The Financial Collapse of Enron Corporation - Case Study Example

The Regulation of Financial Reporting ENRON Report This report examines the relevant events leading up the Financial Collapse of Enron and its impact for the future of financial reporting. The essay goes on to discuss the valuable lessons from financial reporting and the preparation of published financial statements. On October 16, 2001, Enron Corporation of Houston, Texas, one of the largest corporations in the world, announced it was reducing its after-tax net income by $544 million and its shareholders' equity by $1.2 billion.1 On November 8, it announced that, because of accounting errors, it was restating its previously reported net income for the years 1997-2000. These restatements reduced previously reported net income as follows: 1997, $28 million (27% of previously reported $105 million); 1998, $133 million (19% of previously reported $703 million); 1999, $248 million (28% of previously reported $893 million); and 2000, $99 million (10% of previously reported $979 million). 1 Introduction On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. With assets of $63.4 billion, it is the largest US corporate bankruptcy.2The Enron Scandal was the most controversial time for the American Financial Markets as the tax-deferred 401(k) retirement plans of the Enron employees were reduced to nothing. The reason Enron's bankruptcy concerns the field of accounting greatly is that its prominent ,long-time auditor, Arthur Andersen, was charged with a large dereliction of duty and even fraud by the press and members of the US Congress and is still facing countless lawsuits. The current position in the Aftermath of this fiasco is that the Securities and Exchange Commission has called for the creation of a new oversight body to regulate and discipline published financial reporting.The SEC, the Financial Accounting Standards Board (FASB), and the American Institute of CPAs ( AICPA) are all under constant fire for not having clarified and properly implemented the GAAP rules relating to special-purpose entities which were the sham vehicles of Enron's shoddy accounting financial statements. 3 The following table shows some of the accounting statements/figures for Enron 4 This table shows some of the information that was used to mislead the public about the health and wealth of this promising company. Enron became a household name during its zenith, due to its promising financial records. This table shows the data from Enron Corps Annual Reports with its very promising figures concerning the records of its unconsolidated affiliates. _ SUMMARY OF THE EVENTS LEADING TO THE ENRON DISASTER 1996 The use of unconsolidated SPE's allowing the Senior execs to take money from the Enron accounts without the fact showing on the published financial statements- Senior Executives draw large remunerations for themselves ,and an era of shoddy accounting begins with risky ventures and sunk investments paving the way to financial disaster. 1997 Creation of Chewco to hide debt and inflate profits .. 1998 Financial disasters of capital intensive ventures (including a water distribution scheme and power plants in Brazil.) 1999 Permission by the Enron board of directors to waive conflict of interest rules thus allowing Andrew Fastow to run private companies that do business with Enron. The creation of LJM a sham company which is shown on the records to be buying poorly performing Enron assets. Thus a complex and questionable accounting practices saga begins that will lead to the downfall of Enron's 2000 Filing of fraudulent files for the 10-K , 1999 and forged correspondence on accounting matters.There is a large scale sale of Enron shares and more fraudulent filing of accounts for the third quarter of 2000 2001 This was a crucial year for Enron as its Ceo's committed further security fraud by omitting the company's poor financial and the Enron executives got bonus checks for millions of dollars.Ironically at this time Enron was named "most innovative company in America" for the sixth consecutive year by Fortune Magazine. Trouble began in May when tEnron's stock price closed below $59.78, a critical point for one of the partnerships. The Chief executive of Enron sold 1.1 million Enron shares over the next 21 days. At this point further accounting misrepresentations were being made in the published accounts and it was being said that Enron's accounting practices are "legal and totally appropriate," that Enron stock is "an incredible bargain," that he and other executives have bought Enron stock in the last two months, and that "the third quarter is looking great" in an online forum. In the October that year after a lot of reluctance Enron gave in to a SEC enquire into its shoddy accounts and admitted that it had overstated profits by $586 million over five years and announced that the payment of a $690 million note was nearly due as a result of the descent of its credit rating. Enron filed for bankruptcy in December and 4000 people lost their jobs. 2002 This year marked the formal criminal investigation into Enron's bankruptcy and Arthur Andersen admitted to destroying the financial records of Enron documents prices. Also FERC launched a formal investigation into potential misconduct by Enron in the power generating and marketing industry. 2003 In this year Enron subsidiary PGE agreed to pay $8.5 million to settle a case involving illegal trading practices and admitted that . $1.3 million of the payment would go to the state of Oregon. 