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Enron Case Study
Enron was a company that started out small, but through some ethically unsound decisions, grew to control a large percentage of the energy market in America. In order to expand financially, Enron's executives skirted the law, creating several "independent" companies, called "special-purpose entities" (SPEs) into which they were able to hide many bad and devalued assets. In short, the executives used Enron money to create seemingly independent companies which purchased many of Enron's bad investments, clearing them off Enron's books and making the company seem more profitable than it really was. This was because although the bad assets were no longer associated with Enron, they were still owned by companies which were owned by Enron. Enron still owned all the bad assets, they just hid them in different books than the ones they showed to the public.
One of the major causes of fraud at Enron was found to be the Performance Review Committee (PRC) process: a bi-annual review of each employee. This process was a vigorous evaluation which did not just "compare a worker against his or her job expectations -- the worker was compared against all the other employees in the same business unit." (Fox, 2003, p. 83) This created a level of competition that was beyond the normal rivalry and entered the level of cutthroat tactics. Employees were constantly under threat of losing their jobs if they did not perform at unprecedented levels, and this meant making the company more profitable. And because the individual worker's compensation package was directly tied to the PRC process, employees were put into the position of having to report what they viewed as possibly unethical behavior about superiors to the same people who were performing the unethical behavior, and had absolute control over the employee's job security and compensation package. This led to a chilling effect on the employees, who did not want to "rock the boat" in fear of not getting year-end bonuses, or possibly even losing their job.
One clear example of this came when the company decided to create LJM1, an SPE that was first created when Enron formed a partnership with an internet service provider. Enron wanted to sell the shares of the provider but was restricted from doing so by a contractual agreement. So they created a company called LJM1 which purchased the provider's stock at inflated prices and took them off the books at Enron. Later, when the price of the stock fell, Enron did not have the loss on it's books. And because Arthur Andersen, Enron's accountants, allowed LJM1 to be isolated from Enron's books, it went unnoticed. In the end, LJM1 was stuck with stock from the internet provider, which they purchased from Enron at inflated prices, and now were worth much less. When Enron employees did notice the discrepancies they were faced with the problem of informing on the people who were also responsible for the PRC process. For instance, Jeff McMahon, an Enron employee who noticed the shady deals involving LJM1, felt that he "was being put in an awkward position in having to negotiate with Andy [Fastow] and that might impact his compensation package." (Fox, 2003, p. 202) Andy Fastow was the Enron executive who first created the company LMJ1 in order to hide unprofitable assets.
It was the accounting firm of Arthur Andersen who was responsible for identifying and informing about unethical and possibly illegal activities by the company's executives. However, "the original accounting treatments for the…LJM1 transactions were wrong…in spite of extensive involvement and advice from Arthur Andersen." (Brooks and Dunn, 2004, p. 68) And it was later discovered that Arthur Andersen was paid $5.7 million ABOVE their audit fees for their advice. It certainly appeared as if Arthur Andersen accepted a $5.7 million "fee" in order to keep quiet about Enron's business practices. However, this was never proven and Arthur Andersen never admitted to taking any bribes. But when the firm hired to review the financial books of a company failed to find any wrongdoing on the part of Enron executives, despite the fact that they obviously were performing fraudulent practices, the internal review control mechanisms were obviously compromised.
During the 1990's Enron was not alone in committing financial statements fraud, there were a number of large corporations that were also doing it. There were a number of reasons why, but one of the most important causes was the good economy which masked may of the problems. Companies wanted to present the best possible face to the public and would perform almost any action to do so. And as long as a company's stock price continued to rise, making profits for the stockholders, no one cared how it was being done. Another cause was the incentives offered to executive for company performance. Since the stock prices were tied to the company meeting earnings expectations, and the executive's own financial compensation package often included large numbers of shares of company stock options, the executives had a number of incentives to do anything they could to meet, or exceed, earnings expectations. When this situation is mixed with the fact that the accounting standards (GAAP) were "rules based" instead of "principles based," this led to executives finding ways around the rules with no regard to principles of proper and ethical accounting and business practices. (Albrect, 2005)
If I were a certified fraud examiner and came upon Enron's situation and found that I could not explain how Enron was making money, this would be a definite "red flag." First of all, while the fact that the company is making a steady profit is attractive, no one should invest in a company if they do not fully understand how the company operates. And as a certified fraud examiner, it is my job to discover financial fraud in companies like Enron. If I could not figure out how the company is making money, then something is definitely wrong, I would have all the training and experience to dissect the company's financial statements and discover the inner operations of the company.
The Generally Accepted Accounting Principles (GAAP) have been shown to have had two important shortcomings during the 1990's: first the American model of specifying rules appears to have "allowed or required Andersen to accept procedures that accord with the letter of the rules, even though they violate the basic objectives of GAAP accounting." (Bentson and Hartgraves, 2002, p. 124) Specifically, Enron created SPEs, which were supposed to have 3% of their assets independently owned, were in fact, owned entirely by Enron. And secondly, the "fair-value requirement for financial instruments adopted by the FASB (Financial Accounting Standards Board) permitted Enron to increase its reported assets and net income and, therby, hide losses." (Bentson and Hartgraves, 2002, p. 124) Arthur Andersen was obliged to accept these valuations, which turned out to be completely wrong, because Enron was following GAAP rules.
Since the financial collapse of Enron, and the discovery of their scandalous accounting practices, the various accounting authorities, SEC, FASB, and ISAB, have instituted reforms to ensure that the Enron type practices do not defraud investors in the future. In order to prevent other companies from hiding bad assets from investors, "the authorities have required fair value, at least for financial assets, even when they are not based on reliable market values." (Niskanen, 2005, p. 77) Another change that has taken place is the accounting authorities' re-evaluating the "rules based" interpretation of the GAAP against the "principles based" interpretation. Many of the authorities now want to emphasize the principles on which the GAAP rules are based, rather than the letter of the rules as an obstacle to get around. And finally, there is more competition between the standards agencies than before. This is important because at the time of Enron, the different…[continue]
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