The Regulation of Financial Reporting on Enron - Case Study Example

The Regulation of Financial Reporting on Enron Introduction Enron's case has marked history and has been studied from many different perspectives - such as financial, ethical, managerial, corporate governance etc. Enron is the real wonder of America's largest corporate bankruptcy; which has been in the limelight of the domestic and the international press, the financial people, the organizational behavior and also the ethical proponents. The major point here is that it was the offence that was a prime example of criminal activity and corruption in the corporate world. Here we will, analyze the case mostly from the financial accounting purpose. Enron was found in 1985 from a merger of Houston Natural Gas and Internorth, Enron started of with the first nationwide natural gas pipeline network. But as the time passed by the firm's business mix shifted from the regulated transportation of natural gas to unregulated energy trading markets. Since in the energy trading more money could be made in buying and selling financial contracts linked to the value of energy assets than in actual ownership of physical assets. Because of its business nature Enron's reported annual revenues grew from under $10 billion in the early 1990s to $101 billion in 2000, ranking it seventh on the Fortune 500 (Benston 2002). Discussion First, briefly it is important to know what happened which led to the ultimate bankruptcy and collapse. Enron was in the business of energy trading and distribution. It all started with Jeffery Skilling who replaced Kenneth Lay as CEO quitted from his position and Kenneth Lay became the CEO again. Another event of importance was the role of Enron's Chief Financial Officer, Andrew S. Fastow; he was responsible for handling all the off shore partnerships for the company; his actions led to hiding of around a billion dollar debt through these off shore drilling partnership businesses. This was one of the bases which led to the collapse of Enron when it was disclosed. And the admission was made regarding overstatement of profitability of Enron by hiding some of the debt; when the matter was disclosed Enron's share price came slashing down and the company lost its credibility in the financial markets. No one was ready to forward any loan so that the company can come out of the ditch of bankruptcy. The collapse of Enron badly effected the retirement savings of the employees as these were linked to the stock prices which plummeted badly hence, effecting the employees' savings. An important thing to point out is that the accountants, Arthur Anderson did not indicate at any moment the worsening financial situation of the company. Thus, in the end the accountants, Anderson and the Enron shredded the company documents that reflected the audit reports and employees that were against this were fired (Beams 2002). What do we identify after Enron's implosion that we did not identify before it The conventional perception is that the Enron debacle exposes basic flaw in our current system of corporate governance. Conceivably, this is so, but where is the flaw located Beneath what conditions will critical systems fall short Chief debacles of historical dimensions (and Enron is certainly that) tend to produce a surplus of explanations. In Enron's case, the firm's strange breakdown is becoming an effective Rorschach test in which every commentator can observe evidence verifying that what he or she previously believed. However, the problem with viewing Enron as a sign of any methodical governance collapse is that its nucleus facts are maddeningly only one of its kinds. Most obviously, Enron's governance structure was sui generis. Other public corporations just have not certified their chief financial officer to run a self-governing entity that enters into billions of dollars of risky and unpredictable trading transactions with them; nor have they permitted their senior officials to profit from such self-dealing transactions with no wide direction or even understanding of the profits involved. Neither have other corporations incorporated thousands of braches and employed them in a complex web of off-balance sheet partnerships (Feldstein 2002). In brief, Enron was organizationally exceptional - - a virtual hedge fund in the view of some, yet a firm that morphed almost overnight into its bizarre structure from origins as a today gas pipeline company. The tempo of this transition apparently outdistanced the development of risk management structures and an institutional culture paralleling those of traditional financial firms. Precisely for this motive, the inactive performance of Enron's board of directors cannot reasonably be extrapolated and applied as an assessment of all boards commonly. Boards of directors may or may not perform their responsibilities sufficiently, but, standing alone, Enron shows little. In this sense, Enron is an anecdote, and remote data point that cannot yet moderately be estimated to amount to a trend. Viewed from another perspective, however, Enron does furnish ample evidence of a systematic governance failure. Although other impressive