Conflicts of Interest Prevented Accounting Professionals at Enron - Term Paper Example

Case Study Name Name of Institution Case Study Abstract Healy and Palepu’s Enron case study attempts to explain how a successful company could suddenly collapse despite the presence of governance structures that oversaw financial reporting, internal controls, and overall management strategy. The case examines the history of Enron and its innovative practices in areas like trading, talent recruitment, and risk management. This is followed by an explanation of the financial reporting challenges at the firm and the role of the Board of Directors and external auditors in the firm’s rapid collapse. This analysis was completed by combining the information in the case study with past news and analysis on the collapse of the firm. The broad research on Enron and professionalism coupled with my understanding of accounting concepts facilitated the answering of the case questions. The case has allowed the exercising of research skills and the learning of the impacts of mark-to-market accounting. An additional lesson has been an appreciation that complexity is not always necessary in accounting as it can hinder the goal of providing meaningful information on the financial status of an organization. Accounting professionals at Enron had the task of serving the needs of shareholders. The case study has shown that conflicts of interest prevented accounting professionals from doing this basic task. Introduction The fall of Enron came as a surprise to all the firm’s stakeholders. The firm had been established in 1985, and it made significant progress in an energy market that was undergoing deregulation (Healy & Palepu 2013, p. 1). In the 15 years leading up to 2000, the corporation was the leader in energy trading and the international construction of energy assets. The firm was rated as the foremost innovative company in 2000, but within a year, the company had collapsed after the admission of accounting improprieties. Healy & Palepu’s The fall of Enron is a case study that examine some of the causes of the dramatic collapse of the company. The case begins with a description of Enron’s core business and the manner in which it became an admired firm. The company started operations as the owner of 37,000 miles of pipelines, and it offered a bundled service of gas and delivery services. However, deregulation forced the company to become a simple transporter of gas, but there was also an opportunity for the firm to solve the emerging issue of price volatility. The business offered its customers long-term contracts that had fixed prices and this earned the firm a lot of business as the customers wanted to avoid pricing and planning challenges that arose from short-term volatility (Healy & Palepu 2013, p. 2). The firm increasingly involved itself in financial derivatives to protect itself from the short-term fluctuations. The creation of an online-based transaction system and the elimination of some assets like pipelines streamlined the operations of the firm allowing it to become North America’s largest seller of natural gas. The firm experienced further growth as a result of expansion into new businesses and the international energy market. The business competed for the best talent and also spent massive resource on lobbying to ensure that the energy market would remain deregulated. Despite the initial success, the firm recognized that the nature of its business had a lot of inherent risks. The management’s solution to this problem was the creation of an independent body that would assess and control risk. All employees were also expected to read and comply with a 64-page code of ethics, and senior executives had to declare potential conflicts of interest (Healy & Palepu 2013, p. 5). Enron encountered considerable financial accounting challenges as it continued to grow. One of the reasons for the troubles was the firm’s complex model that encompassed multiple products, trading, physical assets, and international operations (Healy & Palepu 2013, p. 5). Each of these divisions was complex, meaning that the consolidation of financial results would be a complex affair. The creation of hundreds of special-purpose entities (SPE) for hedging purposes introduced further accounting difficulties. The Board of Directors was expected to approve the formation of such special-purpose entities, but it failed to recognize the threats and conflicts of interest that would arise from them (Healy & Palepu 2013, p. 8). The Audit Committee that should have recognized such issues met a few times annually, and their effectiveness was questionable. Similarly, the compensation committee failed to notice that senior executives were dumping company stock in exchange for cash. In one case, the chairman managed to convert company stock into $77 million in cash in a period of one year (Healy & Palepu 2013, p. 8). The fall of Enron also highlights the role played by external auditors. According to Healy & Palepu (2013, p. 8), the role of external auditors is to ensure that an organization provides financial statements that adhere to acceptable accounting standards. Changes in professional standards and increased competition forced audit firms