Accounting Implications to Enron Corporation - Case Study Example

Accounting Implications to Enron Corporation Introduction Enron was an American organization based in Houston. Prior to its bankruptcy, it was among the world's major energy corporations generating high revenues. In 2001, there was a revelation that its reported financial accounts were inaccurate and fraud ascribed to its accounts was suspected. Enron provides valuable experiences on the application of accounting policies and raises concerns on the role of accountants on the survival of an organization. Why Enron had high esteem before 2000 Enron was among the leading organizations in the energy sector, making a remarkable revenue of around $111 billion in the year 2000. The company had a robust outlook of accounts; it was highly valued stock, and it had good reputation for making profits. Being a fast-growing company with high promotion activities, Enron was heading for great heights in business. These characteristics are ideal for any person who wants to invest, and therefore, Enron had many investors coming. The accountants did not lay out their true and fair financial records. The accountant’s application of creative accounting practices to manipulate the accuracy of the records was a common practice. The management did this by establishing many limited liability special purpose entities in order for Enron’s accounting officers to transfer liability. This bid to ensure all accounts appear without liabilities was a strategy that sought to maintain a robust and increasing stock price, thereby keeping its investment grade credit ratings. The role of the accountant is to ensure the maintenance of accurate books of accounts, a role that the accountants clearly did not perform. Confidence in the financial information produced by professional accountants is one of the main driving forces for public investments. Accountants have the role of safeguarding the public’s interest by providing information that is true and fair for investors’ decision-making. The manipulation of accounts in order to favor the company and thereby deceive the public to rush to invest is unethical. There is a conflict of interest in these dealings. The accountant has to oversee the maintenance of the image of the organization and at the same time protect the interest of the public. This context becomes worse when an accountant also has personal interests in the dealings of the organization. In such instances, accountants should declare any form of conflicting interests and seek guidance when working during such situations. However, this was fraud by the organization; the public interest should take precedence over personal and organizational interests. The accountants need to be concerned with the financial dealings and investments by the organization. The establishment of limited liability special purpose entities in order to hide liability was an idea that the accountant had to advice the management on its implications. Instead, accountants seem to collaborate with other management officials in perpetrating fraud against the company. The role of the accountant is to safeguard the assets of the institution, and therefore, it was imperative that the accountant should make enquiries on the nature of liabilities the company was incurring, the ways in which the financial obligations were arising, and the utilization of revenue from sale of shares. In relation to this deception of the public to invest in Enron, it is clear that the entity did not keep proper books of accounts; they applied creative accounting policies to conceal liabilities, the company’s accountants had a conflict of interest in the performance of their duties, and the accountants did not have interest in safeguarding the organization’s assets. The rise and fall of Enron Rise of Enron Kenneth Lay’s idea of selling oil at market prices and the subsequent approval by the United States Congress on deregulation of natural gas are Enron’s foundations to success. This deregulation was an encouragement for Enron and other energy dealers to raise their prices. The accountants at that time work professionally and uphold ethics. There was proper recording and keeping of the books of account. In 1999, there was a stock increase by 56% and an additional 87% rise in the year 2000. At this point, it was unclear whether there was fraud. The Downfall of Enron Enron had complex financial statements that were confusing to both shareholders and analysts. Its complex business structure makes it even more difficult understand the statements. The accountants therefore rely on these complexities in order to hide unethical practices, misrepresent earnings, and create modifications on the balance sheet indicating favorable performance. The following are the causes of Enron’s collapse in relation to accounting principles: a) Revenue recognition The entire value of trades was revenue, according to the accounts of Enron, in contrast with what other trading companies did. The accountants did not consider the guidelines in provision of accounts by choosing to present complex accounts that were inappropriate for the business. Enron's way of reporting inflated trading revenue became a trend to other companies in the energy sector in an attempt to maintain competition with the company's great increase in revenue. Accountants need to consider industry guidelines and the recognized financial framework appropriate to their organization in preparation of accounts. This application of different accounting policies in order to create a favorable result is unprofessional and unethical. The application of accounting policies needs to consistent from period to period. b) Mark-to-market accounting Enron became the pioneer non-financial company to use mark-to-market method to account for its long-term contracts (W\"alde, 2005). This method requires that the signing of a non-current contract allow the estimation of the revenue as the present value of net future cash flows. There was no sure way of valuing the contracts. The primary aim was to create a false sense of stability