Enron as the Worlds Most Innovative Company - Term Paper Example

Student Name: Tutor: Title: Case Study: Enron Course: Abstract This is case study report that represents an analysis of the events that led to the collapse of Enron and the important lessons learned from this experience. The introduction begins by giving a brief glimpse into the Enron scandal and highlights the premise of the report. The response to question sections responds to various questions about Enron. It explains why Enron was admired in the first question. The second part discusses the rise and fall of Enron. The failure of internal and external checks and balances to prevent Enron demise is discussed in the third question. The role of continuous auditing in preventing Enron demise is explained in the fourth question. The fifth part explains the role of board of directors in Enron’s demise. The sixth question outlines the beaches of ethical and accounting standards that happened at Enron leading to its collapse. The seventh part discusses four important lessons that can be drawn from Enron case study. The eighth part explains the effect of unethical practices on the society and community as a whole. Finally, the conclusion echoes the important lessons learned from the Enron scandal and the role of irresponsible leadership in its demise. Introduction This case study highlights the events that unfolded at Enron and the aftermath of its demise. Enron had been a reputable company prior to its collapse and donated hugely to lawmakers in the U.S. Congress. The company was a point of destination to top business students and it had set an example to be admired only to file bankruptcy when the accounting malpractices could not be concealed any more. The financial statements were restated from 1997 to 2000 showing the earnings had been inflated by 20% (Hamilton, & Micklethwait, 2006). Many other malpractices were unearthed after the collapse of the company. The Special-interest entities were a source of income to some of the executives at the company. Sherron Watkins was perturbed about the malpractices and foresaw the imminence of the collapse of the company. Her worries were not shared by other people in the management team. Eventually the company collapse and the conspiracy of accounting malpractices were unearthed. This case study review provides an insight into the Enron scandal and draws the important lesson learned from it. Response to the case questions 1. Why Enron was an admired company prior to 2000 Enron Company was an admired company prior to 2000 owing to the many attractive attributes it had. Fortune magazine rated Enron as the world’s most innovative company for a period of six years in a row. The investors valued the company above $60 billion at the time. Environ rated itself as a company that was founded on innovation, and was always rated among the most innovative companies in the entire world. It successfully competed with top consulting firms and investment banks for top business students, and it went ahead to recruit engineers and scientists who helped the traders of the firm to remain abreast of competition in strategies of trading. Recruits were lured to Enron by attractive signing bonuses and besides the promise of earning annual bonuses up to 100% of their salaries (Hamilton, & Micklethwait, 2006). The new employees were motivated to move around freely to positions where they felt they could add value as well as generate additional revenue. The process of performance evaluation was used to drive employee compensation. The salary and bonus awards at Enron were very generous as compared to the industry’s average. Superior originators of new deals as well as traders were rewarded accordingly. The traders’ bonuses were based on trading profits’ present value that they had generated. The senior corporate executives got ‘phantom equity’ in business units that can be converted into Enron stock or cash, or multimillion-dollar bonuses if the stock price of the company hit a new target. They also got special bonuses for major accomplishments like closing a major new deal. Executives and employees were often encouraged to take bonus awards in form of stock option or Enron stock. Skilling had decentralized decision-making and recognized the need for a strong risk-management system (Catanach & Rhoades, 2003). There was a 64-page Code of Ethics that explained the accepted behaviors at Enron. The company had immense power and political influence. Lawmakers in the U.S. received campaign donations from Enron. 