to aggressively seek clients that provided higher margins (Healy & Palepu 2013, p. 9). The external auditor, Arthur Andersen, developed a very close working relationship with Enron to the extent that it also handled internal audit functions. The firm earned huge consulting and audit fees from Enron, a factor that is likely to have contributed to its failure to report the significant financial reporting risks (Healy & Palepu 2013, p. 10). The case study concludes with a description of the rapid unraveling of Enron. The collapse of the firm began with the sudden resignation of the CEO in 2001. Other senior executives also resigned around the same period, and a vice-president raised fears that the a collapse was imminent as a result of accounting irregularities (Healy & Palepu 2013, p. 10). However, the concerns of the vice president were ignored by the board after an internal investigation. The announcement of earnings in October 2001 shocked the market, and revelations about transactions with the SPEs and executive compensation contributed to a steady decline of the firm’s shares. The firm restated financial statements for the previous four years to show the extent of its violations of accounting requirements. The collapse of the firm was complete in on December 2, 2001 when it filed for bankruptcy after an acquisition deal fell through (Healy & Palepu 2013, p. 12). The impact of the collapse was profound with investors losing the capital and thousands losing their jobs and retirement savings (Nanda 2003a). Enron Prior to 2000 Innovation is the factor that made Enron one of the most admired companies before 2000. The firm faced significant problems during its early stages as it had to adjust to a wave of deregulation that altered the way pipelines conducted business. The company developed a new innovative product that would assist gas buyers to minimize the risks associated with volatility. This was the beginning of innovation at a firm that had an attractive culture and that employed some of the most talented individuals from the leading schools. These employees were then given freedom to contribute to the growth of the business, and they were rewarded with very attractive compensation. The firm continuously embraced new trading schemes that allowed it to meet the needs of its diverse clients. There was also rapid expansion into new products and countries. The net effect of the innovation and culture at Enron was the firm’s status as the world’s largest energy company, with the organization controlling 25% of global energy trading contracts (Jennings 2014). The success from innovation made the firm an admired corporation that attracted some of the best human resource talents. The Rise and Fall of Enron The rise of Enron can be attributed to the actions of the accounting professionals. These professionals implemented a strategy that allowed gas users to reduce their exposure to volatility in spot prices. The accountants’ ability to use financial derivatives to minimize exposure while implementing long-term fixed price contracts allowed the firm to capture significant market share in the late 1980’s. This foundation was built upon by the decisions to eliminate assets that increased the firm’s debt burden. The subsequent creation of an online trading platform facilitated aggressive trading that allowed the firm to rise to the position of holding a significant share of global energy trading contracts. It is evident that without these accounting strategies and innovation, the firm would have been relegated to being a simple owner of pipelines in North America. Aggressive accounting practices provided the basis for the firm’s expansion into new products like electricity. While the accounting professionals contributed to the firm’s impressive growth over 15 years, they hold a significant share of the blame for its collapse. Their successes blinded them, and they increased the complexity of the trading to the extent that it was difficult to create accurate financial reports. Accounting professionals also facilitated the creation of hundreds of special purpose entities to implement the strategy of eliminating assets that carried debt burdens. It is worth noting that such decisions would not have been made if auditors fulfilled their mandate of ensuring that the organization was financially sound. According to Nanda (2003, p. 2) conflict of interest meant that Enron’s auditor failed to report financial irregularities to relevant authorities. Therefore, the auditors are the accounting professionals who have the highest responsibility for the failure of Enron. Internal and External Checks and Balances Internal and External checks and balances failed to prevent the collapse of Enron as a result of incompetence and conflict of interest. The effectiveness of internal checks and balances fall under the control of audit committees. In the case of Enron, the audit committee had individuals with strong accounting backgrounds, but it failed to act on information on the risky accounting practices at Enron (Healy & Palepu 2013, p. 8). This indicates that the audit committee was incompetent as it failed to create internal checks and balances that would regulate the use of accounting practices that