Corporate Governance and Enron Case - Essay Example

CORPORATE GOVERNANCE AND ENRON CASE By + Introduction Corporate governance is a system of practices, processes and rules that direct or control a company or an organization. It essentially involves considering the interests of a company’s stakeholders. These stakeholders include the management, shareholders, suppliers, customers, government, financiers and the community (Martin, 2006). The corporate governance principles provide guidelines on how to control a company to ensure that its objectives are fulfilled in a way that is beneficial to the company and adds long-term value to the interests of the company’s stakeholders. In corporate governance, the company’s management takes a trustee’s role for other parties that have interests in the company. Corporate governance is majorly based on principles like conducting business with fairness and integrity, transparency in handling transactions, complying with laws governing operation of companies, making sound decisions and necessary disclosures, ethical issues in conducting business and responsibility and accountability towards stakeholders. There is also need to clearly distinguish between corporate funds and personal funds when managing a company. Enron Corporation was a company dealing in services, commodities and energy based in Houston, Texas state in America. It had approximately 20,000 staff members and was among the world’s major natural gas, electricity, pulp and paper and communications companies before its bankruptcy in December 2001. After 2001, it was found that the company’s financial condition was majorly sustained by a systematic, institutionalized and planned accounting fraud that was termed as Enron scandal (Sterling, 2002). a) Enron Case Analysis The Enron Scandal that was discovered in 2001 led to bankruptcy of Enron Corporation and dissolution of Arthur Andersen, an entity that was among the five largest accountancy and audit partnerships worldwide by then. Enron is rated the biggest failure in audit apart from leading as the largest bankrupt company in the history of America by then. The case analyzes the cause of this failure in details. Causes of the company’s bankruptcy Lack of truthfulness. According to the report given by Kirk Hanson, the executive director of Markkula, a center for Applied Ethics, the Enron management did not give true information concerning the company’s health (Canadian Center of Science & Education, 2010). The senior executives developed a belief that Enron had to take the first position in relation to other companies and also they had to maintain their reputations as well performing executives in the United States. The executives did not observe the duty of full disclosure and good faith. No clear justification was gotten to support allegations that the CEO was selling stock and that he informed the employees about future rise of the stock. The investigations about the company’s bankruptcy revealed the stock sell-off by the CEO before February 2002. This is the time the sell-off would have been disclosed. The shares were sold to Enron in repayment of the money owing to the company by the CEO. Selling of company’s stock is an exception falling under the ordinary officer and director disclosure requirement. Lack of autonomy in management by the company’s board and conflicts of interest contributed to the collapse of the firm. Some researchers suggested that the company’s compensation policies caused a negative impact on stock price and earnings growth. Recent changes on regulation have been aiming at strengthening and enhancing internal control and accounting systems. There was a conflict of interest arising between Arthur Andersen’s two roles i.e. consultant and auditor of the company. While investigations continue, the company sought made steps to spin off various assets. Enron filed for bankruptcy to be allowed to reorganize and at the same time be protected from creditors (Rapoport, Vanniel&Dharan, 2009). Kenneth Lay, the then chief executive resigned and a restructuring expert Stephen Cooper was appointed to be the interim chief executive. The company’s core business of energy trading was tied in a complex case with UBS Warburg. The bank did not make payment for trading but shared profits with Enron Company. Discovery of irregularities in accounting at Enron Company in the year 2001 caused the media and regulators to give extensive attention and focus on Anderson (Sterling, 2002). The magnitude of accounting errors, together with the role of Andersen as the company’s auditor and the media attention offer a powerful setting to find out the impact of the reputation of the auditor on market prices around the failure of the audit. Andersen damaged its reputation after admitting in January 2002 that its employees destroyed correspondence and documents related to Enron engagement. Basing on Special Purpose Entity (SPE), Enron’s high levels of debt would pull down the grade of investment and trigger money lending institutions to recall money. Enron borrowed a lot of funds to balance its overvalued contracts. The SPE thus, enabled the company to convert assets with debt obligations and borrowed money into income. In addition, The company transferred more of its stock to SPE. However, the assets and debt bought by the SPE, that were burdened with significant