Ethics in Accounting: The Consequences of the Enron Scandal - Case Study Example

Ethics in Accounting: The Consequences of the Enron Scandal Ethics in Accounting: The Consequences of the Enron Scandal Introduction The technological landscape has undergone tremendous changes in the 21st century. Those changes have had terrific impacts on the modern business spectrum. The groundbreaking advancements in the field of information technology and web based business over the last two decades significantly contributed to the competitiveness of modern firms. The number of companies entering the online business world has been multiplicatively increasing for the last several years. Every business organization strives to provide a better shopping experience to its customers so as to maintain customer loyalty and brand image. Therefore the modern business environment is intensively competitive, and as a result firms performing below the par would go out of the business. In this context, modern organizations take vehement efforts to compete with their market rivals and to increase shareholder values markedly. Enron Corporation, founded in 1985, grew unimaginably within a short span of time and hit a maximum share price of $US90.75 in 2000. The company spread its business to various sectors within a few years. The company’s unbelievable growth was achieved by its former CEOs Kenneth Lay and Jaffrey Skilling. In reality, Skilling and his crew used unethical accounting practices to keep the firm’s huge debts hidden from investors and shareholders and to maintain the corporate reputation of the company. Although industry analysts and some of the Enron employees raised some doubts about the suspicious accounting practices of the corporation, Skilling and his colleagues verbally attacked those persons to defend the allegations. The company could continue to attract new investors until its share prices plummeted from $US90 per share in mid-2000 to less than $1 by the end of the 2001. This drastic drop in stock prices caused investors losing an amount worth $11 billion. Although Enron’s competitor Dynegy proposed a deal to take over the organization, it did not succeed, and therefore Enron Corporation filed for bankruptcy protection under Chapter 11. The United States Federal government passed a number of laws such as Sarbanes-Oxley Act after the Enron scandal with intent to improve corporate governance policies and to prevent such huge corporate failures in future. Today US companies pay specific attention to corporate governance laws and implement improved internal check systems to detect accounting irregularities and other illegal/unethical business practices. Problem Statement Unscrupulous accounting practices by Enron CEO Jaffrey Skilling and other top managerial person including CFO Andrew Fastow to inflate the profits of the organization resulted in Enron scandal, which was identified as the biggest corporate failures at that time. Although Enron collapse was the biggest in the history and had far reaching dreadful effects, modern organizations have a range of lessons to learn from this corporate failure. This paper will analyze the history of the Enron scandal and the role unethical accounting practices played in this collapse. The paper will also put forward some valuable recommendations for modern organizations in the light of Enron scandal. History of the Issues The merger between Houston Natural Gas and Omaha-based InterNorth led to the formation Enron in 1985 and it began operations as an interstate pipeline company. Kenneth Lay, the former CEO of the Houston Natural Gas, was appointed as the CEO of Enron and he subsequently won the post of chairman in the next year. Over the next years, the company achieved terrific growth in its sales and spread its business beyond the pipeline sector. Industry analysts praised this unbelievable growth of Enron because many contemporary organizations were struggling to survive during that period and such positive expert reviews greatly assisted the company to attract more potential investments. Jeffrey Skilling, a previous consultant for Enron, impressed the company’s former CEO Lay in his capacity as an industry analyst, and consequently Skilling was hired by Lay as chairman and CEO of Enron Finance Corp. in 1990. Considering his potential skills and capabilities, Skilling was promoted step by step and finally he won the position of President and Chief Operating Officer (COO) of Enron Corporation in 1997. According to the CBC News dated 25 May (2006), under the corporate leadership of Skilling, Enron began its broadband sector services in 1999 and the company also launched its website (Enron Online) in the same year for trading commodities. Within a short span of time, Enron Online grew to be the largest business website in the world. Eventually Enron raised roughly 90 percent of its revenues from trades over Enron Online (CBC News). By the turn of the 21st century, the company achieved new heights of success. To illustrate, Enron posted annual revenue of $100 billion in United States in 2000, and was recognized as the seventh-largest company by the Fortune 