Enron Corporation's accounting fraud and the failure of segregation of duty

Segregation of Duty

The Enron Corporation scandal led to its bankruptcy and the dissolution of the Arthur Anderson corporation; a leading accountancy and audit partner worldwide. Besides being the largest bankruptcy case in the history of America, Enron is still viewed as the biggest audit failure (Mesa & Financial Executives Research Foundation, 2012). Although it is the most well-known U.S. firm across the world, Enron collapsed too fast. This study analyses the events that led to the fall of Enron, including details of conflict of interest, the management, and accounting fraud.

Enron's Rise and Fall

In the early 1990s, Enron Corporation was globally recognized as the most innovative company. It revolutionized the old industries in favor of e-commerce business. Enron continued to operate gas lines and build power plants although it gained popularity because of its unique trading businesses. Other than purchasing and selling electricity and gas, Enron created new markets for odd items like broadcast for weather features, advertisers, and internet bandwidth. Founded in 1985, Enron was one of the leading natural gas, electricity, pulp, gas, paper and communication companies before it went bankrupt in 2001 (Mesa & Financial Executives Research Foundation, 2012). In 1995, Enron's annual revenue increased from approximately $10 billion to about $100 in 2000 (Benston, 2013). As of 2001, the company revealed that it had substantially maintained its reported financial condition through systematic, institutionalized, and creatively organized accounting fraud. The decline of stock prices from $92 in early 2000 to about $1 per share at the close of 2001 made shareholders lose almost $12 billion. This caused Enron to revise its financial reports for the previous five years only to discover that it had lost approximately $60 million. It fell into bankruptcy in late 2001 (Jones, 2010).

One lesson acquired from the internet boom is that it is impossible for analysts to grasp and evaluate new types of businesses. As such, executives like Mr. Skilling were unable to support the required open inquiry that could facilitate improved acquisition of information. However, the debacle that Enron faced is emblematic of another problem seen in recent years: the loss of objectivity by Wall Street. Investment banks are known to generate more income from mergers or underwriting deals than they do from the broker fees (Kidder & Oppenheim, 2011). Industry analysts tend to face conflicting loyalties. They fall into positions forcing them to worry whether a company CEO might find the report offensive or an investor might find it attractive.

The Causes of Enron's bankruptcy

Truthfulness

Enron's management lacked truthfulness regarding the health of the company. The senior executives thought that Enron had to be the best from all perspectives. In fact, it had to safeguard its image and its compensation so that executives could appear as the most successful in the U.S. The duty that Enron was to observe was related to full disclosure and good faith. It is shown that the CEO did inform his employees about the possible rise of the company's stock and that he would sell his stock. In addition, it is obvious that the employees could not have learnt about the sale of stock within weeks or days. Through investigations surrounding its bankruptcy, employees were able to discover about the CEO's stock sale (Rapoport, 2013). The company bought the stock to repay the money that the CEO owed to Enron, this sale qualified as an exception under the officer disclosure requirement. It was not to be reported until after forty-five days after the end of the firm's fiscal year.

Interest

Investigations indicate that a lack of independent oversight and conflicts of interest between the management of Enron's board gave birth to the corporation's collapse. Further, it has been suggested that the compensation policies of Enron engendered a myopic focus on earnings growth and stock price. Additionally, recent regulatory reforms have concentrated on improving the accounting and strengthening the internal control and accounting systems of multinational corporations. The conflict of interest between the twofold responsibilities of Arthur Andersen, both as a consultant and auditor for Enron, marks the beginning of the debacle (Mesa & Financial Executives Research Foundation, 2012). With investigations in progress, Enron has sought to rescue its business through spinning off a number of assets. The company has filed for bankruptcy, enabling it to reorganize while safeguarding from creditors. Former chairperson and CEO Kenneth Lay resigned, and the company brought in a restructuring expert as the acting CEO. The core business of Enron, the energy trading division, is entangled in a complex deal with UBS Warburg. Although the bank had not yet paid for its trading unit, it intended to share some of its profits with Enron (Benston, 2013).

Enron and Arthur Andersen reputation

Enron's accounting irregularities revealed in 2001 triggered the media and regulators to concentrate massive attention on Andersen. The magnitude of the alleged accounting errors, the role of Andersen as an auditor, and the widespread media attention created a strong environment exploring the effect of auditor's reputation on client market prices. Researchers investigated the price reaction of Andersen's customers to a number of information scenarios that made investors revise their thoughts about the reputation of the company. The most injurious to the reputation of Andersen was their admission that workers of the company had destroyed communication and documents related to the Enron engagement. Reports indicate that following the shredding announcement, clients of Andersen experienced a substantial negative market reaction (Rapoport, 2013). Andersen's Houston clients, where Enron had established its headquarters, recorded an even stronger negative market response than Andersen's non-Houston clients. The shredding declaration made a significant impact on the perceived quality of audits conducted by Andersen. This led to loss of reputation, which adversely affected the market value of the company's clients. Because studies have revealed how such evidence is consistent with the reputation effect to the auditor, auditor reputation matters to a great deal. Researchers have provided ample evidence that reputation is imperative to auditors and their clients (Mesa & Financial Executives Research Foundation, 2012).

