The Failure of Financial Reporting regarding Enron and WorldCom - Research Proposal Example

Dissertation Proposal The Failure of Financial Reporting regarding Enron and WorldCom. Aims and Objectives This study proposes to examine the failure of financial reporting in cases of Enron and WorldCom and balance of culpability on the part of the individuals charged with compliance of accounting standards when there is conflict of interest. Methodology Qualititative research is the methodology adopted for the study. This is done by case studies, interviews, focus groups, and literature review, the latter being a form of secondary research. Primary search in the form of live case studies, interviews and focus groups are redundant now as there is considerable literature already available for the proposed study. Preliminary Literature Review In a brief history of the cases, Enron, On October 16, 2001 Enron declared to SEC a net loss of $ 618 million for the third quarter effectively reducing share holder equity by $ 1.2 billion. SEC opened enquiry the very next day and called for details from Enron officials who in turn notified their Auditor Arthur Andersen. Pursuant to this, Andersen had his team destroy Enron-related documents. As a result, Enron, Andersen and his lead partner Duncan were convicted of obstruction of justice. Enron's Chief Financial officer faced indictment on 98 counts of fraud and related offences. Besides Enron is now bankrupt, and civil and criminal investigations continue to examine Enron's complex accounting practices and byzantine financial schemes. (Brickey) Close on the heels of Enron episode, WorldCom's fraud surfaced dwarfing the former. Both the cases involved accounting frauds with the companies managements' sole aim of keeping the share prices higher in spite of huge losses which they covered by manipulation of accounts. But for the whistle blowers from both the corporations, the frauds would not have come to light though bubble would have ultimately burst by the operation of economics. But more money would have been swindled, more would have fled the scene had it not been for the whistle blowers who had little protection prior to Sarbanes -Oxley enactment. Sherron Watkins, a Vice-President at Enron who discovered accounting fraud disclosed it to its Chairman Ken Lay in five memos detailing Enron's off-book partnerships, special purpose entities and urged him to disclose accounting irregularities. Though he agreed to engage a law firm to conduct preliminary investigation, he appointed the firm of Vinson & Elkins in spite of Watkins' advice not to engage them as they were also party to structure some of the questionable deals. And the law firm not surprisingly gave clean chit to the questioned transactions. Watkins preferred to depose before congressional hearings probing the Enron's affairs. Similarly Cynthia Cooper, Vice-President, Internal Auditing, WorldCom exposed a larger accounting in her corporation when she came to know of a sample fraudulent transfer of $ 400 million from Reserve account to inflate the corporation's earnings. Here again Arthur Anderson was the Auditor for the corporation. While he tried to convince her by insisting no abnormality, the CFO Scot Sullivan literally tried to silence her. (Ripley Amanda) She therefore independently conducted inspection of account books and found that the management had capitalised operating expenditures and converted a $662 million loss into a fictitious $2.4 billion profit.CFO Sullivan learnt of her attempts to unearth such manipulations and warned of her dismissal if she did not stop. "After going to the audit committee, she and her audit team remained hopeful that they could find something they might have missed that would explain the unorthodox accounting. But Cooper's hopes were dashed when she confronted WorldCom Controller David Meyers, who conceded that the entries could not be justified. " (Brickey) The charges against Andersen were that he had knowledge of accounting irregularities at Enron, and fraud relating special purpose entities used by Enron, that he hired an out-side law firm in anticipation of litigation on engagement with Enron soon after Enron informed him SEC enquiry, that his partners asked employees of Andersen firm in various locations to destroy documents relating to Enron in their offices and also electronic files to pre-empt access for governmental investigations. These charges were resisted by him on the ground that destruction of documents took place before he was actually asked to produce officially and that no incriminating ones had been destroyed(Brickey) Though he tried to take shelter under obstruction of justice provisions, the Government relied on witness tampering act. (Indictment) But Anderson's antecedents weigh much against acquittal. See Tables 1 & 2 in the appendix. Watch Dogs and their legal obligations The Corporate entities being custodians of public money, they need to be kept under surveillance by the watch dog institutions for compliance of various statutes and submission of accounts disclosing true and fair view of the corporate. The institutions charged