Analysis of Enron and Northern Rock - Essay Example

COMPARE AND CONTRAST THEIR ROUTES TO FAILURE OF ENRON AND NORTHERN ROCK INTRODUCTION Free market economy has led to business growth at a global level. On the other hand, this growth in the economy has also increased the corporate scandals at a rapid pace. As witnessed in the world history, some of the corporate failures have directed the world economy to freeze. To cite an example, corporate failure of Lehman Brothers was a leading investment bank in USA. This shook the global economy and raised questions about the financial engineering and practices. There has been considerable debate on the factors that leads to the corporate failures. However, according to The Forbes, lack of transparency was the most important reason in comparison to the reckless financial engineering, risk taking, and lending (Denning, 2013). This paper aims to review the two renowned corporate failures including Enron and Northern Rock. The comparison and contrast of the two corporation failures are produced with respect to financial engineering, the role of regulatory bodies, and corporate governance. 2. KEY ISSUES FACED BY THE ENRON AND NORTHERN ROCK Enron was established in 1985 as a merger of Houston Natural Gas and InterNorth. The offerings of the company included marketing of electricity and natural gas. The company also offers to the delivery of energy along with other physical commodities to the world. The financial department of the company was offering services for the financial and risk management to a diverse set of customers across the globe (CNN, 2014). The accelerated success of the company in different services made Enron as one of most innovative companies of the world (Moncarz, 2006). Enron operated on two fronts. Firstly, it had footings in almost all aspects of the energy supply chain. This used to provide the company with complete information about the production to distribution aspects. On the other hand, the business had complete information about the order flow. This dual side business marked the real competitive advantage for Enron (Moncarz, 2006). The ability of Enron in managing the risk that initially brought success to the company, however this also became the reason of the demise of the company (Chatterjee, 2003). There were different reasons for the demise of Enron. Some of the most important reasons include; the corporate culture of innovation in operational, financial, and accounting disciplines and exploiting opportunities mainly from deregulated markets for success. It can be analysed as the company introduced special purpose entities to hide mounting debt to equity ratio from stakeholder. This was one of the major reasons for the failure of Enron as investors could not analyse the actual debt to equity ratio (Fox, 2003). Financial instruments like Volumetric Production Payment, Cactus funds and mark to market value system of accounting were the other important examples of Enron’s failure contributors. Importantly, the failure did not lie in the compliance by law. However, the failure was on the part of the regulatory bodies in depicting the mal-intention as they did not reflect the mounting risk in the financial statements (Moncarz, 2006). The merger of Northern Counties Permanent Building Society and the Rock Building Society led to the establishment of Northern Rock Bank in the year 1965. This bank was then changed to a public limited company in 1997 (The Telegraph, 2014). Northern Rock reported a growth of 23.2% from 1998 to 2007. In this period of nine years, total assets reported of the company growth to BP 113.5 billion from 17.4 billion (Shin, 2009). Analysing the growth over the years, it can be identified that the failure of the Northern Bank in 2007 marked considerable importance in the history of banking for multiple important reasons. One of the main reasons was that UK faced such crisis after 140 years of history. This failure also aggravated the panic among people despite the assurance of recovery from authorities. Secondly, the case study carries critical importance mainly for offering example for every single aspect that can be noted to go wrong with the bank. Finally, the failure is accounted for weak financial structure that was complimented with the inefficiencies from the regulatory authorities (Llewellyn, 2009). According to the Onado (2009), the business model of the bank was stretched enough that overlooked the role of capital in the banking system. The author further stated that the bank stretched to every possible opportunity for the arbitrage with respect to regulation offered by Basel I system (Onado, 2009). Hence, both case studies share some of the similarities as well as differences to each other. These case studies are similar in a way that businesses as well as regulatory authorities lacked in reviewing the changing structure of the business model. The capital structure became more risky, but they were not able to analyse and identify these changes. Another similarity lies in the fact that both cases shed light on the weakness of the systems that is only attended as a result of the shock to the sector or the economy on the whole. On the other hand, the cases are dissimilar in a way that the Enron case accounted clearly the deliberate intention towards innovative conduct with mal-intention. For example, special purpose entities are part of the Enron and were aimed to shadow the growing debt and this clearly signifies the intention of the respective people to deliberately misrepresent the financial statements (Abrams, 2012). The case of Northern Rock reflected extensive carelessness on the part of the regulators (both inside and outside the bank). The evidence of this is the fact that despite FSA issued warnings related to non-variability of the Collateralised Debt Obligations and Credit Defaults Swaps due to the changing market dynamics, the bank continued to exploit the opportunity of ignoring the mounting risk (Llewellyn, 2009). 