THE ENRON SCANDAL
Enron Corporation is a United States company established in Houston, Texas and was constituted in 1985 by the founder Kenneth Lay after merging the Intern North and Houston Natural Gas (Markham, 2010). The company dealt with energy based services and products and was considered to be one of the most innovative companies in the United States. However in the country’s history it is the first ever large cooperate bankruptcy to ever been filed, with assets worth $63.4 billion (Markham, 2010). A swift turn of events took place with shareholders which comprised of the employees who had the corporates’ stock in the 401(k) retirement plan and other investors losing billions of dollars. This paper delves into the important systems that failed to meet the expectation to eventually lead the company to the biggest audit failure ever, how the auditors colluded with the management to hide critical issues as well as failure by the board members to questions the proceedings in the company. The stock analysts such as Wall Street and bond raters, the rules that govern the employer share in a company pension plan as well as the unregulated energy derivatives trading that Enron exercised for an extended period. The paper shall also look into the related legislation surrounding the Enron scandal.
The company was almost considered to be a new economy maverick that set aside musty, out dated industries with their hard assets that favored the carefree circle of e-commerce. It proceeded to build up more power stations and run gas lines but later changed its concentration inn distinction to governed conveyance of gas to an uncontrolled energy trading market. The company started engaging in diverse businesses such as creating markets i.e. for the broadcast time for advertisers, internet bandwidth, and weather futures. The principle that might have guided the company into adopting this idea was probably the existence of better financial outcome in purchasing and marketing of fiscal contracts associated to the measure of energy assets as opposed to the literal ownership of the real assets. Many observers that included professionals from Wall Street termed this as a spectacular achievement in the transformation of the company just before the fall of the company in late 2001.
The problems that surrounded the company may have probably not originated at the time when the company invested its core business of energy operation. For instance, in the early 1990s the company’s income sprang up from below $10 billion to a high of $101 billion in the financial year 2000 which got the company a seventh position on the Fortune 500 ranking (Fox, 2009). The dealings that might have inflicted losses on the company would stem from the other ventures, for instance, the internet and communication business and various other foreign subsidiaries. The company adopted CRS-2 accounting system that involves loose partnerships and peculiar purpose entities that would cover up the substantial losses from being captured in their financial statements thereby concealing the magnitude of its indebtedness. On disclosing these unwarranted accounting tactics, all the profits that the company had recorded since 2000 disappeared and the company collapsed after a short while.
The unfolding of these events started in August 2001 with the resignation of Jeffrey Skilling the CEO without disclosing the grounds (Rapoport, 2011). Later on October 16 the company accounted its first quarterly losses in the four years accepting a charge against net income of one billion dollars for badly doing companies. On the 8th of November, Enron publicized at securities and exchange commission abbreviated as (SEC) filing its intent of restating the earning from the company from previous year beginning at 1997 to the present year, reducing them by $586 million (Rapoport, 2011). The company ended up filing for bankruptcy in accordance to chapter 11 on December 2, 2001, which was after a coup-de-grace offered to the company on November 28, whereby the leading bond rating bureaus rated Enron’s debt to be considered below investment grade.
The sudden fall of such a huge corporation had to raise eyebrows on the United States system of regulation, and not only that but also proper answers had to be sought. Close to nine commissions in the senate and the house held hearings related to Enron’s downfall. The legislative arm of the government is not the only one that had intentions of unearthing what transpired in the company, the justice department also conducted several criminal investigation to get the responsible people. Despite the outcome of the investigations on the management of the company, whether the lawyer or the accountants had carried out grievous acts. The major problem still revolved around the United States organization of security regulation that centers on an accurate and full disclosure of every bit of financial data so that market players need to arrive at an informed investment decision. The scandal, therefore, opens up a discussion on how to ascertain the authenticity of the information dissipated to the public about various corporations.
The federal security laws state that any accounting statement of a publicly traded corporation must be certified by an independent auditor (Niskanen, 2011). On the contrary to the expectation that external auditors could give credible information, the Enron auditors did not satisfy that expectation. The investors that included major financial institution were made to believe faulty information concerning the company’s earnings that were reiterated, and the liabilities and losses that were bigger than what was reported. The occurrence lead to the arrest of Arthur Andersen who was the auditor to the company on felonious obstruction of justice accusations that relates to the invalidation of relevant files.
The oversight of all the auditors has been a responsibility of the American Institute of certified public accountants. It is the body that regulates the legitimacy of auditors’ performance in the whole country. A primary concern in the Enron auditing issue is that due to the extensive consulting service Andersen had offered the corporate may have led to the compromise of judgment and independence in ascertaining the nature, extent, and timing of audit processes and in making requisition of revisions on financial statement which is the obligation of the management body.