debt amounts, were never reported on the financial report of Enron. This condition misled the shareholders that the debt was decreasing and revenue was increasing. Basing on market to market element of accounting fraud, Enron, as a public company was exposed to external governance sources such as market forces, oversight by regulators and private entities like auditors, credit rating agencies and equity analysts (Rapoport, Vanniel&Dharan, 2009). To convince investors to maintain a profiting situation that is consistent, the company’s traders were forced to forecast low discount rate and high cash flows on their long-term dealing with Enron. The difference between originally paid net present value and the calculated value was considered as Enron’s profit. In fact, the reported net present value might never happen in the coming years of the contract. Prisoner’s dilemma in Enron’s case When it collapsed, Enron was involved in different lines of production like energy and trading of commodities and derivatives that are energy-related. Many of its dealings were being monitored by the Federal Energy Regulatory Commission (FERC) or Commodities and Futures Trading Commission (CFTC). The primary role of CFTC is ensuring that market options and commodity futures operate in a competitive and open manner while the FERC regulates market and transmission of energy products (Canadian Center of Science and Education, 2010). To achieve maximum, wrong acts such as fraud in accounting will cause harm to the shareholders’ interests. Arthur Andersen, as Enron’s consultant and at the same time auditor, has to take responsibility for both shareholders and managers since the accounting information provided has a direct impact on the economic benefits of these parties. Clearly, Arthur Anderson and the managers chose to betray shareholders to achieve their maximum self-interests. Who carried the moral responsibility of Enron’s collapse? From Individual’s Angle: The then CEO, Jeffrey Skilling and board chairman, Kenneth Lay allowed Andrew Fastow, the then CFO to secretly build a private corporate institution and transfer it illegally. Andrew Fastow committed a crime of malfeasance and violated the ethics of his profession. When the board chairman and CEO ordered conspiratorial workers to perform an act which both of them knew was wrong, the employees also take moral responsibility for the act. Regardless of the court’s ruling, the company’s senior managers get a low grade on the principle of truth and disclosure. Andersen violated its market specifications as a well-known certified public accountant. The managers’ actions are taken to be the corporation’s actions only if the managers act within their stipulated authority (Bierman, 2008). However, Enron’s shareholders did not realize this fact from the high stock price. Therefore, Enron as a corporation was not responsible for the scandal. Actually, if the shareholders and the board paid proper attention to the decisions of the CEO, CFO, chief and relevant staffs, then Enron could avoid this scandal. b) Effectiveness of the amendments to the legislation/code. After the collapse of Enron, many attempts have been made by agencies to ensure a positive change in corporate governance. Reforms have been formulated and implemented to ensure effectiveness in corporate governance in the United States and around the world. The Enron scandal is among the major accounting and auditing scandals involving US corporations. In response to this scandal, the 107th Congress passed an act termed as Sarbanes-Oxley Act known as the most sweeping amendments to securities laws since 1930 (University of Maryland School of Law, 2003). This Act was formed by the Congress in July 2002 to create reforms in accounting. The 108th Congress stressed on several accounting issues like financial derivatives contracts and stock options, replacing rules with principles in the accounting system and an oversight to ensure implementation of the reforms in accounting as stated by Sarbanes-Oxley Act. The main intention of the Congress in passing this Act was to restore truth and confidence in financial and stock markets by enhancing corporate accountability, strengthening corporate governance and improving the degree of public disclosures of accounting information. Creation of the Public Company Accounting Oversight Board (PCAOB) Implementing this reform has been a great problem in the US. The goal of this agency is to regulate public company auditors and ensure that financial statements are subjected to outside and tough scrutiny and that the client-auditor dealing is free from conflicts of interest. This reform has been ineffective because many nominees and appointees to this board have been found to have some conflicts of interests. The first nominee withdrew after sources revealed that he was once a director of a corporation that was under SEC investigation on grounds of securities fraud (University of Maryland School of Law, 2003). Harvey Pitt, the SEC chairman also resigned because of this incident. The effectiveness of this reform has not been properly felt because the board members have headed several companies and are shareholders of other companies in the US yet they should monitor the operations of the same companies. The corporate governance issues may not be clearly resolved due to the main factor of