Accounting Fraud of Enron Corporation - Essay Example

Accounting Fraud of Enron Corporation Introduction Accounting fraud is the falsifying of an organization’s financial records pertaining to its income, sales, liabilities in order to inflate its profits or assets when its actually running at a loss. Enron’s fraud is among America’s landmark cases which resulted to its bankruptcy in year 2001. Enron was a public limited company formed by Kenneth Lay in 1985 dealing with energy. The paper seeks to evaluate the causes of its financial fraud which lead to its bankruptcy. Rise of Enron In the 1990s period, Enron was considered one of the most famous companies in the world due to its innovations. According to Bierman 24 besides building power plants, buying and selling of natural gas and electricity; the company also developed new markets like internet bandwidths, weather futures, pulp and paper business, water plants and oddball products which provided broadcast time for marketers which rocketed its financial incomes. Between the periods of 1995 to 2000, its revenues rose from $9 billion to an impressive $100 billion. The company won America’s most innovative company by Fortunes Most Admired Companies Survey for six years straight which added to its successful reputation. Causes of fraud Mark to market system The accounting system required that the company’s future profits were to be estimated at present value based on the signing of its long term contracts. The system was introduced by the joining CEO Jeffery Skilling, who ordered the company’s reporting system to be changed from its actual sales and supply of its natural gas to the new system. The mark to market accounting estimations were in reference to the future net value of the cash flows which were often difficult to predict. This included estimated Enron’s projects’ incomes that were irrespective of whether they were received or not and if changes were made like additional losses or incomes, they would be incorporated in subsequent periods. Enron Incorporation was the first non financial company to be given approval by the Securities and Exchange Commission (SEC) use the system. Due to the numerous discrepancies in matching their cash and profits; the shareholders were given false reports. Therefore, a strategy to appease the investors was created (Bierman 45). Based on Bierman 55 the company executed pressure on its traders in order to forecast low discount rates and high future cash-flows on long-term contracts with the company. In essence, the difference margin between the original paid value and the present calculated net value was the company’s profit. Contrarily, the estimated net present value could not even be realized in the future years of its long-term contracts. For example there was a partnership between Blockbuster video and Enron on a 20 year deal where they were to introduce on demand entertainment to numerous US cities. Enron Incorporation estimated future incomes of close to $110 million where the analysts doubted the feasibility of the service and market demand. Its long term incomes were in no doubt overly inflated. After the project failed, Blockbuster Company withdrew from the contract. Even though the project resulted into a loss, Enron Incorporation still recognized its future profitability. There is no doubt its long-term projected incomes were overly projected. Dysfunctional cooperate culture Its performance management criteria and compensation scheme led its failure due to its unfavorable corporate culture that valued short term earnings in order to boost bonuses. The company gave away bonuses and incentives like stock options and cash sums for the productive employees. The company’s culture turned over-competitive. The employees closed deals irrespective of whether they were bad or good irrespective of their outcomes, so as to get bonuses and good performance review ratings. The company’s performance review committee greatly influenced the employees’ performance level. It replaced the company’s cooperation culture to competition. The employees’ performance was reviewed either by rewards or by sacking if underperformed (Bierman 72). Bierman 87 the accounting outcomes were recorded immediately in order for the company’s stock price to be kept up to date. The method ensured that the executives and deal closers received huge stock options and cash bonuses. This culture created a problem whereby, numerous projects were being made with limited follow ups. This is because they never wanted to be accountable for the deal’s outcome but they just focused on their financial rewards. The company frequently emphasized on its stock price. Like other organizations, the company’s management was hugely compensated on the stock options. The stock option policy made the management to formulate expectations on its exponential growth. The move was necessary in meeting Wall Street’s expectation. The stock ticker was placed at elevators, lobbies and on the company’s computers. The CEO would develop the stock price at budget meetings randomly even though it was impractical to achieve it. The CEO believed that if the employees constantly feared on costs would interfere with their principal thinking. The company therefore induced extravagant spending more especially on its executives. Booking accounting issues The company had the tendency of recording cancelled contracts as assets. This was negligently assumed the contract was still in force due to lack of official letter declaring the lapse of the contract. This practice was termed as ‘snowball’ where it used to account for projects that were worth less than $90 million. However, due to the potential of the projects, it was later raised to $200 million (Bierman 102). The company also used a fooling practice of touring the financial analysts to its offices. Enron toured the analysts at its Enron Energy Services where the employees were instructed to act vigorously in order to please them. Skilling the CEO transferred other employees from other departments and ordered them to pretend to act extra busy so as to create an appearance that the division was actually large than anticipated. The malpractice was used on several occasions in order to induce the analysts to increase its stock price based on the company’s progression. Unethical and political issues Bierman 117 Enron’s mismanagement was brought about by the executives’ greed, lack of situation ethics, lack of SCR (corporate social responsibility) and the get it done mentality. The employees were instructed to close deals irrespective of their disclosure in order to get the deal done. The employees used unethical means like non disclosure of the company’s financial status so as to woe the investors. Another notable situation was when the company was named a fraudster in 2002 and the then