2. Reasons for the rise and fall of Enron All the professionals were unable to sense any kind of trouble at Enron before it blossomed into something big. The complex business model at Enron that extended across many products comprising of physical assets as well as trading operations across national borders overstretched the limits of accounting. The trading business was marred with complex long-term contracts. The concept of prudence that advocates for quick recognition of losses and slow recognition of gains was reversed. An approach known as mark-to-market accounting was adopted (Coffee, 2006). The present value of the stream of future contract inflows was imminently recognized as revenues, while the present value of expected costs of meeting the contract was automatically expensed. Unrealized losses and gains in the market value of long term contracts that had not been hedged were reported as annual earnings. This is fraudulent and a misrepresentation of the true picture on the ground. How could losses be recognized as earnings in the final reports? Whereas determining the present value of future inflows was not a challenge, estimating the cost completing the contracts by the Enron’s traders posed a big challenge. Cost estimation was made more difficult owing to the fact that many states had not yet deregulated energy hence estimating the timing and likelihood of deregulation in future (Schwarcz, 2006). Consequently the estimates of contract fulfillment costs were highly subjective leaving room for errors and blind estimations. The problem at Enron spiraled because of lack of strict accountability of its operations and transactions. Any gain on Enron assets that were sold to Special-Purpose entities (SPE) were removed from the balance sheet of the company while sale was included in its income. The vice president for corporate development, Sherron Watkins warning about Enron imminent slide into a wave of accounting scandals was ignored. The appointed counsel only termed Enron’s accounting practices as aggressive and creative and not anyway compromising accounting standards to warrant any further investigations. It is only Watkins who was worried about the imminent implode of a wave of accounting scandals and her future careers. The rest of the members of the company laid back unperturbed. The board members who had a great responsibility of determining the future of Enron were unperturbed about the accounting malpractices and did not heed the warning by Watkins. It is reported that they were unconcerned about the company’s future (Hamilton, & Micklethwait, 2006). The fall of Enron was aided by the inaction of all professionals that should have raised an alarm when things started going wrong in the company. The conflicts of interest among directors at Enron and other special business partnership created room for malpractices that unduly benefited interested parties. Investigations revealed that Fastow had profited in a huge way from transactions involving Enron and the SPEs that he controlled. These malpractices were only revealed after an independent investigation by Powers Committee was commissioned by the directors. The initial internal control checks and balances were not impartial in their reports and did not expose any accounting malpractices that were happening in the company. 3. Why internal and external checks and balances of Enron failed to prevent its demise It is unfortunate that the internal and external checks and balances failed to foresee the collapse of forewarn the investors and other shareholders. The frequency of internal auditing was not adequate and internal auditors were superficial in their analysis of the accounting processes in the company. The audit committee met only for a few times in the course of their years and surprising the members had very little background in finance and accounting. The audit committee relied heavily on information obtained from the management together with external and internal auditors. The audit committee should have been independent and unbiased or directed by the management. Arthur Anderson being the external auditor of Enron had a very close working relation with the client since 1985 (Schwarcz, 2006). It is highly unlikely that Arthur understood would have acted as the whistleblower and exposed the accounting malpractices that were being carried out at Enron. The external auditors that should have been independent helped in concealing liabilities and colluded with Enron management to go against the open disclosure requirement of any accounting performance. The external auditors made the company’s reporting to be more obscure and complicated or altogether jumbled out. Arthur Anderson doubled up as a consultant in various sections for Enron like tax work, assets’ appraisal that Enron had an interest in buying or selling, and risk management. Anderson helped in concealing the accounting malpractices that were taking place at Enron. Anderson seemed to have been compromised by Enron’s management into playing along to their game of misrepresenting the performance of the company and engaging in shady dealings. Anderson may not have been at all independent in conducting audits at Enron. The management ignored the warning signs even when it was very evident that Enron was engaging in high-risk accounting. Conflicts of interest contributed to this situation since of the executives were involved in the partnership deals and aimed at making profits. The personnel at Enron were very sophisticated and engaged in several transactions that were sophisticated and are were very aggressive in structuring transactions for the purpose of attaining objectives of derived financial reporting. The issues that Anderson uncovered as an external auditor at Enron were neither shared by the audit committee at Enron nor the management of the company. The external auditor was worry of the accounting practices that were being applied at Enron but there was no action that was taken to address the problems to ensure compliance to accounting standards. The management