with the oversight are SEC, Board of Directors, Auditors, Wall Street Securities Analysts and Credit Rating Agencies. An examination of these entities' roles played by them in the case of Enron and WorldCom leave much to be desired. The misdeeds though were the acts of Enron and its management, it some how prevailed over the monitoring agencies both private and public to turn blind to their activities and public disclosures. The Senate Committee on Governmental Affairs examined the roles played by these agencies "in monitoring the financial activities of publicly held companies, from the company's Board of Directors to the accounting firm that audited Enron's books to stock analysts and credit rating agencies that purported to give the public accurate and objective information about Enron's financial health" (Report 2002) The failure of the watch dogs in discharging their duties have been detailed in the report of the senate committee on governmental affairs of October 2002. Not one even one of them was alert. The short coming calls into question the expectations upon which the frame work of regulatory mechanism is built. The SEC which is a small set is not meant for directly involving itself to oversee day to day affairs of the entities though it can only gauge the performance and goings-on by analysing the periodical returns to be filed by the corporates. Besides, it basically relies on the reports by Auditors and other agencies that are supposed to be independent and not to involve with any transactions which will give rise to conflict of interests. Different Surveys indicate that 57 % of the respondents do not believe in the reports of corporate executives and brokerage firms as giving honest information about their companies and one third indicates that what happened at Enron is very much happening in most of the companies. 72% informed that stock brokers acted on their own interests and not on the interest of clients. 73 % informed that there is widespread practice of auditing, hiding damaging information about the companies. 77% indicated that top executives indulged in self-serving actions. The Senate Committee report cited above says that SEC did not review Enron's post 1997 filings although it had reported significant growth and changing nature of its business knowing pretty well that other gate-keepers namely Board of Director and Auditors were becoming quite unreliable. Its interaction with Enron shows that they were merely reactive rather than pro-active and not taking anti-fraud measures. Enron did not fully disclose the details of transactions it had with related parties mainly that of Enron's CFO Andrew Festow and those who worked under him. It deliberately excluded the debts of certain special purpose entities from the balance sheets and showed as sales of assets certain transactions in order to get poor performing assets out of the books of accounts though ownership remained intact without being transferred. Taking loans and showing receipt as sales proceeds and failure to disclose the extent of contingent liabilities in full, showing exchange of shares for notes as assets in order to increase equity which in fact reduced it were also being indulged in by Enron. These transactions amounted to staggering figures. The loan-cum commodity trade itself amounted to $ 7-8 billion. About $4 billion contingent liabilities was kept off the Balance Sheet. Failure to consolidate two SPEs resulted in restatement of net income for four years and amounted to $500 million. Improper hedging transactions resulted in a charge against the earning to the extent of $710 million. Improper exchange of note for stock reduced $1 billion of equity. All the above transactions were supposed to have been prevented by the Board of Directors of Enron and its Auditor Arthur Andersen who were the first lines of defence for the company. It is no surprise for Enron's auditor to have indulged in such fraudulent activities as in the past few years 270 such incidents have taken place in the year 2001 alone." Though Andersen has surely had its share of audit failures with Sunbeam, Waste Management, Enron, and now WorldCom, the other big four accounting firms can hardly boast spotless records: PricewaterhouseCoopers audited Microstrategy, Ernst & Young audited Cendant, KPMG audited Rite-Aid and Xerox, and Deloitte & Touche audited Adelphia, all of which resulted in significant audit failures" ( Report 2002 foot note 91) It has been clearly established that Andersen was well aware of the problematic transactions and in fact warned the management that they were in the nature high risk accounting. "Among themselves, Andersen partners involved on the Enron engagement were even more frank. In its yearly client risk analysis on Enron, Andersen expressed concern about some of Enron's business as "form over substance transactions"; in an e-mail describing the content of one annual client retention meeting regarding Enron on February 6, 2001, Andersen acknowledged "Enron's dependence on transaction execution to meet financial objectives," and how "aggressive" Enron was in its accounting." Yet compromising with the