securities frauds have been exposed from time to time over current decades, they have not in general worried the overall market. In contrast, Enron has undoubtedly roiled the market and created a new investor demand for clearness. At the back this disturbance lays the markets' finding that it cannot rely upon the professional gatekeepers - - auditors, analysts, and others - - whom the market has long believed to strain, verify and assess complicated financial information (Eichenwald 2002). Financial issues of Enron Some of the Financial Accounting Issues that emerged relates to the auditing of the firm, accounting treatment, pension issues, derivative issues. According to the Federal Securities Law requires the accounting statements of the publicly traded corporations should be certified by the independent auditors. The external audits of Enron have contributed to both the rapid increase and the sharp plummet in its stock price. The investors of the Enron outside the company i..e not including employees and the management, but including financial institutions, were misled about the corporation's net income that was reported highly overstated on one hand and the understatement of the contingent liabilities The auditor, Arthur Andersen, also was a party to such misstatements and admitted some mistakes. Several accounting issues were involved in the Enron case. First concern was regarding the rules governance of the financial statements of special purpose vehicles established by a corporation. The issued related to whether the financial statement of the special purpose vehicles is consolidated with the corporation's financial statements. Under the law it is needed for certain partnerships between the special purpose vehicle and the company and not for others. The consolidation is not required if among other things an independent third party invests as little as 3% of the capital, a threshold some consider too low. In case of Enron, Special Purpose Vehicles were used to hide the debt of the company so that these debts were not visible on Enron's financial statements. Whereas, the proceeds from this special purpose vehicles were inflows to Enron and added to its income. This increased the stock prices by having less debt and more income (Jessica 2002). Enron's Assets Treatment According to the Standards There are two imperatives under the law by FASB which must be met before a special purpose entity can achieve off-balance-sheet treatment under GAAP. It requires that the assets should be sold to it by the company and also be legally transferred from the company to the special purpose vehicle. Next it requires an independent third-party owner who has made a substantive capital investment that amounts to at least 3% of the vehicles' total capitalization must both control the special purpose vehicle and possess the substantive risks and rewards of owning its assets. In this process the equity of the investor is at risk. If the investor's return is guaranteed or not at all risky then the transferring company is required to consolidate the special purpose vehicles in its financial statements. Enron had three special purpose vehicles which did not qualify. Enron created another one in 2000 and, as part of the initial capitalization and a series of ongoing transactions, issued its own common stock in exchange for notes receivable. In the financials Enron increased notes receivable and the shareholders' equity to reflect these transactions. However, in announcing its restatement, Enron disclosed that it had concluded that, pursuant to GAAP, these notes receivable should have been presented as a reduction of shareholders' equity. Whereas, the Generally Accepted Accounting Principles require that the notes receivable occurring from transactions involve company's capital stock to be presented as deductions from stockholders' equity and not as assets. But, Enron overstated both its assets and shareholders' equity. Later it had to disclose it has also purchased a limited partnership's interest in a special purpose vehicle, and that transaction resulted in a further reduction of shareholders' equity (Jim 2002). The next matter was about the latitude permitted in valuing derivatives, mainly over the counter deal energy contracts. Next there are calls for better disclosure, either in notes to financial statements or a management debate and study, particularly for financial arrangements concerning contingent liabilities. Accounting standards for companies are compelled to follow the Financial Accounting Standards Board and there are also SEC requirements. What causes this unexpected point in earning restatements For the reason that public corporations should fear stock price drops, securities class actions, and SEC exploration in the stir of earnings restatements, it is not believable to read this sudden augment as the product of a new tolerance for, or indifference to, restatements. Although some piece of the change might be ascribed to a new SEC activism about earnings management, which became an SEC priority in 1998, corporate issuers will not voluntarily expose them to vast liability just to please the SEC. furthermore, not only