in the organization’s income for investors to have confidence in it. The practice is against the generally accepted accounting principles. This is unprofessional since it involves intentional misapplication of an accounting policy with aim of deceiving the public. This practice also contributes to the failure of organizations, since they lack sufficient funds to finance both current and future obligations. It is necessary that accountant play the role of the financial advisor to their organizations so that they make wise investments to avoid losses. c) Special purpose entities Enron made use of special purpose entities to fulfill the purpose of funding or managing risks associated with certain assets. The company decided to disclose minimal information on its use of the entities. There was no consideration of the financial oversight role of the accountants. Accountants are required to ensure the timely handling of the organizational debts, viable investments in place, and proper management of assets. This practice of providing false information to woe investors is unethical. Enron also used special purpose entities for dealings other than circumventing accounting conventions (Weeden, 2002). Because of a violation, the organization’s balance sheet understated the liabilities and overstated the equity, overstating its earnings. In the acquisition of CalPERS, Enron established Chewco (a special purpose entity) to offset a given amount of liability for the transaction to occur without debt on Enron’s balance sheet (Bryce, 2002). Sale contracts require good faith in their performance. The accountants have a duty to disclose information that is necessary for this kind of transaction. d) Employee compensation The employee remuneration systems encourage fraud in the organization. Employees get into deals in order to make quick money and earn bonuses. This is a compromise to the safety of the organization’s assets. The accountants need to ensure the compensation of employees does not contribute to fraudulent tendencies in the organization. The organization culture helps in identifying fraudulent tendencies in the organization, and affirming the internal controls to enhance the safety of the organization’s assets. The remuneration of executives also needs careful consideration. This auditor needs to seek clarification on the bases of remuneration of the top management employees in order to identify potential areas of conflict. The compensation of executives needs to be reasonable and the general human resource costs need monitoring. Fraud, ghost workers, payment for work not done, and double payments require checking to prevent the organization from incurring unnecessary costs. e) Risk management The reckless use of special purpose entities and derivatives led to Enron’s bankruptcy. Accountants have a role to play in risk management and investment decisions. They need to advise on risk management options and provide an analysis of expected returns from potential investments for making the right decisions. f) Other accounting issues Booking costs of projects such as assets that fail to materialize, with the rationale that there was no official letter had stating the cancellation of the project is also an accounting weakness that needs consideration. Stage shows by employees to present a hardworking and busy division in order to present a false picture of the number of employees is also a common practice. Exaggerations in the number of employees usually translate to inflated payrolls in the accounts. The accountants have to ensure the employees on the payroll exist and are working, and reconcile the account with the human resource records. Internal and external checks The audit firms have to ensure their independence in the course of performing their duties. Due care and expertise is also important in the audit work. Enron compromises on the independence of the auditors. In order to enhance the independence of auditors, the auditors are not required to perform other accounting functions or consultations for the client. The remuneration of auditors needs to be reasonable and commensurate to the nature of engagement. A high fee compromises on the independence of the auditor in ascertaining truth and fairness of the accounts (Fox, 2003). Auditing standards require an auditor or audit firm to disclose any conflict of interest in the performance of their duties. In the case of Enron, the audit firm is facing a threat on audit engagement. The audit firm in fear of losing its client, it follows the desires of the client organization (Weaver, 2003). The auditor or audit firm requires performance of their duties without the fear of intimidation or harassment. Enron’s audit firm also provides consultancy services, which Enron ensures it provides a competitive price. The audit firm lacks the authority to make professional decisions on audit issues as it receives an attractive compensation package (Thomas, 2002) The auditors of the organization failed to detect these dishonest dealings. It is the duty of the auditor to ensure clarification of any cases of fraud, error, or inconsistencies in application of accounting policies. The auditor has the role of an agent. He/she provides an independent check on the organization’s internal control systems, collects evidence on existence, ownership, valuation in order to secure the investors’ confidence on the management of the organization. Therefore, timely expert action by the auditor was necessary to avert Enron’s collapse. The internal checks may not be functioning since the top management initiates fraud in Enron. The lack of commitment by the top management to ensure honest and smooth running of the organization, is a barrier to the implementation of the internal controls. The accountants manipulate accounts and therefore fail to set a good example in the implementation of internal controls. The fact that the auditor has no independence worsens the situation, and therefore there is no watchdog to ensure the effectiveness of the internal control functions (Schneider, 2004) Continuous audit A continuous