accounting manipulations, Andersen earned $ 52 million as fees from Enron for the year 2000 out of which $ 25 million was for audit work and $ 27 million for consulting services. The latter should not have been taken for services rendered as it resulted in conflict of interests as an independent auditor of Enron. However fact remains that Enron's auditor did not verify the accuracy its accounts. As for the Board of Directors, it appointed a committee to investigate the transactions which was connected to the Enron's Chief Financial Officer Andrew Fastow and his ex-colleagues. Permanent Subcommittee on Investigations (PSI) of the committee mentioned above, held that Board of Director did not take sufficient care to protect share holder value. It investigated more than one million documents and several interview with board members who had to say the management below concealed facts from them though the Board did have knowledge of high risk accounting. Despite their inefficiency, the members of the board earned $ 350,000 per head from the company in the year 2000 which is more than double the standard wages for nationally traded corporation directors. This high remuneration must have motivated them to compromise with the management practices of fraudulent accounting. SEC which was the last resort to ensure accuracy, could have done something to prevent or at least discover sooner the accounting fraud of Enron. It had come to notice that Enron had at least one lobbying contact with SEC during the first half 2001. Besides the above watchdogs, there were Wall Street Security Analysts and Credit rating agencies. who displayed more interest in pleasing Enron rather than disclosing true position to the investing public."The analysts who covered Enron, as a group, maintained an optimistic outlook on that company's prospects, even as the stock slid over the course of 2001. After reaching a high of $90.75 in August 2000, the stock's high in 2001 - $84 - occurred on the first trading day of the year; by the end of September, the stock closed at about $25, after a fairly consistent fall throughout the year. Nevertheless, Enron analysts retained their bullish stance: of 15 sell-side analysts who covered Enron, 250 13 had a buy or strong buy on August 7, 2001; on October 17, 2001, the day after the company announced a $1 billion charge to earnings and the day that the Wall Street Journal broke the story of Enron's financial shenanigans involving related-party transactions with partnerships headed by Enron's own chief financial officer, 15 out of 15 of the major analysts who covered Enron had a strong buy or buy rating on the stock."( Report 2002 page 74). Coming to the Credit Rating Agencies, they did not perform by paying attention to allegations of fraud and believed what the company officials said. "As of late March 2000, the three agencies gave Enron the same rating: Moody's405 gave it a Baa1, and S&P406 and Fitch407 both rated Enron as BBB+, indicating an upper level within the category of good credit quality.408 Retaining this investment grade rating, and even improving it, was vital to Enron because its ability to operate and grow its trading business as well as to access the capital markets for its liquidity needs were absolutely dependent upon the stability that the rating provided. In fact, the company consistently lobbied for a higher rating.409 Nevertheless, given the volatility inherent in an industry that was in the process of deregulation, and given that Enron was a company that took a number of risks, the rating agencies did not consider a higher rating appropriate" (Report page 110,111) Discussion. The preliminary literature review would show that the Enron's story is mixture aggressiveness in enhancing the firm value by hook or crook and with the aim of ultimately catching up with real high performance by some section of stake holders and self-enrichments by some sections in the process. This calls for balancing between aggravating and mitigating factors of culpability of the parties involved in the episodes of both Enron and WorldCom. The factors mentioned in Table 3 of the appendix would serve as a guide to arrive at the balance culpability which shall be main conclusion of the study after initiating even more detailed literature review on both Enron and WorldCom. Conclusion It is hoped that this proposal would arouse interest of the investing public and academic community for the main study which might contribute to avoidance of such scandals in future. REFERENCES Brickey F. Kathleen Washington University Law Quarterly vol 81.357 'from Enron to Worldcom and Beyond: Life and Crime After Sarbanes-Oxley' Brickey F.Kathleen Washington University Law Quarterly vol 81; 931 Indictment, United States v. Arthur Andersen LLP, CRH-02-121, at 7 (S.D. Tex. Mar. 3, 2002 Report of the Staff to the Senate Committee on Governmental Affairs October 8, 2002 Financial Oversight of Enron: The SEC and Private-Sector Watchdogs Ripley Amanda, Amanda Ripley, The Night Detective, TIME, Dec. 30, 2002/Jan. 6, 2003, 44, at 46-47 Appendix Table 1 Table 3 (Source 1997 Administrative office of courts) . Read More