500 survey and the sixth largest energy company in the world. In addition, the firm’s stock price substantially increased to $90 US. In reality, this unbelievably high stock price of Enron Corporation during this period was achieved through a set of fraudulent accounting practices by Skilling and his crew. Skilling created many special purpose entities using accounting loopholes to conceal huge financial losses incurred from failed projects. Skilling could mislead Enron’s board of directors and audit committee with the unfair support of Chief Financial Officer Andrew Fastow and other high rank officials, and therefore he was encouraged to continue high risk accounting practices. Skilling also forced his subordinates to ignore the pitfalls identified and to keep silent about the actual financial position of the firm. Despite the extensive measures taken by Skilling and his crew to keep the actual debt level of the firm a secret, the accounting cracks began to appear in 2001.First industry analysts and investigative journalists raised many doubts concerning the reliability of Enron’s accounting transactions. A Fortune article ‘Is Enron Overpriced’ sparked a series of debates about the fairness of Enron’s high stock prices. The article criticized that either Enron investors or other key stakeholders were not informed of how Enron was maintaining high share prices in spite of industry slumps and global market downturns. Even though many other news reports and industry analysis reports also questioned the suspicious accounting practiced by the company, Skilling and Fastow attacked those reports aggressively to maintain shareholder confidence. Sometimes Skilling even personally attacked individuals who raised their voice against the suspicious accounting practices at Enron. However the whole corporate world, particularly Enron shareholders, became doubtful about the integrity of the strong financial position of the Enron Corporation. In addition, the company’s share prices began to drop despite the doubling revenues. More people realized the need to consider the negative company reviews seriously when the company incurred huge financial losses from the Dabhol Power project launched in India. Enron was also attacked fiercely when its subsidiary named Enron Energy Services contributed notably to the California electricity crisis of 2000-01. As Riley and Hunt (2014) point out, although Skilling and his supporters had done everything possible to hide the actual financial status of the company, Enron investors and other stakeholders clearly identified the accounting fraud involved when the company’s share prices dropped from US$90.75/share in mid-2000 to less than US$1/share by the end of 2001. In response, Enron shareholders filed a lawsuit worth $40 billion against the company (pp.256-257). The US Securities and Exchange Commission (SEC) immediately launched an investigation. Although Enron’s competitor Dynegy had expressed its wish to take over the company, the deal failed because they could not mutually agree upon a price. As a result, Enron Corporation filed for bankruptcy under the Chapter 11 of the US Bankruptcy Code in the biggest case of bankruptcy in the US history. Ethical Aspects of Enron Scandal The Enron scandal reflected how unethical accounting practices could contribute to the failure of a fast growing organization. The Enron failure involved both illegal and unethical practices. It is awful to hear that the Chief Financial Officer Jeffrey Skilling and CEO Kenneth Lay played major roles in this largest corporate scandal (at that time) in the history. Reports indicate that Lay and Skilling practiced off-the-books partnerships to conceal the real debt status of the company. According to Carroll and Buchholt (2008), Lay and Skilling deceitfully convinced investors and employees that company’s financial situation had been fine while selling their own company’s shares (p.256). Enron’s top management personnel violated several accounting rules and SPE laws and altered accounting principles to meet their personal financial desires in the short term while totally ignoring the long term consequences of such unethical practices for investors, shareholders, and employees. The unfair relationships between top management officials and the board of directors encouraged the Enron management to act in an unethical manner because they could feel a sense of invincibility. In addition, the CFO Andrew Fastow was allowed to control two major special purpose entities, and he saw it as an opportunity to abuse his power to make personal financial gains. Enron widely used SPVs (Special Purpose Vehicles) to hide its debts from the balance sheet and to keep it hidden from industry analysts and investors. When the actual debt burden of the corporation came to light, the company’s credit rating significantly dropped, and as a result creditors demanded immediate payment in full, which amounted to nearly hundreds of millions of dollars. However the Enron management treated it as short period issue arguing that the firm was financially stable. They also claimed that those emerging problems were not too serious, and