were not generally accepted. The external checks and balances fell under the control of Arthur Andersen. The audit firm was compromised as a result of conflicts of interest. Auditors have to maintain their independence and ensure that they serve the needs of shareholders and not the needs of management. Andersen failed to maintain its independence and integrity as seen in the fact that it handled internal and external audit functions. The firm took up consulting, tax work, and asset appraisal duties that brought in considerable earnings (Healy & Palepu 2013, p. 10). This led to conflict of interest as the auditor could not report irregularities as this would compromise its other lucrative businesses with Enron. As such, Enron lacked adequate external checks and balances that would prevent its collapse. Continuous Auditing The purpose of auditing is to ensure that financial statements portray the status of an organization in an accurate and timely manner. The availability of accurate and timely information allows managers to make the correct decisions. Continuous auditing defines the use of a methodology to validate control on a recurring basis (Mainardi 2011). The methodology can be automated, and its main objective is to ensure that controls are effective by testing them repetitively. The conclusion from the Enron case is that the internal and external controls were ineffective. Additionally, the firm was unaware of the ineffectiveness of the checks and balances that it relied on. These reasons validate the conclusion that the use of continuous auditing would have prevented the collapse of Enron. The firm’s implementation of a complex online transaction system shows that it had the technical skills to implement an automated system for continuous auditing. This automated system would have provided clear warnings about risky accounting practices as it would not be compromised by conflict of interest. Role of Board of Directors As in the case of the accounting professionals, the board failed to prevent the collapse of the firm as a result of conflicts of interest. The board of directors had an extremely close working relationship with the management to the extent that management attended the five scheduled annual meetings (Healy & Palepu 2013, p. 7). The excessive compensation given to the board, which included stock grants and stock options, also compromised the board members. They supported unusual accounting practices and the creation of suspect special entities that would boost earnings and increase the value of the stock they owned. One of the critical roles of boards of directors is the protection of organizational assets and shareholder investment. The board is also responsible for the monitoring and control function. Evidence from the case study suggests that the board ignored these tasks. The chairman of the board provides a poignant example as he abused a credit line to dispose company stock and gain $77 million in cash in just a year (Healy & Palepu 2013, p. 9). The management should not have given the chairman the credit line or allowed him to dispose of company stock in such a manner. It is evident that such favors from management compromised the board’s ability to protect company assets and shareholder investments. In the same way, the board was unable to monitor and control the business with a sufficient degree of independence. Enron’s board should have met in the absence of management to guarantee independence. The board should have empowered the audit committee to monitor some of the decisions made by management and the board. For instance, the audit committee was informed of the very risky transactions and new accounting practices, but it did not take any meaningful actions (Healy & Palepu 2013, p. 9). An independent board should have taken immediate action after such reports and instituted new accounting policies to protect the firm from collapse. Breaches in Accounting and Ethical Conduct According to Nanda (2003b, p. 1), there are numerous instances where clients cannot evaluate the quality of the services provided by professionals. This necessitates the presence of professional pledges that professionals will work towards meeting the interests of their clients. When it comes to professions that are related to business, the professional pledge appears in the form of a code of ethics or a code of conduct. Enron had a comprehensive code of conduct that addressed issues such as conflict of interest, external business interest and investments (Healy & Palepu 2013, p. 18). For instance, the code expected officers and employees not to engage in external businesses that might compromise job performance. There were several breaches of accounting and ethical standards that led to the collapse of Enron. Instead of prioritizing the long-term well-being of the company, accountants utilized complex accounting techniques to overstate the current profitability of the business. When it comes to ethical conduct, conflict of interest was present in numerous dealings. As stated, the firm’s code of ethics prohibited involvement in external businesses but it gave the board the power to examine individual cases of involvement in external businesses (Healy & Palepu 2013, p. 18). The