conflicts of interest. Principles-Based Accounting This reform was introduced to replace rules-based accounting because many companies and their auditors ignored accounting rules. Rules were also very complex such that when fully followed, traders would lose a clear understanding of a company’s financial position. Companies which adopt Generally Accepted Accounting Principles (GAAP) are seen to have few financial struggles compared to those that have adopted the full application of rules. The principle of disclosure requires all public entities to publish their financial reports so that any potential investor is able to assess the financial positions of these entities before making a step to invest. The main element that makes the principles-based accounting effective is flexibility. As the complexity of the financial field increases, it becomes difficult to formulate standard rules for the economy as a whole. Through the principles-based accounting, corporations have been able to present their financial reports in the best way they prefer to ensure accurate and full disclosure of their financial positions (Coe, Schildhouse, Weygandt, Kimmel &Kieso, 2010). This amendment has been effective in resolving many corporate governance issues relating to disclosure. The strict adherence to rules and regulations made disclosure very difficult and sometimes less informative eg a firm could not easily present industry or market specific information in the best way it thought because of the many rules and bureaucracies it was bound to. Auditor independence, this reform is very effective in corporate governance because it has saved companies from financial losses. This reform requires that, a company’s external auditor should have no other dealings with the company’s affairs neither any influence by the company’s management in the exercise of his/ her duty, Arthur Andersen was Enron’s auditor and at the same time the company’s consultant. This consultancy dealing may have caused an influence on the audit function of Andersen leading to the Enron scandal. Many firms are surviving because independent audits serve as a check on directors and workers from engaging in fund embezzlement or defalcations. It is the duty of an independent auditor to report any detected frauds that have been committed by a company’s directors (Sterling, 2002). Andersen was partially held responsible for Enron scandal because of its failure to disclose the misuse of funds by Enron directors. An independent audit also plays the role of appraisal or evaluation by reviewing the existence and effectiveness of an organization’s internal controls and reporting any inadequacies and weaknesses detected. The aspect of independence is meant to prevent any collusion hence an effective way of solving many corporate governance issues in companies. Many shareholders have little knowledge about the internal dealings of their companies, more so in the finance section. This reform was meant to ensure transparency and accountability when dealing with shareholders’ funds. Internal auditors have no independence because they work under the control of the management. There is, therefore, need to involve external auditors who are independent. Reform on criminal and corporate fraud accountability This reform majorly targeted company defrauders and criminals. It is an effective reform to ensure high level of corporate governance by resolving many issues. The reform was meant to prevent falsification of company’s documents like income statements and tax returns, bank account records, record keeping books etc. Forging signatures, using letterheads without permission, distributing fake documents knowingly and destroying information necessary for an investigation are other common offences that the reform seeks to minimize. The reform has helped to ensure high ethical standards among company directors and workers. Criminals having committed these offences are liable to monetary fine and imprisonment depending on the nature of the offence. Falsifying of documents may also lead to job termination, lack of access to bank loans and frequent audits by the Internal Revenue Service IRS (Monks &Minow, 2011). To avoid such allegations, directors have taken a lot of caution and high degree of care when dealing with company finances and other resources. No one would want to be held responsible for an offence due to negligence in performance of duty. There is need for these directors to learn to differentiate clearly between corporate matters and individual affairs to avoid unnecessary offences. Enhanced financial disclosure Reforms on this principle have helped to ensure that material items in the financial statements are brought to the attention of all company stakeholders. In an attempt to resolve corporate governance issues, there is need for the public to understand the accounting basis of any corporation through face or footnote disclosure. Users of accounting information have been able to get information on legal proceedings, contingent asset and contingent liability details of companies in which they have interests. The users can know which events have been happening before and after the date of the balance sheet and other related financial statements before taking any action (Tulsian,2006). Issues relating to subsidiaries, associate companies and holding companies can only