There were several proposal fronted from different quarter on how to prevent an occurrence of a similar scenario in the future. Ranging from the SEC, in the Congress and Bush administration that a newly regulatory system that would handle disciplinary, independence oversight, and quality control of auditors gets instituted. There seemed to be a uniform agreement that the Securities and Exchange Commission would exercise direct control of the administrative process, and that the large section of the member of the newly formed institution would be drawn away from the accounting industry. The benefit of having members from outside accounting discipline is that they can provide critical information and question anything that is not clearly defined.
An important auditing argument is the supplying of non-audit service to the audit consumers. Many perceived that the provision of similar dispensation is a situation that may sabotage the arm’s-length, overseer posture anticipated by the outside auditors. Considerable number of bills were brought before the 107th Congress would restrict the furnishing of non-audit services by auditors to their customers. Some major accounting firms at that time made a decision not to provide their customers with internal audit and information technology service, which is deemed to likely increase levels of independence.
The Enron contention involved significant accounting system contentions. The spectacular one is that which relates to the principles regulating whether a financial statement of special purpose entities, constituted by an association ought to be centered within the firm’s financial statements. In some various SPEs partnership at issue, consolidation is not a necessity additionally an autonomous third party can invest as low as 3% of the capital that many consider to be a very low threshold (Niskanen, 2011). The other issue pertains the usage of derivatives to misrepresent accounting results, which its outcome may not give the true picture of a company’s performance. A third matter is about the rampant calls for mended disclosure in remarks to management analysis or financial statements especially the arrangements made concerning the liabilities. Financial Accounting Standards Board (FASB) has the mandates to set the accounting standards for corporations, SEC makes up another body that sets requirements especially since it has the statutory authority to establish accounting standards for firms dealing in sales of securities to the public.
Taking a similar course to the other established companies Enron rolled out a retirement plan for its employees named 401(k) whereby they chip in a segment of their earnings on a tax-negotiated basis. According to the records provided as of 31st December 2000, 62% of the total assets held in the firm’s pension account constituted of its stock (Sterling, 2009). Some of the employees invested in the companies’ stocks through their 401(k) accounts. As a consequent of the reduced shares that traded at less than 70cents in January, 2002 these employees lost a higher value of their retirement benefits when the value of the company shares fell from $80 per share.
The losses that the contributors in the Enron’s 401(k) program suffered, aroused a lot of questions revolving around the regulations and laws that govern similar programs. A legislation presented before 107th Congress proposed that account data should be furnished more often so that the participants may be updated. In addition there should be a limit set to regulate the number of executive stock that 401(k) program can control, the shareholders should be at liberty to sell the stocks contributed by employers within the first three years, enhance the members’ access to financial consultations besides prohibiting the ability of a company to sell its stock while there is a plan underway.
Corporate governance issues
The board of directors in a company play a watchdog role to the management and to ensure that they protect the shareholders’ interests. In 1999 the board of Enron Corporation gave up rules that governed conflict of interest in the company, this, therefore, gave the company chief financial officer who at that time was Andrew Fatsow the liberty to make private partnerships business with the firm (Sterling, 2009). Such partnerships made the company incur big losses and debts that were concealed and had a substantial impact on the company’s accounted profits. The collapse of this great corporation raises a question on how best to reinforce the directors’ potentiality to challenge doubtful transaction by the corporate managers. More worry involves the independent director, which the stock exchange regulations require to constitute a given part of the board members, these members have no affiliation in any way with the firm or its management.
With the expectations of the country growing on how to avoid a similar occurrence in the companies in the future, there is a concern on whether the mode of selection of such outside directors should be changed. The concern is valid since in most cases during the elections candidates that the management fronts often pass with a unanimous vote. Other suggestions fronted are whether there should be an increment in the individual responsibility of the directors in events of corporate fraud.
The rules should be reshaped to capture the literacy level of board members concerning finances, to help them identify any possibility of fraud. However important this could be it may be very hectic since big corporations such as Enron employ complex financial and accounting strategies that the little-informed members may not readily grasp. Among the reforms proposed also entails the quick electronic revelation of stock trades by company senior managers, directors, and some insiders. Some other aspect of the change will be the part played by the audit commission of a corporation board that will require them to take an active function in the supervision and selection of outside auditors.