board misused this provision when they allowed the CFO to manage and earn excessive rewards from special purpose entities. In general terms, Enron ignored provisions in its code of ethics as the management, and the board pursued self-interest at the expense of the interests of shareholders. In essence, they ignored the professional pledge that is central to the accounting profession. Lessons from the Enron Case The first lesson from the Enron case is that mark-to-market accounting is not applicable to all types of business. According to Healy & Palepu (2013, p. 6), the accounting approach could estimate the present value of future inflow with relative ease. However, the company could not predict the cost of fulfilling these contract in a national market that was regulated in some areas and unregulated in other areas. The lesson from the case is that the accounting approach can create the appearance that a business is profitable while this profitability relies on inaccurate projections. Therefore, accounting professionals should report book values as there will be fewer repercussions when there is a decline in the market. The second lesson relates to the special purpose entities. Enron used them to generate fictitious profits that would be added to the balance sheet. In the same way, the SPEs were used to hide losses from the balance sheets. This created the impression that the company was financially healthy. The lesson from the case is that SPEs introduce a level of complexity that is undesirable. Accounting professionals should strive to create consolidated financial reports that project an accurate picture of a firm’s status. Detailed information should be provided to shareholders and analysts in cases where an organization has to use such entities. The third lesson concerns corporate culture. The firm had a competitive culture where employees were encouraged to be innovative. The innovation extended to the accounting and auditing sections where “leading edge” practices were adopted (Healy & Palepu 2013, p. 9). The lesson, in this case, is that corporate culture can have a negative impact on the ethical practices of an organization. Accounting professionals need to ignore certain aspects of corporate culture to remain true to their professional pledges. The case study indicates that accounting rules and government oversight can be insufficient. The complexity of accounting practices at the firm means that regulators could not understand and, therefore, institute regulations to govern excesses. In the same way, the board failed to understand the effects of some accounting policies. The lesson is that complexity can be a tool for escaping checks and balances. Accounting professionals should utilize generally accepted standards to eliminate chances that they will take advantage of their advanced knowledge for personal gain. Effects of Unethical Business Practices on Society Unethical business practices have a direct impact on the community. The lessons from Enron show that the business concentrated on short-term profitability. This focus meant that the business would not be sustainable, and its subsequent collapse affected thousands of individuals. Employees lost their sources of income as well as the prospect of getting pensions. The legal system had to spend massive resources in investigating the fraud and coming up with tougher legislation. The filing of bankruptcy meant that thousands of investors would lose billions. The customers also lost an organization that had been able to provide innovative products. Lack of confidence in corporations is the other long-term impact of unethical business practices. Conclusion Enron was a reputable company that had achieved tremendous success in its first fifteen years of operations. Innovation was at the core of the firm’s considerable success and eventual failure. Conflict of interest at the board and management levels allowed accounting professionals to use innovative accounting approaches that placed the entire firm at risk. The same conflict of interest meant that auditors were unable to report on these risky practices. The case study has revealed that the use of continuous auditing could have rescued the firm from bankruptcy. The lessons learnt from the case are that mark-to-market accounting is not suited to some businesses and that special entities should be avoided or reported on clearly. The other lessons are that accounting professionals should stick to generally accepted practices and ignore certain aspects of corporate culture that might compromise their professional pledge to act in the interest of the organization and its shareholders. References Healy, P & Palepu, K 2013, The fall of Enron. Harvard Business School Publishing, Boston, MA. Jennings, M 2014, Business Ethics: Case studies and selected readings, Cengage Learning. Mainardi, RL 2011, Harnessing the Power of Continuous Auditing: Developing and Implementing a Practical Methodology, Vol. 10. John Wiley & Sons. Nanda, A 2003a, Broken Trust: Role of professionals in the Enron debacle. Harvard Business School Publishing, Boston, MA. Nanda, A 2003b, The essence of professionalism: Managing conflict of interest, Harvard Business School Publishing, Boston, MA. Read More