did the number of earnings restatements amplify over this period, but so also did the amounts involved. Earnings restatements thus look as if an indication that earlier earnings management has gotten out of hand. therefore, the point in earnings restatements in the late 1990's involves that the Big 5 firms had earlier acquiesced in hostile earnings management - - and, in particular, premature revenue recognition - - that no longer could be continued (Laura 2001). Affairs of Enron The Enron affair - no matter what the outcome of the ongoing investigations in the US - has got to light a number of important international policy matters. These matters have most imperative significance for the EU in the context of creating its proficient and competitive capital market by 2005. There are five key matters existing in this paper. Each matter is inspected in order to show what actions have previously been taken and to recognize what balancing actions (a summary of the policy actions is incorporated in the back of this paper) now need to be pursued at European level: (1) Financial Reporting (2) Statutory Audit (3) Corporate governance (4) Transparency in the international financial system (5) Financial analysts' research and the role of rating agencies. COMPREHENSIVE AND TRANSPARENT FINANCIAL REPORTING US GAAP is mainly a rules based approach to financial reporting. It includes tens of thousand pages of accounting rules build up over decades (e.g. 600 pages on derivatives, more than 800 pages on particular purpose vehicles). US GAAP enclose numerous supposed "bright lines" - in effect they set out demarcation lines between the acceptable and the not acceptable. In a dynamic business atmosphere with management remuneration more and more based on financial performance (share based payments) and inventive financial engineering (derivative financial instruments), ingenious accountants and lawyers have developed products and accounting techniques that have little economic purpose other than to fall inside the letter, if not the strength, of these "bright lines". This has guided some financial statements in the US not to imitate correctly the true financial position. Nevertheless, it would be erroneous to criticize all features of US GAAP and to think that accounting failures are not possible somewhere else, including in Europe. The Commission has powerfully endorsed a strategy based on a principles-based move towards the financial reporting, intended to reflect economic authenticity and so giving a true and fair expression of the financial arrangement and performance of a company. This preserves the long term good of investors and other stakeholders and needs company directors to make a cautious judgment in decide on and applying the most appropriate accounting policies. At the heart of the Union's strategy is the submission, from 2005, of International Accounting Standards (IAS) as the reporting framework for all listed EU companies. IAS has promoted at the global level and focus on principles rather than on comprehensive rules. In IAS the policy which flow reasonably from the principles have far less complex exceptions and exclusions than US GAAP. Harmonized enforcement will make sure that under IAS the alike conditions will be accounted for in the same way. In numerous areas, they are already extremely developed and the best obtainable in the world. For example, the off balance sheet treatment for Special Purpose Entities which are in reality under the control of the reporting entity, would not be achievable under IAS. The US has accepted that their standards dealing with off balance sheet financing necessitate revision and the establishments are calling for new IASB-style, principle-based requirements (Michaels 2002). After a single evaluation of the Commission's proposal for a Regulation, IAS will be compulsory for listed EU companies - with few exceptions - from 2005. Efforts must now be made right through the EU to make sure proper accomplishment, harmonized interpretation and enforcement of IAS. We must also make stronger coordination within the Union and develop best practice at European level. The EU's commitment to IAS is evidently helping to attain improved global convergence of financial reporting. Concerted actions are wanted at all levels to influence the US authorities to acknowledge IAS financial statements prepared by EU companies without further reconciliation to US-GAAP. A recent contact proposes that the US authorities and congressional leaders are less opposed to discuss this issue. The EU must reveals its political determination to the US that a solution must be found. Strong study on the proceedings taken by Enron's auditor in the US has provoked much critical comment and led to some loss of public faith in the audit function, although so far it has not deeply exaggerated overall trust in EU capital markets. The Enron case tinted deficits and weaknesses in US auditing and led to criticism particularly of audit firm to audit firm peer reviews (external quality assurance); the uselessness of the present public oversight body funded by the audit profession; the out of order of audit committees; and anxiety