and the board were complacent and did not thorough go over the transactions with partnerships to ensure that they were credible (Catanach & Rhoades, 2003). The external and internal auditor were not independent hence did not give an honest opinion about the running of the affairs of the company. The audit committee was formed as a matter of formality and not to ensure continuous checks and balances in the operations of the company. The audit committee rarely met and it would be impossible to learn about the malpractices that were being carried out in accounting standards by only meeting a few times in a year. 4. Would continuous auditing have prevented the collapse of Enron? Continuous auditing that is independent and credible would have prevented the collapse of Enron. There was utter complacency in the auditing committee and in both internal and external auditors’ responsibility to give independent and unbiased reports. The audit committee did not have regular meetings that provided a way forward about malpractices in the company’s aggressive transactions (Schwarcz, 2006). Continuous auditing would have revealed any accounting malpractices and the misuses of the company’s resources by the management for their personnel gains. The internal and external auditing that was being done at Enron was a bog sham and did not purpose to ensure that the company adheres strictly to accounting standards and regulations. The audit and compliance committee demonstrated complacency and did not probe further to uncover any discrepancies in the accounting practices and transactions. Continuous audit that is transparent and genuine would have exposed the malpractices that were being witnessed at Enron. 5. The role of Board of Directors in the demise of Enron The board of directors had a lot to do with the collapse of Enron. They stood and watched as the company slid into unprofessional accounting conduct and did not provide the leadership role to the management. The board of directors lacked foresight and oversaw all the malpractices to occur under their noses without critically questioning the business transactions and partnerships that the company was involved in. Enron’s board of directors despite being among the highly compensated in the world did not live to their expectations of ensuring that there are checks and balances within the company to prevent malpractices and ensure strict adherence to financial reporting (Coffee, 2006). Any investment done by senior managers where there were imminent conflicts of interest with the company has to be certified or approved by the Chairman of the Board and the CEO. However, the board did not see the close association of Anderson and him offering consulting as well as auditing services to the company as a problem. The board did not probe to expose some of the evils that were being supervised by Enron executives. The board of directors completely failed in its oversight and leadership role. 6. The breaches of ethical and accounting conduct that happened at Enron Enron did not present the true picture of what was happening in the company. It conceded that the method of reporting grossly violated the accounting standards that started that 3% of assets should be owned by independent equity investors. Enron ignored this requirement hence being able to consolidate the SPEs on its balance sheet; this led to overstatement of its equity and profits and further understatement of liabilities. Consequently the balance sheet showed that the company was doing well when it was actually on its death bed. The restating of its financial statements from 1997 to 2000 to correct the violation reduced earnings by twenty percent for that period. The owners’ equity went down by $929 million. These concealments were done to hide the true picture of the performance of the company to the investors, shareholders and the general public. The management drew heavy perks and salaries of the account of these profits when in the real sense the company was not doing well (Catanach & Rhoades, 2003). The CEO and other officials resigned before the scandal was made public. Kenneth Lay and Jeffrey Skilling had resigned sighting various personal reasons. It raises eyebrows that the management may have been privy to the situation in the company and hid it from anyone else who was not closely involved in the scandal. The external auditors did not do their job properly and there was conflict of interests because Anderson was closely associated with the company. Some of the discoveries that he made about improprieties in the company was not shared by the board or the management team. The external auditors forfeited their duty of providing checks and balances to the company. The restatement of the financial statements and the information about the nature of partnerships that the company was involved in completely destroyed the trust and confidence of investors in the company. Its stock price dropped tom mere $8.41 (Catanach & Rhoades, 2003). In a rightful illustration of conflict of interests, some Enron executives were involved in ownership stakes in off-balance sheet partnerships hence profiting from Enron’s losses. Accounting rules were grossly violated and the actions by the executive were directed by personal interest rather than the welfare of the company. In the course of a potential acquisition by Dynergy, one of its main competitors, for a market value of $9billion, credit-rating agencies were discovered to have written down the company’s debt to junk-bond status (Mclean & Elkind, 2004). This was utterly unprofessional and many transactions at Enron were enshrined in mysteries and sophistication that baffled even the most experienced auditors. 