still continued to make financial decisions that would protect their personal gains. Enron officials practiced unfair accounting policies only to take advantages of executive compensation plans such as cash bonuses and stock options. While analyzing the ethical issues in the Enron scandal with regard to accounting, it is necessary to discuss the involvement of Enron’s accounting firm, Arthur Andersen. This accounting firm contributed notably to Enron collapse because it had failed to perform the roles of an auditor or consultant properly. The CFO Fastow had initiated many business deals with intent to protect his personal interests, and many of those deals were against the shared interests of Enron investors and shareholders. In short, Fastow placed his financial greed above his duties, responsibilities, and professional ethics. However, Arthur Andersen could not point out such unfair intentions behind the business deals or the firm simply did not try to do it. Reports indicate that the accounting firm had charged huge prices for the services provided to Enron. Herrick and Barrionuevo (2002) report that Arthur Andersen received $25 million in audit fees and $27 million in consulting fees from Enron in 2000 and the sum amount represented the nearly 27% of the firm’s earnings for its Huston office. Many analysts questioned the auditing methods employed by Arthur Andersen arguing that the firm was simply operating to receive its annual fees. Some others criticized the accounting firm for their lack of expertise in properly evaluating Enron’s revenue recognition, SPEs, and other accounting practices. Since Enron had maintained a close relationship with Arthur Andersen, it was easy for the Enron management to keep its financial losses and debts hidden from investors and stockholders. As Li (2010) notes, later in November 2001, it was identified that Enron’s had incurred $586 million in losses for the previous five fiscal years. As a professional accounting firm, Arthur Andersen completely failed to perform its duties and responsibilities, and thus played a major role in the Enron scandal. If the accounting firm had identified and reported the accounting weaknesses timely, regulators could have taken proper measures to fix the issue and hence the corporate failure would have been prevented. Enron’s top managerial persons including the COO Skilling used illegal and unethical accounting practices to inflate the company’s profits and thereby hid its debts from stakeholders; Arthur Andersen, Enron’s accounting firm, failed to identify and report these accounting irregularities in time and the situation resulted in the corporate failure of Enron. These unethical accounting practices and the resulted corporate failure had far reaching consequences on Enron Stakeholders including employees, shareholders, investors, and communities. First, Enron scandal led to thousands of job losses in the United States, and the situation adversely affected the whole US economy. With the collapse of Enron Corporation, the accounting firm Arthur Andersen went out of the business in 2002 and consequently a large number of employees lost their job. Likewise, nearly 5,600 Enron employees became unemployed due to this corporate scandal. As The New York Times report dated June 3 (2007), many Enron employees had vested their entire pensions in Enron stock as Lay and Skilling had advised them to do so even when the firm’s stock prices were plummeting. As a result, thousands of Enron employees lost their savings. Similarly, shareholders and investors lost millions of dollars when the corporation filed for bankruptcy protection under the Chapter 11. “Shareholders lost nearly $11 billion when Enron’s stock price, which hit a high of US$90.75 per share in mid-2000, plummeted to less than $1 by the end of November 2001” (Riley & Hunt, 2014, p.254). In addition to contributing to massive job losses in the United States, the Enron scandal also affected the country in several ways. For instance, many related industries experienced significant sales decline following the collapse of Enron Corporation. Recommended Solutions The only positive aspect of the Enron scandal is that it extremely highlighted the importance of enhancing integrity in accounting and other business activities. In the context of Enron collapse, it is advisable for corporate enterprises to review their corporate governance policies. Firstly, it is clear that Enron was a harsh company that exerted extreme pressure on employees to improve overall organizational productivity. To illustrate, the company maintained an employee rating system that would rate 20% of the total number of employees below the par every year, and those employees were encouraged to leave the organization. Although the Enron management believed that this rating system would encourage the employees to work hard and thereby improve their performance constantly, this rigorous performance evaluation system developed a culture of deception in the organization. Since Enron employees were worried about losing their jobs, they only focused on improving their productivity or achieving periodical