2004 Enron creditors are allowed to receive 11 billion in cash and stock and Andrew is sentenced to a ten-year prison sentence and forfeiture of $23.8 million. Lea Fastow, former Assistant Treasurer for Enron, will serve a five-month prison sentence and a year of supervised release, including five months of house arrest. Both provided testimony against other Enron corporate officers. . Analysis of Events leading to the Enron collapse For the purposes of accounting practices the most important thing to analyse is that who exactly in the accountancy/auditing profession should have taken responsibility for the shortcomings in the accounting records .These accountants were clearly abusing their authorities as watchdogs for shoddy practices and instead they perpetrated fraud on the investors.. The Statement of Accounting Standards 100 clearly allocates responsibility to auditors in the matter of financial statements 'the responsibility for the preparation of the financial statements is that of the directors of the entity'. The auditor has to scrutinise and guard any financial wrong doing on behalf of the directors with regard to Auditing and Accounting Standards. It is evident from the events leading up to this disaster that the auditors and accountants were responsible for providing shareholders with 'reasonable assurance' that the published statements would present a true and fair view of the company's financial position.In the case of Enron not only was there evidence of malpractice with in the accounts,the destruction of these accounts was a criminal offence in itselfAnderson's defence of merely expressing an opinion on the financial statements prepared by the company did not hold up in the court of law either .He acknowledged that there was one error of judgment and blamed Enron for providing the wrong information.This was in breach of his obligations under the SAS 600 and even though this accountant/auditor tried to say in his defence that the information was provided by Enron itself to make its stock attractive to unsuspecting investors. Interestingly Anderson (despite his obligation to neutrally examine the company's financial statements and report any due shoddy transactions) not only accepted this information provided to him by Anderson but also accepted a salary of $52 million last year in return for his consulting services.He aided and abetted Enron in making its corporate icon fallacy come true and it is often said that the money paid for his consulting services equalled to a bribe being given to auditors in other times for not calling an to such fraudulent practices.Coupled with this concealment for its disturbingly shoddy practices Andersen gave the go ahead for Enron to invest in a large number of risky projects which proved to be failures and Enron tilted further towards its downfall , in a rather precarious situation where all they had was their false management credibility and creditworthiness. The manipulation of financial statements started with the use of SEP's (Special-Purpose Entities (SPEs) ) to deceive shareholders.Enron applied for loans through the sham SPEs so these debts would not would not appear on their financial statements.They managed to dope the investors into accepting lower interest rates by showing their fake credibility and the practice of setting up fake SPE's escalated.Very soon the situation had deteriorated to Enron using its own stock as collateral.This was a clever way of showing increased stock through the method of equity in accounting. All this time Enron was able to carry out such transactions unnoticed because of the fact that the accounting standards had not taken into account the new techniques in off-balance sheet financing. In accounting terms it meant that the off-balance sheet items were been used to keep liabilities of its books and by passed the US GAAP accounting standards. Also apparent from the above facts is that Enron has did some shoddy tax practices by recording revenues early and expenses were then shown in a delayed manner and this way it by passed the GAAP standard of timely recognition of assets and liabilities.Of much accounting interest is the fact that it used certain techniques of "illegal recognition of revenue".For example the holding of open books until certain sale targets were reached.They cleverly bypassed the rules under SAB 1010 as well by recording revenue and shipping merchandise to private warehouses for storage before their sales were final and later on they counted the shipments as sales. This graph5 shows how as early as the end of 1999,the warning was clear in the form of an uncontrolled share price rate increase, followed by the share price exceeding the share price capacity, chaos and then collapse. Lessons from Enron: The Accounting Problems associated with the Enron disaster. 1. Academics have often blamed the decline in audit quality for the reasons such disasters occur and the rise of the limited liability firm. The reluctance and diminution in the incentives of accounting firm partners in monitoring the practice of their co workers led to the gross mishandling . 2. The removal of aid and abetment provisions for auditors made them less vigilant after the Public Securities Litigation Reform Act 1995. 3. The complex procedures underpinning accounting ,thus making auditing more and more complex. " As a consequence, audit firms that were engaged by large public companies found that the "audit engagement teams" they assigned to perform audits had to spend increasingly large percentages of their time performing audit services for that client. Thus, for example, the head of Andersen's Enron audit team spent 100 percent of his time on the Enron account.9 This, in turn, led to the capture of auditors by their clients, since auditors' careers increasingly came to depend entirely on the "care and feeding" of single clients. Thus, just as the danger of client "capture" of auditors was increasing, the incentives of accounting firms to develop internal corporate governance structures to combat capture may have been decreasing due to the passage of statutes providing limited liability to accounting firm partners."6 4. The fact that auditors today provide consulting services erodes auditor independence as the balance of power shifts from the auditor and to the discretion