3. ROLE OF ACCOUNTING AND FINANCIAL ENGINEERING AND INNOVATION IN LEADING FAILURES OF ENRON AND NORTHERN ROCK The financial fraud has evolved as a critical concern in the corporate world, and a large number of measures are being taken by the regulatory bodies to deal with the challenge. Simply stating financial fraud refers to the manipulation of the financial reports to shade the questionable elements in the business conduct. Siskos, (2014) in a research has entitled the case of Enron lesson enduring this case with regards to the financial fraud. The research claims that misrepresentation of the financial position of the company was quite evident in the financial statements produced back earlier in 2001. In an attempt to justify the case of Enron, it can be argued that it was simply financial engineering that could not sustain. However, the evidences are present to counter such arguments. For instance, Enron early in the year 1992 developed a contract for the company Sithe in early 1992. The value from the contract was consistently added to the financial position of the company. In the late 1990s, the value attributed to the Sithe was more than USD 1.2 billion whereas the Enron’s internal Risk Assessment and Control (RAC) group estimated the project at a value that was 66% less than the reported value. If the case had been the failure of the financial innovation only and not the fraud, then revalued price would also have been accounted in the financials. Contrary to this, Enron’s did not report this aspect unless the company had to file bankruptcy (Walton, 2007). With respect to the Northern Rock bank, it is not regarded as the fraud. This stance is justified as the comprehensive collection of the analysis produced by different scholars. These scholars have concluded it to be the failure of effective management, weaknesses in structures and failure in the response system when bank is in crisis; and not fraud (Llewellyn, 2009; Giles, 2012). Though it is important to mention that irrespective of the technical imperatives, the failure of Northern Rock Bank was a mere fraud in the view of depositors who faced trauma of mishandling (Bummer, 2008). The dimension of creative accounting has brought considerable challenges for the corporate world. The evidence from the global financial crisis noted the abuse of the creative accounting with extensively complex engineering of financial products (Sornette, and Woodard, 2010) and the case of Enron is a crystal clear example of this aspect. For instance, Enron utilised mark to market value mode of accounting for booking of the transactions of the firm in the year 1999 (Millman, 2002). According to the Benston, (2006), FASB and IASB leading boards of accounting have limited the use of fair value methods for the valuation of financial assets and liabilities. Contrary to this limitation, accountants at Enron used this method for the wider purpose such as accounting for the energy contract, other merchant investments and finally for the compensation of the management. The reflection of revision in the prices of energy was not made in the balance sheet (Case of Sithe). The fair values of merchant investments were not available to Enron as these techniques were introduced by the Enron on first place. Enron used fair valuation technique for the recoding of assumptions driven income. This was due to manipulation (Benston, 2006). Additionally, the accounting firm of Enron, Arthur Anderson had a significant role in creative accounting even to the point of policy and regulatory violence such as not consolidating the liabilities of SPE with overall Enron’s liability to disguise the fact of high risk (Millman, 2002). Curral and Epstein (2003) cited that employees of accounting firm who raised questions about such questionable conduct were fired. This is another important point that clearly highlights and raises questions towards the intentional violence. Mortgage backed Swap (MBS), Credit Default Swaps (CDS), and collateralised debt obligations (CDOs ) are branches of the complex financial engineering or financial innovation (Gennaioli, Shleifer, and Vishny, 2012). Evidence of the Special purpose entities benefitting Enron is depicted below: (Tavakoli, 2004) It is evident that the over dependence on such financial vehicles led to the failure of Enron. The debt swaps also carried the risks such as incentive problems, disclosure constraints, systemic risk and most importantly