about a apparent lack of independence of the auditor. Enron's collapse has augmented awareness that appropriate Corporate Governance is crucial to the competent functioning of capital markets and high quality financial reporting. The EU has not yet methodically addressed corporate governance matters (Michael 2002). The Financial Services Action Plan specifies useful Corporate Governance as a key situation for the development of European capital markets. A relative study has lately been finalized, which offers the Commission with a wide-ranging picture of all presented codes in the EU, their main provisions and how they are enforced. The study is being made by Company Law Experts; preside over by Professor Jaap Winter. The Group is also exploratory policy priorities on Corporate Governance matters and will report by July 2002. To answer to the Barcelona Council conclusions, the Commission will make wider the consent of this Group to comprise additional Corporate Governance matters, along with the liability directors; management compensation; and the accountability of management for the preparation of financial information. The Enron case also brought to glow the risks of permitting a company's pension fund to invest a big part of its assets in shares of that company. In the Commission's Proposal for a Pension Funds Directive, investment in the sponsoring company is incomplete to a maximum of 5 percent of the assets held by the pension fund. Acceptance of this proposal remains a high main concern of the Financial Services Action Plan (Michael 2002). Enron also avoided paying hundreds of millions of dollars in taxes by issuing of stock options. Corporate executives at Enron received large amounts of stock options. Exercised these options, let the company claim compensation expense on their tax returns. Accounting rules let them omit that same expense from the earnings statement. The stock options only required their disclosure in the footnote. Options allowed them to pay lesser taxes and report higher earnings while, at the same time, motivating them to manipulate earnings and stock price. Enron sponsors a retirement plan - a "401(k)" - for its employees to which they can contribute a portion of their pay on a tax-deferred basis. The accumulation in the account amounted to 62% of the assets held in the corporation's 401(k) retirement plan that consisted of Enron stock. Many individual Enron employees held even larger percentages of Enron stock in their 401(k) accounts. When shares of Enron went down as low as 70 cents the direct hit was this wiped many employees' retirement accounts were wiped out. The losses suffered by participants in the Enron Corporation's 401(k) plan have prompted questions about the laws and regulations that govern these plans (Nick 2002). Conclusion Enron's all performance and condition came in our discussion in this paper. All the aspects have been viewed in detail, like the accounting and reporting standards for marketable securities, derivatives and financial contracts are found in FAS 115 and FAS 133. The mark to market process requires changes in market values which are reported in the income statement for certain financial assets and in shareholders' equity (component of Accumulated Other Comprehensive Income) for others. Any gains are often determined by proprietary formulas depending on many assumptions about interest rate, customers, costs and prices-provide opportunities for management to create and manage earnings. The policy of Enron was that it used to recognized revenue at the time contracts (even private) were signed based on net present value of all future estimated revenues and costs. Its profits really trailed the prices of oil futures and had a high degree of correlation with it (Tom 2002). Enron collapse had many implications not only in the US but also in the UK. Once the reasons of Enron's debacle are known and understood by all UK's bodies are recognizing the part played by auditor independence and has made the issue a priority for all the companies. But still what is emphasized is the higher level of integrity and strength of character. References Benston, G J and Hartgraves, A L (2002), 'Enron: what happened and what we can learn from it', Journal of Accounting and Public Policy, 21(2) Beams, M. (2002), 'The Enron collapse and the crisis of the profit system' [Accessed at:www.wsws.org Feldstein, D. (2002), 'Special Purpose Vehicle used to control market, credit rating'. Houston Chronicle Eichenwald, K. (2002), 'Enron's Many Strands: Legal Strategy; Shredded Papers Key in Enron Case'. The Newyork Times Jessica Sommar. (2002). Business.New York Post, N.Y.: pg. 035. Jim Smith. (2002). Business; Opinion Calgary Herald.Calgary, Alta.: pg. B.15 Laura Goldberg, Michael Davis. (2001). "News". Houston Chronicle.Houston, Tex.: p1. Michaels, Adrian, Peel, Michael. (2002). Corporate Finance...London (UK): pg. 24 Michael, P. (2002), 'Enron: could it happen here' Accountancy Age Nick Land. (2002). "Business". The Times.London (UK):pg. 34 Tom Hamburger and Jonathan Weil. (2002). financial statements. Wall Street Journal.(Eastern edition).New York, N.Y.:Jan 25, pg. A.3. Read More