of the client . " consulting services provide a means by which audit-clients can reward auditors for succumbing to the client's wishes about what accounting treatment should be used to report novel or complex transactions and business practices"7 5. The inability of the accounting firms has been about the quality of their internal corporate governance. "Carl Bass, an Andersen partner and member of that firm's Professional Standards Group, was apparently removed from the Andersen Professional Standards Group when he tried to correct accounting errors in Enron's financial reporting. It also appears that accounting partners at Andersen were able "to ignore with impunity the advice provided by higher level, more objective experts within the firm" and that these higher-level officials were unwilling or unable to assert their authority by following through to ensure that their recommendations were followed. It appears that the Enron-Andersen relation really was an example of an accounting firm captured by its audit-client."8 6. Another criticism of accounting practices which lead to Enron like disasters is the large amounts of payments meted out to auditors like Anderson who is reported to have been paid a whooping $25 million in audit fees and $27 million for non-audit consulting.There is growing concern that CPA's should be prohibited from offering non-audit services on the assertion that these fees corrupt the independence of CPAs. In the aftermath of the Enron saga all of the "Big 5 CPA firms announced that they would no longer offer certain consulting services to their auditing clients. At this writing, it is unclear whether or not these consulting opportunities include such non-audit services as tax preparation and non-financial systems analysis and design."9 Further more the literature on Enron has also pointed out that there were six accounting and auditing issues which were of primary importance10 The policy of unconsolidated SPEs to conceal losses and debts from investors. The accounting records relating to sales of Enron's merchant investments to unconsolidated SPEs . The income recognition practice of recording as current income fees for services rendered in future periods and recording revenue from sales of forward contracts, which were, in effect, disguised loans. Fair-value accounting which resulted in restatements of merchant investments based on unreliable figures. Accounting for its stock that was issued to and held by SPEs. Inadequate disclosure of related party transactions and conflicts of interest, and their costs to stockholders. The future of published financial statements and accounting in the light of the Enron Disaster In the light of the Enron's disaster the future of published financial statements is all set to change and efforts are already underway to never let a such a large scale lie breed so healthily ever again. Published financial statements should be subject to laws concerning misrepresentation and fraud and the use of shoddy accounting practices like the setting up of fake SPE's should be investigated by independent third parties. When a company as large as Enron is operating it is inevitable that it has the risks of many stakeholders involved. The drawing of large remunerations by the directors and the use of SPE's was not dealt with strictly at that time.In the future any such practices should be discouraged and the destruction of financial statements of public importance should also be made a criminal offence. The reason the Enron disaster happened was because the directors in this case were trying to get away by using the "paper shredder". Never again should any company be allowed to practice such a large scale fraud and therefore in the light of this financial disaster the use and abuse of published financial statements needs to be governed by criminal law.In England the Companies Act 2006 has taken strict notice of such accounting frauds and imposes heavy penalties upon companies who use fake or misleading published accounting records. _________________________________________________________________ __________________________________________________________ References 1. C. Richard Baker, Department Of Accounting & Finance, Investigating Enron As A Public Private Partnership University Of Massachusetts Dartmouth, North Dartmouth, Massachusetts, USA 2. George J. Benston, And Al L. Hartgraves ,Enron: What Happened And What We Can Learn From It , ,Goizueta Business School, Emory University, 1300 Clifton Road, Atlanta, GA 30322-2710, USA . 3. Accounting For Enron: Shareholder Value And Stakeholder Interests ,Thomas Clarke,Corporate Governance: An International Review, Volume 13, Issue 5, Page 598-612, Sep 2005, Doi: 10.1111/J.1467-8683.2005.00454.X 4. Regulation Of UK Corporate Governance: Lessons From Accounting, Audit And Financial Services ,Ian P. Dewing1 And Peter O. Russell,Corporate Governance: An International Review, Volume 12, Issue 1, Page 107-115, Jan 2004, Doi: 10.1111/J.1467-8683.2004.00347.X 5. Evading Enron: Taking Principles Too Seriously In Accounting Regulation David Kershaw,Modern Law Review, Volume 68, Issue 4, Page 594-625, Jul 2005, Doi: 10.1111/J.1468-2230.2005.00552.X 6. Enron/Andersen: Crisis In U.S. Accounting And Lessons For Government ,Richard E. Brown,Public Budgeting & Finance, Volume 25, Issue 3, Page 20-32, Sep 2005, Doi: 10.1111/J.1540-5850.2005.00365. 87, Issue 2, Page 395-410, Jun 2006, Doi: 10.1111/J.1540-6237.2006.00387.X 7. Did Enron's Investors Fool Themselves ,Chris Higson, Business Strategy Review, Volume 12, Issue 4, Page 1-6, Dec 2001, Doi: 10.1111/1467-8616.00186 8. Theodore Eisenberg, Jonathan R. Macey (2004) ,Was Arthur Andersen Different An Empirical Examination of Major Accounting Firm Audits of Large Clients ,Journal of Empirical Legal Studies 1 (2), 263-300. doi:10.1111/j.1740-1461.2004.00008.x _____________________________________________________________________ Read More