enron Corporation filed for bankruptcy on 2nd December 2001. The company had possessed assets worth $63.4 billion at the time of bankruptcy and hence it became the largest corporate bankruptcy in US history until the WorldCom underwent bankruptcy proceedings the following year. Many of the Enron executives were alleged for different charges and sentenced to prison. Employees and shareholders lost their billions of money despite limited returns received in lawsuits. Later on it was estimated that the Enron had nearly $23 billion in liabilities and this figure constituted both secured loans and debts outstanding. The corporate giant’s fall caused many financial institutions, particularly Citigroup and JP Morgan Chase to lose huge amounts. In addition, a large portion of the Enron’s assets were pledged to money lenders for the purpose of securing loans. While analysing the root causes of Enron scandal, it is obvious that the company’s non-transparent financial statements significantly contributed to the failure as they did not share the firm’s actual state of affairs with shareholders and financial/market analysts. In addition, the organisation’s complex business model and executive’s unethical business practices also fuelled the Enron collapse. The company greatly exploited accounting limitations to misrepresent its cash flow statements and balance sheet with intent to inflate the returns on the company operations. The company could hide huge derivative losses by a decentralisation strategy by which the company divided its operations among various subsidiaries and shell corporations. “The Enron scandal grew out of a steady accumulation of habits and values and actions that began years before and finally spiralled out of control” (McLean & Elkind, 2003, p.132). A management culture that encourages greed and fraud also added its share to the failure. The Enron management’s only aim was to create an illusionary image for the company rather than maintaining a real value. Some divisions of the company largely replaced its workforce annually in order to conceal the unlawful practices. Evidently, lack of strict audit policies also fastened the collapse of Enron Corporation. It has been clearly discovered that unfair political support also assisted the company to secretly continue its fraudulent operations many years. Hence, the combination of the above identified issues resulted in the bankruptcy of Enron Corporation. Lessons from Enron The rise and fall of the Enron Corporation gives so many lessons for everyone, especially regulators and auditors. According to an opinion, “the most important lesson from the Enron collapse is both the centrality and fragility of organisational trust.” (Currall & Epstein, 2003). The authors present a model for depicting the complex process of trust evolution. According to the writers, trust will be near the zero point during the early phases of a relationship since parties involved lack information about each other. Progressively, the level of trust grows during the maintenance stage as a result of trust building actions. The level of trust stays constant during this phase as long as any of the parties involved does not take actions that hurt trust Currall & Epstein, 2003). To illustrate, it is clear that the Enron could continue its deceitful business operations for a long period on the strength of trust until the SEC investigation adversely affected the company’s trustworthiness. Referring to Currall and Epstein (2003), the model indicates that the level of trust achieved will quickly turn into the domain of distrust if any trust-destroying event occurs; and it also adds that it would be very difficult for a party to achieve a zero level of trust once distrust exists. As already discussed, the company’s stock prices began to fall as it lost its trustworthiness despite the attractive financial provisions offered by the organisation. Hence, the first lesson says that every organisation must give its primary priority to the trust factor. From the Enron case study, it is obvious that the company took unfair advantages of its subsidiaries to engage in off-balance sheet financing and thereby to secure its own investments. On the strength of this unethical practice, the company could inflate its profits and deflate debts on the balance sheet. The Enron was indirectly supported by the Andersen accounting firm, who ignored the fact that the organisation’s practices were apparently unethical. Although such unfair practices assisted the company to fool its stakeholders and the rest of the world, it failed to survive in the long run. Hence, the second lesson is that firms must focus on long term business sustainability rather than short term economic benefits. A loophole may assist an organisation to make something legal but, this practice may not necessarily make the act right. Hence, every firm must specifically ensure integrity, honesty, and accuracy of the business transactions recorded. After the Enron scandal, Arthur Andersen reported that the Enron’s board of directors certified and signed the company’s (Enron) off balance sheet transaction even though they had not clearly understood what those transactions represented. In addition, although the Enron employees were aware of the fact that company’s transactions were to inflate the profits, they could not comprehend the seriousness of this practice. Furthermore, the company’s transactions were too complex to understand. Therefore, the third lesson is that people at various management levels must be well aware of the implications of every action they take. Davis (n.d) opines that if an employee has any doubt