be brought to shareholders’ attention through full disclosure. This has been an effective way of relating with shareholders and eliminating any doubts and tension among other company stakeholders. Enron Company gave wrong disclosure to the shareholders. The shareholders knew very well that the company was reporting increasing revenues and reduced debts not knowing that the corporation was in a great financial risk. The directors did not clearly state the financial position of the company to shareholders. In agency law, directors are agents of the shareholders. It is clearly noted that Enron directors failed in their agency duty and many companies in the US and around the world must have learnt from Enron’s collapse. The amendment on disclosure principle is, therefore, effective in resolving corporate governance issues. This is because the number of companies collapsing in the US is very minimal since the Enron collapse. Once directors give wrong information and stakeholders discover, they lose trust in the directors and many are likely to withdraw from the company. Corporate tax returns amendment. The main aim of this was to ensure that all public and private companies comply with the taxation law in the United States. It is through filling and submission of tax return forms that companies can be assessed and their payable taxes determined. The Internal Revenue Service has the mandate to audit companies and find out about their tax status. Submission of returns and payment of tax to the government is one way of upholding corporate governance within organizations. The setting of clear laws by the Internal Revenue Service is another effective way of resolving corporate governance issues because firms have clear guidelines on actions to take and actions to avoid ( Bierman, 2008). Taking the responsibility to pay taxes to the government is an ethical practice that eliminates conflicts between the United States government and companies. Clear tax penalties have been put in place to discipline firms which do not observe taxation acts and regulations. Issues like evasion of tax and non-compliance have reduced since the formulation of reforms on corporate tax returns. Corporate responsibility reform The reform was established by the Congress to ensure that companies and audit firms take responsibility of their actions. The public company audit committees have greatly streamlined the audit profession in the US. Continuous and final audits are carried out in all public companies to ensure that errors and frauds are detected before publishing financial statements. This prevents wrong information being passed to companies’ shareholders. The audit committees have a responsibility to ensure that audit procedures are conducted in a manner that is recommended and that auditors are free to give a fair view of the financial statements of any company (Garner, Mckee&Mckee). An auditor who conducts the audit exercise in a company is held responsible for any outcome because shareholders rely on his/her report given that he/she is their agent. Responsibility as a corporate governance issue has been greatly resolved because many audit firms have learnt a lesson from the dissolution of both Enron and Andersen firms. Highly rated audit firms like Deloitte, Price Water House Coopers and Ernest and Young are performing well in the audit industry because they are very keen on preserving their reputation. Many firms entrust them because of their high competence and integrity in performance. Their practice of highly ethical audit standards has ensured that no firm which they have audited is financially hit without their notice. If they detect an error or fraud, they disclose and recommend effective measures to be taken. Through taking responsibility, corporate governance is upheld in the audit industry because no firm is ready to face compulsory dissolution due to negligence. The amendment on insider trading has also enhanced fairness in business dealings by preventing some individuals and companies from having a trading advantage over the others. This amendment has helped to ensure that all trading entities have equal information concerning trading activities (Tulsian, 2006). The fair funds for investors are another reform that was formulated to ensure proper use of investors’ money. It has helped to ensure that traders use the funds of investors with great care and caution. It is clearly noted that many of the changes are effective and will help give more resolutions to issues affecting corporate governance in the US and around the global. In conclusion, the Sarbanes-Oxley Act passed by the US Congress is of great significance because it has led to many reforms in corporate governance which are effective in dealing with issues affecting this area. Several reforms have been realized in the accounting systems around the world like adopting Generally Accepted Accounting Principles (GAAP). Many accountants, directors and auditors around the globe have learnt to take high degree of caution and care in performance of their duties in attempts to prevent cases similar to Enron scandal. The law of agency has been keenly observed by many management teams after the Enron collapse where managers act as shareholders’ agents with high level of transparency, integrity and accountability. 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