audit would not have helped much because of the extent to which the top management had gone to frustrate auditing practices. It does not matter the number of times the auditor does his/her checks, what matters is his/her independence, commitment to professionalism, and the cooperation of the client. Payment of high fees to the auditor and threatening the auditor, influence the auditors independence and thus they implement the dictates of their client no matter what evidence they have in place (Ifac.org, 2014). The board of directors Members of the board of directors in Enron had a conflict of interest. The board of directors makes crucial investment decisions and other financial decision for the organization. Once the board members start to enjoy huge benefits in the organization, they are likely to begin acting on their own interests at the expense of the organization’s good. This conflict of interest cannot be able to prevent the organization from collapsing. The board of directors plays a crucial role in assessment and monitoring of the financial performance of the organization. The members of the board need to understand the accounting policies and advise on the application of the appropriate accounting policies for the true and fair view of the organization’s financial statements (Businesscasestudies.co.uk, 2014). The board has the ability to change the accounting policies based on advice from an independent auditor or financial expert on the need for the change. The members of the board have a responsibility to go through the financial statements of the entity in order to ensure appropriate application and consistency in application of accounting policies. The board needs to work closely with the external auditor to be able to understand various accounting policies, internal controls, and other issues related to the management and safeguarding of the organizational assets. Breaches in accounting a) Inappropriate application of accounting policies There was a change in accounting policies with an aim of reporting higher income although the policy was inappropriate for Enron’s type of business b) Fraud The management and employees of the organization did manipulations on the accounts in order to conceal money deals. The organization was keen on maintaining a good image and therefore it window-dressed its accounts to continue attracting investors. c) Insider dealing The management and the employees of the organization involvement in shares and other investments of the organization while using the information at their disposal for personal gains. False information was available to the public so that they undergo exploitation when they invest in Enron (Emshwiller, 2011). d) Keeping of books of accounts There were manipulations and changes in the books of accounts in order to appeal to potential investors. Lessons learned a) Accounting policies are important in showing the true and fair view of transactions. A change in the accounting policies may distort the state of affairs, bring about confusion, and this may raise possibilities of fraud. b) Always update and keep proper books of accounts. Non-recording of financial transactions may lead to disorganization and encourage fraud and errors. c) Risk management is crucial for the sustainability of the organization. The hedging of the organization of its own assets was one of the major contribution to the collapse of the organization. d) Management of costs determines organizational success. The ability of the organization to manage its costs and generate revenue enables the organization sustain its operations. Unethical business practices on the society a) Unethical practices lead to closure of organizations and subsequent loss of employment to many people b) Unethical practices damage the reputation of other organizations, and may cause failure of other organizations Conclusion Accountants play a key role in the survival of an organization. Either they can make the organization prosper by using their ethical considerations and professionalism in handling organizational finance, or they can cause the downfall of an organization when the fail to adhere to professional code of conduct just like what happened in Enron. Bibliography Bryce, R. (2002). Pipe dreams. 1st ed. New York: PublicAffairs. Businesscasestudies.co.uk, (2014). The role of the accountant - The contribution of accountants to sound, ethical business practice - ACCA | ACCA case studies, videos, social media and information | Business Case Studies. [online] Available at: http://businesscasestudies.co.uk/acca/the-contribution-of-accountants-to-sound-ethical-business-practice/the-role-of-the-accountant.html#axzz3FYcsIyIk [Accessed 8 Oct. 2014]. Emshwiller, J. (2011). Power Failure: The Rise and Fall of Enron. Reynolds Ct. & Media LJ, 1, p.3. Fox, L. (2003). Enron. 1st ed. Hoboken, N.J.: Wiley. Ifac.org, (2014). Roles and Importance of Professional Accountants in Business | IFAC. [online] Available at: http://www.ifac.org/news-events/2013-10/roles-and-importance-professional-accountants-business [Accessed 8 Oct. 2014]. Schneider, J. (2004). The Smartest Guys in the Room: The Amazing Rise and the Scandalous Fall of Enron by Bethany McLean and Peter Elkind. Energy LJ, 25, pp.441--459. Strouhal, J., Bonaci, C., Matis, D. and Mustata, R. (2010). Failure of measurement system? some lesson from fall of Enron corp. WSEAS Transactions on Systems, 9(9), pp.969--978. Thomas, C. (2002). The rise and fall of Enron. JOURNAL OF ACCOUNTANCY-NEW YORK-, 193(4), pp.41--52. W"alde, T. (2005). The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, a book review. Oil, Gas & Energy Law Journal (OGEL), 3(2). Weaver, J. (2003). Can Energy Markets Be Trusted? The Effect of the Rise and Fall of Enron on Energy Markets-excerpts from a forthcoming book on the involvement of US energy markets and energy regulators in the collapse of ENRON. Oil, Gas & Energy Law Journal (OGEL), 1(3). Weeden, L. (2002). Rise and Fall of Enron: A White House Nondisclosure Entangles Seperation of Powers and Contempt of Congress, The. McGeorge L. Rev., 34, p.65. Read More