regarding the accountability of a business transaction, he must clarify it with the help of his superior officer. Obviously, several Enron employees, including some top ranked executives, tried to convince the company management about a set of threatening accounting issues. Although some persons’ claims were duly proved, the company management did not take any necessary action. In addition, the company terminated one of its key advisors. In short, the company management adopted a passive approach to its employee queries. Hence, the fourth lesson is that a company must not ignore concerns raised by its personnel regarding potential issues. In the words of Davis (n.d), every business manager has to be willing to pay specific attention to legitimate concerns raised by his subordinates and take appropriate actions. The corporate history of Enron Corporation reveals that the company had a reputation as a rapidly growing concern and it rewarded employees for structuring deals that completed in a short period of time and resulted in huge profits. Such a strategy persuaded employees to restructure a deal in a way that make it appear profitable to clients. Referring to the words of some senior Enron employees, teamwork and co-operation among employees eventually replaced with unhealthy competition and dreadful business approaches and this situation gradually led to the collapse of the company. The fifth lesson for business houses is not to achieve success at the price of unfair or unlawful activities. As Davis (n.d) argues, operating a fair business is more important than increasing the number of subsidiaries. Kenneth Lay, the former Chairman and CEO of the Enron Corporation, had close connection with Bush family. Lay has acted as the co-chairman in the re-election campaign of the President Bush in 1992. Lay and his company have also donated a total of $575,000 to the political carrier of George W. Bush. On the strength of such money donations and other services, Lay could get a central role in determining the nation’s energy policies. He could influence even the appointment of people to the Federal Energy Regulatory Commission. However, even such costly connections could not prevent the Enron debacle. Hence, as the sixth lesson points out, unfair political relations would not serve an organisation better in the long run. Hence, business organisations should not try to make profit by taking unfair advantages of political relations. The Enron collapse not only hurt the interests of its employees and shareholders, but also caused big troubles to taxation authorities, financial institutions, and pension funds. The loosened government policies and deregulations in business practices greatly contributed to this dreadful issue. According to Gutman (2002), this incident throws light on the fact that “workers, consumers, taxpayers, and stockholders can be victimised by unethical and the dishonest individuals and corporations” if the government develops policies without sufficient insights (Gutman, 2002). The Enron caused the US government to deregulate gas and electricity policies in order to preserve its interests; and evidently, electric rates doubled in California during the last summer as a result of this deregulation. Therefore, the seventh lesson tells that the US government has to reassess its thoughtless move to deregulate everything. Only the government can safeguard the interests of its citizens against unscrupulous business practices in the marketplace. Likewise, various service institutions, particularly banking, accounting, and law must also keep themselves reliable and sustainable because, such restructuring strategies may only benefit the institutions to double their revenues temporarily. Referring to the Enron failure, Gutman (2002) strongly argues that privatisation of social security would cause undesirable effects; for instance, unethical business practices of Enron caused thousands of employees and retirees to lose their pensions. The author also argues that “the relentless pursuit of profits, without regard for social values or economic fundamentals, is a cancer in our society” (Gutman, 2002. The Enron debacle strengthens the argument that regulators must play a central role in ensuring the integrity of markets since investment bankers and other lending institutions cannot regulate themselves. In addition, governments must enforce legislation so as to make accounting firms responsible for damages arising out of undisclosed balance sheet errors and frauds. Lessons for auditors The Enron scandal also gives some specific lessons for auditing firms. The Enron’s auditor, Arthur Andersen, was forced to surrender its Certified Public Accountant license when the firm was found guilty of criminal charges. Most of the practices of Arthur Andersen were acquired by other accounting firms. Although the firm was overturned by the Supreme Court of United States, the legal proceedings damaged the firm’s market reputation and hence it could not return to a viable business (World News Inc, 2012). Undoubtedly, an auditor must give great emphasis on the professional code of ethics and should not compromise with the accuracy and authenticity of the work. Furthermore, the auditor has to observe all managerial activities under suspicion. An auditing firm must understand the fact that disclosing of frauds and errors in the books of accounts of a company would add value to its reputation. Likewise, the failure to disclose frauds and errors will certainly spoil the stature of the firm and it can never come back to a viable business once its trustworthiness is damaged. Hence, auditors must sincerely work to