auditor Author Andersen influenced the employees to destroy correspondence and documents regarding Enron business deals. This was unethical undertaking by the employees to necessitate conspiracy. The management including the chairman and founder, Kenneth lay and Jeffery Skilling the then CEO, allowed its CFO, Fastow, to secretly build a private corporate institution so as to illegally transfer the property. The CFO went against his professional ethics and was charged with malfeasance crime. Conflict of interest was noted due to the Auditor Author Andersen playing two roles. He was the company’s Auditor as well as the company’s consultant. Due to the Enron’s malpractices, the auditor was the one to clean up the mess in the company’s financial records. The company’s fraud was also contributed by lack of an oversight team to oversee the management and conflict of interests. The company’s compensation policy engendered the company’s stock price and growth (Bierman 143). The company was able to receive deregulation from the government due to its backing. Its founder, Kenneth Lay was closely related to the then president Bush who assisted the company to sell its natural gas across all the borders. False financial auditing Bieramn 155 adds the company’s auditing company, Arthur Andersen, played a major role in falsifying Enron’s financial records. The auditing company was hugely remunerated in terms of consulting fees. The company further benefitted from conflict of interest from Enron. In the year 2000, the auditing firm was paid $25 million as audit fees and $27 million as consultancy fees. The company was hugely compensated so as to hide the financial debts of the company and inflate on its revenues (Bierman 210). Additionally, Enron Incorporation employed the services of numerous (CPAs) certified public accountants and other accounting professionals who contributed to (FASB) financial accounting standards board rules. The professionals assisted the company on ways to save the company’s financial loopholes. The professionals applied the accounting principles (GAAP) Generally Accepted Accounting Principles to accrue to the company’s benefits. The credit risks having been known, the company’s management pressured Andersen to derecognize special purpose charges. This is because the entities would never have returned a profit to the company where the accounting guidelines provided that company should institute a write off and the entities would be declared a loss (Bierman 245). In order for Enron to meet its financial expectations, it pressured Andersen. Enron would hire other auditing firms like PricewaterhouseCoopers and Ernst and Young in completing its financial operations which disillusioned Andersen of a possible replacement. Bierman 246 explains even though Andersen had internal control against colliding incentives it faced the issue of conflict of interest. Andersen’s Houston branch which was responsible for Enron’s auditing, at one time overruled its Chicago Branch regarding Enron’s accounting decision. Furthermore, following the SEC public announcement on investigations against Enron, Andersen auditing firm shredded Enron’s financial records and deletion of relevant emails which were more than 30,000 and its existing computer files. Due to its unprofessional conduct, the Power’s Committee formulated by Enron’s Board to investigate the company’s financial statements, led to its disengagement from the company. The Board wanted to investigate on the internal contracts regarding its related transactions. Special purpose entities Enron Incorporation used Special Purpose Entities (SPEs) to overestimate its equity, hide its debts, under-estimate its debts for a specific and temporary purposes. The SPEs were created in order to manage and fund its risks related to the particular assets. The entities were formed so as to hide the debts of the companies that would otherwise minimize its investments value and make the financial institutions to recall their money. Enron gave little details regarding its purpose for the SPEs. The sponsor created the entities which were however funded by debt financing and independent equity investors. The companies borrowed huge sums of cash spearheaded by Enron’s CFO, Fastow; where they used Enron’s stocks as security. The borrowed monies were used to settle the overvalued contracts in Enron (Bierman 256). Bierman 260 the entities were purposely used by Enron in the conversion of assets and loans into revenues. Enron later moved more stocks into the SPEs. For hiding purposes of huge Enron’s debts, the assets and debts bought by the SPEs were not recorded in the company’s financial reports. This was used to disillusion the shareholders that the debts were constant but the revenues were increasing. By the year 2001, Enron had acquired more than a hundred SPEs to hide its financial debts. Some of its notable SPEs include Real Estate Investment Trusts (REIT), Thomas and Condor tax shelters and Real Estate Mortgage Investment Conduits. Due to their malpractices, Enron’s financial statements were falsified. Its liabilities were under-valued; its revenues were overvalued as well as its equities. Aftermath of the fraud Bankruptcy By November 2001, the company’s credit rating was to dismal status while its proposed acquisition company; Dynergy, disengaged from the partnership. The company could barely operate due to its minimal cash and an enormous debs amount. Its high stock price had fallen from $90.75 per share to $0.61 by the close of the day’s trading (Bierman 268). Employees and shareholders Bierman 288 confirms the bankruptcy led to loss of 21, 000 jobs who were basically its employees. Four years before bankruptcy, its investors lost $74 billion where $45 billion of the amount, was linked to fraud. Its creditors demanded approximately $67 billion which meant that the employees and investors could hardly be compensated. In order to meet its creditors amounts, the company sold its assets including its logo signs and arts. The company collapsed while its management and fraud associates were later convicted and charged with relevant fraud criminal charges Conclusion The unethical practices among the financial traders and executives resulted to greed which led to raising of the stock price and in-genuine bonuses. Enron’s culture created an unhealthy environment which promoted inappropriate competition among the employees. The use of financial machineries like mark to market and SPEs created an inflated financial record while the company was struggling. Businesses should avoid complex accounting or merely accounting frauds so as to escape the financial, social and legal wrath of its consequences. Works cited Bierman, Harold. Accounting/finance Lessons of Enron: A Case Study. Singapore, SG: World Scientific, 2008. Print. Read More