the unrealistic pricing of the credit (Skeel, and Partnoy, 2007). The use of creative accounting in Northern Rock Bank was though present; but not at the massive extent with which Enron exploited the opportunity. Nesvetailova and Palan, (2013) also stated that creative accounting and financial innovation was employed by the Northern Rock. Granite Master Issuer plc was a shadow company established by a trust that was established by Northern Rock. Though stated to be a charitable organisation, the core objective behind the development of the Granite was to form supported Northern Rock in the financial engineering. The company in question issued considerable debt and owing to the shock from global financial crisis, Northern Rock had to support the payments of debt of Granite that affected its performance. The relationship between the two firms, which remained under constant denial was later confirmed (Hansard, 2008). The option has not been discussed with respect to the Northern Rock bank’s case is the fair value accounting. Furthermore, Amel‐Zadeh, and Meeks (2013) in a paper as a proponent of fair value accounting have claimed that the bank under question remained solvent even when assessed for the fair value systems. Therefore, the defaults resulting from the fair valuation shall only be attributed to misuse of the function and the not the function itself. With respect to the financial instruments of MBS, CDS, and CDOs, the securitisation process of the Northern Rock business produced following flow: (Shin, 2009) Shin (2009) discussed that Northern Rock failure was not in the first place attributed to its high level of securitisation. Instead, it come under distress mainly due to the high level of leverage that was complemented with extensive reliance for short term funds on the institutional investors whereas the securitisation with Granite was mainly short and long term period. It can be safely stated that the main objective of the most of these twists applied in maintaining the financials of the company is to the present polished earnings. For instance, the fair value accounting and the use of Special Purpose Entities by the Enron were done to produce the target earnings. This in turn was the basis of the earnings of the management (Palepu, and Healy, 2003). Earnings management can also be determined among the leading objective of the Northern Rock as the rise of the bank was determined with the cycle present below: (Onado, 2009) The close relationship between the outer and the inner cycle in turn produced favourable results. However, the business had not managed to the quality of assets that some analyst already pointed towards this dis-balance and called it high risk behaviour (Onado, 2009). Hence, the role of the financial engineering, that is claimed to be the main contributor of the growth of the real and financial economy, is found to be the leading contributor in the current crisis (McSweeney, 2009). The collective discussion produced above in turns self point fingers towards the role of auditors in the context. The job of an auditor is to determine the quality of the financial produced and their respective strengths. In specific reference to the concept of the materiality, an auditor is also given an edge to determine the aspects with the judgment that measures taken by the balance sheet developers will have material impact on the decision of the stakeholders. With this extensive authority resting with the auditors; such measures of fraudulent, excessive use of special purpose vehicle as well as securitisation claim that auditors failed to the highest extent in performing their duties. At this point about failure of auditors, both cases under consideration are on the same page while have differences on different aspects. Though, Goodhart (2008) claims that banks become insolvent when auditors stated that the company does not of excess of liability over assets; however, before such happening bankers and other accountants usually manage to restructure their conduct in a disguise. This argument created a very subtle line for defining the responsibilities of auditors to extract the accuracy and strength of the financials developed by the company. 4. ROLE OF REGULATORY BODIES IN FAILURE Financial markets and institutes have a notable role to be played by the internal and external players. Internal players such as the CEO, CFO and other boards of directors, and the external players played important role in manipulating the financials along with the regulatory bodies and the government. It is presumed that financial markets and institutions are the very strictly regulated as they involve the money of other people. However, failures of the corporations mainly from financial factors have continued to raise questions on this presumption and claim. Firstly, examining the role of CEO and the directors of the company, there are serious implications evident in both cases under study. The regulatory requirement of approval from the board of directors is aimed to restrict the employees from misconduct for results generation. Violating this responsibility, Enron’s board of directors allowed various measures that surpassed requirement of basic risk management structure (Apgar, and Crime, 2002). To cite some instances, Fastow, the CFO then, was paid much higher management fees by SPE for hiding the troubled position of the company with high debt (Thomas, 2002); Enron adopted mark to market and other accounting creativity to pay higher benefits to the management (Gwilliam and Jackson, 2008). Braddy, (2010) clearly reported the failure of Enron as a consequence of the fraudulent measures by the management. Similar, mistakes go for the Northern Rock. In a way, Onado (2009) stated that Northern Rocks failure resulted from the extensive strength from the regulatory options provided by Basel 1. Extensive securitisation, use of SPE and handsome remunerations provide evidence of the failures and more clearly involvement of the management in the case (Nesvetailova, and Palan, (2013). Silverstein (2013) simply comprehends the case as the role and equal importance of the character in the organisation as in person. Furthermore, the role of regulatory authorities is equally moot in these cases. The involvement of CEO, misuse of accounting regulations in the name of the creative accounting, and the direct dealing with auditors and accounting firms are not hidden from the regulatory boards (Nguyen, 2011). Moreover, if they cannot identify such frauds, then their existence is of no use. In response to the case of Enron, though new regulatory framework of Sarbanes-Oxley Act was put in force; however, the question still remains in the effectiveness of these laws. Political influence of the corporate being no hidden fact, there are already evidences of lobbying to relax the law (Roland, 2008).  Similarly, organisations have been spending millions in convincing the government to relax Dodd-Frank Wall Street Reform and Consumer Protection Act, another law for table after the failure of the Lehman Brothers. Additionally, the auditing rules have also been diluted as a consequence of pressure from corporate world (McKenna, 2011). With the case of the Northern Rock, where according to the Basel framework regulators had the power to call banks for the higher capital in place due to high risk, the evidence stated that regulators did not practice such power. Hence, the matter of implementation is to have more attention seeking than introducing new regulations. Additionally, the strength of the coordination between the regulatory bodies is found to be flawed. Also the failure of the Northern Rock put forward that the business specially the bank shall have strong working relationship with the central bank as the bank is the lender of the last resort for the banks. Further, Lastra (2009) has notified on the deficiencies in the systems of UK in dealing with distressed banks. Hence, safe and clear lessons can be concluded from the cases. Though, Northern Rock case created panic mainly due to lack of effective mechanism to deal with banks; concurrently, the case of Enron clearly put forward the inefficiencies in the implementations. Finally, the role of government and deregulation policies is important players in the context. According to the Kuttner, (2002), deregulations leave consumers and utilities are on the mercy of traders and as expected Enron manipulated the earnings by highly publicising the electricity power shortage. Also, Enron exploited the opportunity of gas trading. As a result of deregulation and over extensive approach to exploit the opportunity without safety precautions resulted in the demise of the company (Moncarz, 2006). Concurrently, in a discussion related to the Northern Rock bank, Nesvetailova and Palan, (2013) have stated that though shadow banking has grown to an outreach, but such parallel banking systems are found common in almost all major financial crisis. Therefore, Walter (2004) has emphasised on the increasing the level of discipline in the market to refrain from such failures. Governments are required to take into effect those systems that are not too complex but has eagles’ eye on the corporations performance as survey has proved that regulations are not very effective way of dealing with the challenges (Wade, 2008). 5. CONCLUSION The learning from both cases presents significant lessons for the corporations, institutes, direct and indirect stakeholders. From the comprehensive discussion, it has been concluded that both failures have originated from the use of the current accounting practices and principles that offers opacity advantage and most important parallel corporations and entities that provide heaven for tax, as well as opaque intentions. From the assessment, it is safe and clear to conclude that the management of the both companies; specifically, the top management has the highest responsibilities as they were the ultimate custodian of the investors’ money. Secondly, auditors’ role needs to be clarified, and auditors shall equally be charged for such irresponsible performance of duty as CEO. Moreover, the role of regulatory bodies is critical, and both failures happened under the nose of the regulatory bodies. To ring the alarm bell, Denning (2013) has already pointed to keep an eye on the conduct of the banks and corporation. References Abrams, C. J. (2012). 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