Accounting fraud (using SPE and "mark to market" as tools)

Mark to market

As a publicly traded company, Enron has been subject to external sources of governance such as oversight by government regulators, market pressures, and credit rating agencies. In this case, the amount of which the asset will sell on the future market reports on the current financial statements after signing a long-term contract. For Enron to continue appeasing investors and creating a consistent profitable situation, its traders were pressured to forecast low discount rate and high future cash flows on the long-term contract. Enron regarded its profit as the difference between the originally paid value and the calculated net present value (Jackson, 2009). Indeed, the net present value that Enron reported never happened during the future years of the long-term contract. Obviously, the projection of the long-term income was inflated and overly optimistic.

SPE -- Special Purpose Entity

Accounting standards enable a company to exclude Special Purpose Entities (SPE) from its financial statements given an independent party has control of the SPE. The case will be the same if the party also owns at least three percent of the SPE. Enron was required to find a way of concealing the high debt: high debt rates would have lowered the investment grade that could have made the banks recall their money. Using the company's stock as collateral, the SPE borrowed large amounts of money. They used this money to balance Enron's overvalued contracts. Therefore, the SPE enabled Enron to convert assets and loans burdened with debt obligations into revenue. Additionally, when SPE took over, it made Enron transfer its stock to SPE. Nevertheless, the assets and debt bought by SPE that was burdened with vast amounts of debts were not included on Enron's financial reports. The shareholders were misled that the revenue was increasing yet the debt was becoming unbearable and increasing (Jackson, 2009).

Dilemma in Enron's case

At the time of Enron's collapse, it was engaged in a range of activities such as trading of energy related items, energy production and energy derivatives. As a result, most of its activities were potentially subjected to oversight by the federal energy regulatory board (FERB). The FERB's prime mission was to ensure the options markets and the commodity features operate in a competitive and open manner. The entity regulated the market and interstate transmission of energy products. In fact, FERB is the prime source of government oversight of publicly traded firms. In Enron's zero-sum game plan, each party is making attempts to secure more gains for themselves if best results require cooperation between the two (Jones, 2010). With no doubt, to pursue maximum gains, violation of industry standards such as accounting fraud tends to harm the interest of shareholders. As the auditor and consultant, Arthur Andersen was held responsible for both shareholders and managers because the provided accounting data has a direct consequence on economic gains of both parties. Obviously, Arthur Andersen and the managers chose to betray the shareholders to maximize their personal interests.

Moral responsibility for the collapse of ENRON

Individuals' Angle

Because corporate principles stem from actions and choices of human persons, these individuals ought to be seen as the principal bearers of moral responsibility and moral duties. The former board chair, Kenneth lay and the then CEO Skilling allowed the chief financial officer (CFO), Andrew Fastow to build a private corporate institution secretly and later made illegal transfer of property. The CFO defiled his professional ethics by engaging in a crime of malfeasance. The board's chair lay and the CEO Skilling requested some workers to conduct the conspiratorial act, which they knew was wrong. These workers were also morally responsible for the act. The court was left to establish the facts but regardless of the legitimate outcomes, the senior management of Enron got a failing grade on disclosure and truth. Ethics serves to enable practitioners recognize how a situation will be perceived (Markham, 2010).

At this level, regardless of the court's decisions, Enron was already bankrupt. This happened to the company and its managers one day before the court's ruling. No business that engages in similar activities will ever derive encouragement for lawsuits, which could be terminated in favor of Enron. The most injurious to the reputation of Andersen was their admission that workers of the company had destroyed communication and documents related to the Enron engagement. The damage to a firm's reputation via a negative perception of corporate ethics and principles was evident. Arthur Andersen, as Enron's auditor and consultant, violated the company's industry specifications, despite being a certified public accountant (Mesa & Financial Executives Research Foundation, 2012).

Corporation's Angle

The acts of a company's top executives are attributed to the company given the executives act within their authority. However, Enron's shareholders did not know. They did not notice this issue from the superficial high price of the stock. As such, the entire company was not responsible for this scandal. In fact, if the shareholders and the board members paid more attention to the decisions made by the CEO, CFO, and relevant employees, Enron could have avoided this scandal (Jackson, 2009).

Lessons learnt from Enron's scandal

Four crucial lessons can be derived from Enron's debacle

Companies must establish a healthy corporate culture. In the case of Enron, its corporate culture made a major contribution to its collapse. The top managers thought that Enron had to be perfect at everything they did. The shareholders who were not involved in this debacle were over-optimistic about the operating conditions of the company. When losses and failures emerged in Enron's performance, all they did was cover up the losses so that they could protect their reputation; they should have tried something to correct the situation. The board directors of companies must be attentive to such situations, which are "too good to be true" (Niskanen, 2007).