targets but totally ignored ethical standards. Such an employee mindset or workplace culture notably contributed to accounting irregularities and other deceitful business practices. Hence, it is recommendable for organizations to provide a relaxed worksite environment to employees to feel a sense of belongingness and job security. In addition, employees must be free from extreme work stress in order for enhancing employee productivity. Furthermore, organizations should ensure that their employee evaluation standards do not hurt the confidence of employees or force them to engage in unethical practices. Secondly, covering of errors was easy in Enron’s work environment because employees were really uncooperative and seldom communicated with each other. Since Enron’s workplace culture promoted intense employee competition, employees were hesitant to ask questions because such a practice was regarded as humiliation. In addition, Enron employees were unwilling to share resources and information as they did not want to help or support each other. Although many employees did not actually understand their job tasks, they just tried to make their work look good by simply hiding errors instead of correcting them. Hence, it is advisable for modern organizations to enhance healthy worksite relations because it is a potential way to promote shared understanding of job tasks. In addition, it is vital to ensure better flow of up and down communication in the organization in order to pass information as and when needed. Encouraging interpersonal relationships between employees is also a great strategy to enhance the spirit of teamwork in the organization. Evidently, teamwork is a proven approach to avoid unnecessary competition and worksite conflicts to a great extent, and the situation in turn would minimize chances of errors and unethical practices. Thirdly, Enron had focused too much on setting financial goals. According to the Enron culture, the person who could achieve the target numbers would be respected the most. In addition, the company’s benefits plans were purely based on financial achievements. In order to become the hero of the company and to take advantages of those benefits plans, both employees and executives focused on improving their target numbers instead of increasing shareholder values. It is evident that Enron was less concerned about the needs and values of its stakeholders as the firm was financially placed in a well position and had a superior bargaining power. Referring to Enron case, it is advisable for companies to prioritize shareholder needs and desires most, because companies use shareholders’ money to run their businesses. Since shareholders take a great risk by investing for the uncertain future of a company, the firm’s operations must maximize the wealth of shareholders. Furthermore, benefits plans should not be only to reward employees and executives based on their target achievements but also to consider their ethical values. Fourthly, Enron CEO and other top executives tried to keep its employees and outside persons quiet so as to continue the fraudulent accounting practices and to make personal financial gains. Enron discouraged its employees from raising queries about the financial position of the company or the decisions made by the company executives. As already discussed, Enron’s top officials abused inside and outside parties who publicly expressed doubts about the way the company was making profit. To illustrate, John Olson, an analyst in a Houston company, was terminated from his job because Olson discouraged his client from investing in Enron since he had many doubts about the actual financial position of the company. In addition, an Enron employee named Clayton Verdon was fired for commenting on ‘overstating profits’ in an employee chat room. The Enron experience makes it clear that it is not good for companies to pressure their employees to work blindly because such a practice would assist frauds to hide errors easily. In addition, it is also recommendable for organizations to welcome criticisms from industry analysts and other outside people, because it is a potential way to point out operational pitfall that went unnoticed. In addition, this approach would assist organizations to correct errors timely and to improve operational efficiency constantly. Finally, the Enron scandal provides many other lessons for modern organizations that take excessive risks to increase the overall market share. It is recommendable for business firms to avoid complex and doubtful accounting practices like market-to-market accounting so as to ensure that their financial reports are easily understandable for investors. Modern businesses must also make certain that there is a well-structured risk assessment system in operation to spot accounting irregularities and to promote fairness and reliability of the financial statements. It addition even a simple business transaction should be supported by vouchers and invoices because such an accounting culture would prevent the chances of errors and fraud to a great extent. It is particularly important for accounting practitioners not to