7. Four lessons learned from the Enron Case The first lesson is the risks of perceived success at the company. The high visibility of ‘success’ at Enron through media, academia and stock market encouraged ambiance of arrogance and euphoria in the company hence making the executives to lapse into a sense of certain invincibility. The reduced critical sense made people to stop probing whether the right thing was being done in the company for its long-term welfare. The second lesson is about blind trust and investors’ greed (Bratton, 2003). Investors who invested their retirement money at Enron did not question how Enron was able to grow 50% annually considering its large commodities industry. The investors were attracted by Enron’s advantages and extravagant and hoped to gain in the short-term. The Enron case also points to the danger of poor regulation. Many challenges at Enron resulted from regulatory loopholes that were exploited in the balance sheet of the company. Fourthly, Enron case highlights the big gap between ‘checklist’ governance and effective governance. The corporate governance on paper at Enron was in line with the best practices but practically things were very different. Many directors had subtle bonds to Enron as well as its leaders hence undermining the ability to question things. 8. The effects of unethical business practices on community and society Unethical business practices have lasting impact on the community and society for posterity. The Enron scandal has been studied by many accounting scholars and will be told over and over again for generations to come. Unethical business practices are capable of destroying individuals’ careers completely. This concern was conveyed clearly by Sherron Watkins in her letter to Mr. Lay pointing out the anomalies in the accounting practices used in the company. Watkins was worried that her eight years of service at Enron will never be recognized on his resume should the company be found to have engaged in accounting hoax. She said that the resignation by Skilling for personal reasons was prompted by the enormity of the accounting problems at the company that were unfixable. Debt holders and shareholders lost their capital while employees lost their precious jobs as well as pension plans that had been held vastly in Enron stocks. The stock prices had plummeted rapidly prior to the demise of the company. Many people future was a mere blink since they had lost their source of livelihood. Unethical business malpractices affect negatively the source of livelihood for many people and it is only the perpetrator who benefits for a little while as the scheme exist but he loses the income when the business collapse. When the Anderson’s auditing firm collapsed following several litigations and lawsuits against it, 85,000 professionals lost their jobs and source of livelihood (Schwarcz, 2006). The story would have been different if Anderson had been transparent in his auditing and prevented Enron’s demise. The firm had been existence for 88 years but it collapsed within six months. The auditing regulations had to be adjusted by the U.S. Congress to ensure tightly-regulated audits that were in turn highly priced. Conclusion The Enron scandal will be told for generations and generations to come and its role in financing account and reporting regulations. It was a big scandal that took many people by surprise because the company had been doing very well. The lessons learned from this incident are very important to the future of accounting, auditing and finance and the role of corporate governance in organizations. Conflicts of interest and the greed of management can lead to the demise of a company. It is the responsibility of every member of the organization to be vigilant to raise alarm as Sherron Watkins did when things are not being done properly. Careers were fractured, reputation damaged and source of livelihood shuttered because of lack of foresight and responsible leadership at Enron. Internal and external checks and balances are important to ensure that the company operates according to the required regulations and ethics of accounting and reporting. References Bratton, W. 2003, Enron and Dark Side of Shareholder Value, Tulsa Law Review 76: 1275-1361. Catanach, A. & Rhoades, S. 2003, Enron: A Financial reporting Failure, Villanova Law Review 48: 1057-1076. Coffee Jr. J. 2006, Gatekeepers: The role of the professions and Corporate governance, 1st ed, USA: Oxford University Press. Hamilton, S. & Micklethwait, A. 2006, Greed and Corporate Failure: The lessons from recent disasters, Palgrave MacMillan, Sydney. Mclean, B. & Elkind, P. 2004, The Smartest Guys in the Room: The amazing rise and scandalous fall of Enron, USA: Penguin Books. Schwarcz, S. 2006, Enron and the use and abuse of special purpose entities in corporate structures, University of Cincinnati Law Review 70: 1309-1318. Read More