Securities Analyst Issues
The security analysts assume the role of carrying out research on various corporates and then give recommendations on their status and thereby rate them as “buy,” “sell,” or “hold”, the recommendations pegged on a corporate can the utilized by the company staffs and investor clients. All the information gathered about a company are crucial and are widely spread for use across the markets by investors. Analyst backing was crucial for Enron because it relied upon funding from the financial markets. When the company’s stock had fallen by close to 99%, rating agencies downgraded it as “junk bond” status except for only two which still rated its stock as “sell” (Markham, 2010).
With the events that occurred at the Enron corporate and the company thereafter losing most of its rating, it was not logical for an analyst to rate it as a sell that raises critical question on whether the analysts are always compromised. More questions would still arise similarly to what was being raised during the “dot com” stock crash in 2000, such as how objective are the stocks analyst or they get compromised by insistency to avoid disaffecting lucrative investment banking customers. Another concern whether there should be a regulation imposed that will disclose the analysts’ personal holding or the deals undertaken with their employers, or to prevent the associating of analysts compensation to investment banking profits. Another burning concern is whether the analysts’ qualification and performance be monitored by self-regulatory organizations or by SEC.
Banking related issues also lead to the fallout of Enron. The notable banks that the company transacted with include J.P. Morgan Chase and Citigroup, they equally got affected in both the commercial banking and investment banking and profoundly felt the effect of the company’s fallout. These two activities were initially separated by Glass-Steagll in the 1933 Act, but by 1999 it was repealed, this, therefore, gave an opportunity for the conflict of interest and the banks that got involved with Enron, for instance, got a major blow due to the losses incurred (Markham, 2010).
The mode of relation of Enron with its banking partners have raised many questions, for instance, do financial holding companies, i.e. the companies that have both commercial along with investment banking operation, suffer conflict of interest on whether to avert excessive danger on loans from their various firms sides against their prospect to reap profits from deals that fall on their respective banks. Secondly whether the bankers might have been enticed by Enron so that they could keep on funding the company and then recommending its derivatives and securities to other parties? Thirdly the Dynegy rescue plan contrived towards Enron’s prostration, that involved further investments of Citigroup and J.P. Morgan Chase involve acts as a protective self-dealing.
The fall of the company served a purpose to identify the proper accounting format that should be used for banks off-balance-sheet details containing derivative berths and allowing credit for instance the one given to Enron. The Enron position provided an insight into the need of fine tuning of the manner GLBA mixes the dissimilar business exercises of commercial banking and Wall Street.
The central constituent of the firm’s energy business comprised deals in the derivatives contracts founded on the prevailing costs of oil, electricity, gas and other vital variables. For instance, the company would get clients on long-term agreements for fixed prices they sell out the energy. This type of plans enabled the buyer to avoid risks that are involved with increases in the energy prices affect their income in businesses. The market explores by the company was largely unregulated, and little information could be obtained in the degree and profitability of Enron’s derivative activities beyond what financial records contain that may have had problems.
While there existed a lot of speculations that Enron could have possibly incurred losses through the derivative trading being considered as a high-risk activity, there were no evidence found to indicate that these links led to the fall out of the company. However despite the lack of proof, trading in the derivatives probably played a role in the downfall of the company. Enron’s case elicits the concern of the oversight of the derivatives markets. It makes a logical point to ensure that the regulators have to a greater extent information about the risk exposures and portfolios and major dealers in the derivatives.
Enron a well-established corporation would not stand and then fall so fast but, due to a difficulty in dealing with very crucial matters surrounding its management it had to fallout. It’s fall did not only affect the company alone but took down even the well-established auditing partnerships such as Arthur Anderson. The management problem, the conflict of interest and major accounting fraud brought the company down too fast, as well as the biggest audit failure, just at a moment when it was thought to be in its prime states with good performance in the stocks market. The Enron’s bankruptcy may have caused a little impact in the energy prices and supplies but alike dealer bankruptcy in the future may lead to adverse effects on its lenders and trading partners and could cause a widespread disruption in financial and or actual commodity markets.
Fox, L. (2009). Enron: the rise and fall. Hoboken, N.J.: Wiley.
Markham, J. (2010). A financial history of modern U.S. corporate scandals from Enron to reform. Armonk, N.Y.: M.E. Sharpe.
Niskanen, W. (2011). After Enron: lessons for public policy. Lanham, Md.: Rowman & Littlefield Publishers.
Rapoport, N. (2011). Enron and other corporate fiascos: the corporate scandal reader. New York: Thomson Reuters/Foundation Press.
Sterling, T. (2009). The Enron scandal. New York: Nova Science Publishers.