preserve shareholder values. Corporate governance The Enron accounting fraud raises questions about the current corporate governance policies and persuades regulators/auditors to think about the development of global approach to regulate corporate governance policies. According to an opinion, Corporate governance can be defined as “the set of processes, customs, policies, laws, and institutions affecting the way a corporation (or company) is directed, administered or controlled” (Solms & Solms, 2009, p.2). Therefore, it can be undoubtedly stated that the corporate governance structure plays a pivotal role in determining the management culture of an organisation. As discussed earlier, poor management culture contributed to the corporate failure of Enron Corporation. Many of the financial analysts strongly believe that the Enron scandal could have been prevented if the company had maintained an effective corporate governance framework. Hence, the regulators must immediately consider a total restructuring of current corporate governance policies in order to establish an improved management culture. A well structured corporate governance framework has the ability to integrate shareholder interests with the fundamental objectives of the organisation and thereby add to shareholder values (OECD, 2004). The concept of corporate governance has undergone tremendous changes over the last three decades mainly due to the emergence of globalisation. However, the Enron collapse points out the fact that the current corporate governance principles have to be improved a lot to prevent unethical management practices and to promote a more regulative business approach. The Enron failure also indicates that it would be very difficult to get a true and a fair view of the financial statement if fraudulent activities are committed by persons at the helm of affairs like Chief Executive Officer. Therefore, it is advisable for regulators to refer to recent corporate governance developments in Asia that assisted countries like India and China to survive the global financial crisis 2008-09 effectively. A global approach towards corporate governance is recommendable for regulators to ensure smooth and fair management practices. Economists argue that the concept of economic globalisation promotes the idea of global economic integration which in turn would rapidly lead to the emergence of a single global market. Under such a business condition, a global approach to corporate governance would be necessary to prevent accounting fraud and deceitful management practices. A global corporate governance approach would make it compulsory for companies to follow common practices in preparing financial statements and disclosing their material facts. Such a strategy may greatly assist stakeholders to ensure the reliability of the annual reports released. Likewise, a regulative and globally accepted corporate governance strategy would be beneficial for third party stakeholders such as banks and other financial institutions to clearly evaluate the financial status of an organisation and thereby to determine whether or not to extend further credit to that particular organisation. This strategy will certainly safeguard the interests of the company shareholders by preventing the firm from accumulating huge amounts of debts. A well structured corporate governance framework suggests specific management levels and the way of management information flow. In addition, recently developing corporate governance strategies are giving primary importance on internal control systems so as to eliminate errors and frauds. These systems put a moral check on people at all management levels ranging from clerks to CEO, and hence eliminate troubles associated with errors and frauds to a large extent. Moreover, systematic management reporting and issue analyses would probably improve the productivity and thereby the profitability of an organisation. Anyhow, the corporate governance policies must give first priority to shareholder interests rather than merely concentrating on wealth maximisation. Conclusions In total, regulators and auditors have a lot to learn from the rise and fall of Enron Corporation. The case study reveals that greed and unethical business practices were the root causes of Enron scandal. The Enron case scenario also points that the element ‘trust’ plays a significant role in determining the market position of a business. In addition, the Enron collapse also reminds auditors to be more vigilant while issuing an unqualified audit report. A global approach to corporate governance would be an effective strategy to prevent unethical management practices and thereby to set up an improved corporate culture. References Currall, SC & Epstein, MJ 2003, ‘The fragility of organizational trust: Lessons from the rise and fall of Enron’, Organizational Dynamics, vol.32, no. 2, pp.193-206. Davis, D n.d, ‘Enron lessons for everyone’, Viewed 26 January 2012, Gutman, H 2002, ‘The lessons of the Enron debacle’, Common Dreams, Viewed 26 January 2012, IFAC: International Federation of Accountants n.d, ‘Audit quality and international standards on auditing’, Viewed 26 January 2012, McLean, B & Elkind, P 2003, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, Portfolio Publishers, USA. OECD: Organization for Economic Co-Operation and Development 2004, ‘OECD Principles of Corporate Governance’, pp. 1-66, Viewed 26 January 2012, Solms, SHV & Solms, RV 2009, Information Security Governance, Springer, New York. World News Inc 2012, ‘Globe broadband scandal’, Viewed 26 January 2012, World News Inc 2012, ‘Arthur Andersen’, Viewed 26 January 2012, Read More