consider any money as revenues before it is actually received by the organization. Appointing whistleblowers is a better strategy to prevent organized accounting fraud and other business malpractices hurting shareholder values. A strong internal check system can benefit the company to enhance the transparency of its accounting operations to a large extent. In addition, companies must hire professional and experienced auditing firms that do not have any personal interest in the financial affairs of the client organization. Above all, corporations should not assume that their persons at the helm of affairs are honest and out of suspicion. For every firm, there should be a well defined set of governance policies that can effectively prevent accounting irregularities and other inappropriate business practices. Conclusion From the above discussion, it is clear that accounting fraud committed by Enron CEO and his crew to hide the actual debts of the company ended up in the biggest corporate failure in the history. Enron CEO Jeffrey Skilling, with the support of the CFO Andrew Fastow, used accounting loopholes like special purpose entities and complex accounting practices like market-to-market accounting to keep actual debts hidden from shareholders and investors and to create a fake reputation for the company. Admittedly, Skilling and Fastow succeeded in their effort to mislead stakeholders. Skilling often verbally attacked news reporters and industry analysts for questioning the way the company was making profits and fired employees who raised doubts about the actual financial state of the organization. The Enron’s corporate culture always focused on extreme competition and the management promoted the approach of ‘survival of the fittest’ in its worksite environment. In other words, the company encouraged employees who fail to achieve annual targets to leave the company, and this harsh performance evaluation system brought more harms to the company than benefits. Since employees were feared about losing job, they focused only business practices that would help them meet their target numbers and those employee activities did not add to shareholder values. Likewise, Enron’s top management officials including Skilling and Fastow tried to protect their personal financial interests such as cash incentives and stock options instead of increasing the shareholders’ returns on their investment. Since employees were nervous of being fired, they did not raise any queries about the suspicious accounting practices at Enron or even share their doubts with colleagues. The Enron scandal dreadfully affected the company stakeholders including employees, shareholders and investors, and the whole US community. With the collapse of Enron, 5,600 employees lost their job and savings vested in Enron stocks. In addition to the huge number of job losses, some organizations like Arthur Andersen that had greatly depended on Enron went out of the business. Evidently the economic confusion caused by the corporate failure of Enron has had profound impacts on the US communities as a whole. Although the Enron scandal had far reaching negative consequences, it was helpful for the corporate world to become more aware of the importance of better corporate governance policies. From the Enron experience, it is identified that a harsh employee performance evaluation system would negatively affect employee productivity. Employees must be provided with a relaxed worksite environment so as to minimize their mental stress and hence to improve their performance efficiency. In addition, it is vital to promote interpersonal relationships among employees to enhance the spirit of teamwork in the organizational environment. Improved internal check systems can play a crucial role in reducing the chances of accounting errors and fraud in firms despite their nature and size. A well developed risk assessment system is also better for modern organizations to analyze the feasibility of various business options and to choose the most potential one. Finally, even CEOs should not be out of suspicion because Enron evidence suggests that fraudulent business operations may be supported by the persons at the helm of affairs too. References CBC News. (May 25, 2006). The rise and fall of Enron: a brief history. Retrieved from http://www.cbc.ca/news/business/the-rise-and-fall-of-enron-a-brief-history-1.591559 Carroll, A & Buchholt, A. (2008). Business and Society: Ethics and Stakeholder Management. US: Cengage Learning. Herrick, T & Barrionuevo, A. (Jan 21, 2002). Were Enron, Anderson Too Close To Allow Auditor to Do Its Job? The Wall Street Journal. Retrieved from http://online.wsj.com/article/0,,SB1011565452932132000,00.html Li, Y. (2010). The Case Analysis of the Scandal of Enron. International Journal of Business and Management, 5 (10): 37-41. New York Times. (June 3, 2007). The SEC reportedly supports Enron shareholders in high court case. Retrieved from http://www.nytimes.com/2007/06/03/business/worldbusiness/03iht-sec.1.5974951.html?_r=0 Riley, D. D & Hunt, K. A. (2014). Computational Thinking for the Modern Problem Solver. US: CRC Press. Read More