Analysis of the Enron Scandal - Case Study Example

ANALYSIS OF THE ENRON SCANDAL by CONTEMPORARY ISSUES FOR BUSINESS AND SOCIETY ANALYSIS OF THE ENRON SCANDAL The corporate scandal concerning Enron was exposed in October, 2001. This eventually led to bankruptcy of the Enron Corporation which was an American company that was mainly based in Houston in Texas. Further, there was the dissolution of Arthur Andersen which was among the top five largest audit and accountancy partnerships in the whole world. Other than being the largest bankruptcy reorganization in the History of America at that time, it is with no doubt the biggest audit failure. Enron was the most popular and famous company in the world during its rise. However, its downfall was too fast than any of the companies that were in existence at such a time. The paper will analyse in detail the Enron scandal. It will moreover examine its causes, social and environmental impact. It will further analyse the reason for the scandal including the overall management, accounting fraudulent acts and the conflict of interest in the organization. Review of Enron’s Rise and Fall Enron Company was founded in 1985. During that period it was one of the leading in electricity, communications, natural gas, and pulp and paper production before its collapse in the year 2001 due to bankruptcy (Mclean & Elkind, 2004). Throughout the 1990s, it was termed as one of the most innovative and creative company in the world (Sterling, 2002). It further established a new market for purchasing commodities such as broadcasting time for advertisers, internet bandwidth and weather futures. The revenues of Enron Company increased suddenly from $ 10billion in the year 1995 to about $100billion in the year 2000. This was because the assets of Enron increased by about 38%, and the revenue increased annually by about 61% while the level of earnings rose to about 13%. In August, the major driving personnel in Enron known as Skiing decided to resign for personal reasons. Skiing was the company’s Chief Executive officer at that time for a period of six months. Later, after his resignation, Lay decided to take the post of the Chief Executive Officer in the company. Thereafter, the Chief financial officer who was Fastow was replaced and the Securities exchange decided to investigate the company’s overall financial statements. In 2001, the results exposed that Enron’s financial status was upheld by institutionalized, organized and ingenious arrangement of accounting fraud. Enron, engaged in hiding its major debts. Enron’s stock price per share dropped from $90 to about $1 at the end of the year in 2001.This resulted in shareholders losing about $11billion in the process. Enron further revised its financial statement for the past five years and found out that about$586 billion was lost. Finally, Enron succumbed to bankruptcy in 2001. Many workers in the company lost their jobs. After a second investigation, Lay who was both the Chief Executive officer and chairman also left the organization for personal reasons. Causes of Enron’s Failure-Bankruptcy Enron filed one of the largest bankruptcy cases in the world. This was due to the following issues: Truthfulness There was lack of truthfulness by the management about the overall position or health of Enron. The senior executives at Enron had a belief that Enron had to be the best company in the US so as to maintain its reputation. Also, it offered the best compensation to the executives as it was a top performing organization. The Chief Executive Officers did not tell the employees or shareholders that the stock price was likely to increase and he would be selling his stock. Further, the employees would not have known about the stock sales within days or weeks. Therefore, the Chief Executive Officer was conducting insider trading. The shareholders came to learn about the Chief Executive Officer who was selling stock after the investigation was conducted .The sell off stock would be announced in February. This would be a delay in which the shareholders did not understand why they took so long to disclose. Self-interest Interest was another cause that contributed to failure of Enron. There was lack of independent judgment by the audit committee (Rapoport, 2009). Conflicts of self –interest in the board of directors and management contributed a lot to corporate failure of Enron. Further, the compensation policies of Enron involved a myopic focus on earnings growth and the stock prices. There was a conflict of interest whereby Arthur Andersen played the role of an auditor and a consultant (Quires, 2003). While the investigations continued, Enron sought to salvage some of the business that it owned by spinning off various assets. It filed for bankruptcy so as to reorganize while protecting itself from creditors. Moreover, the CEO and Chairman Lay resigned for personal reasons and another Chief was given the role known as Steven Cooper to help Enron in restructuring. However, the core business of Enron which was the energy trading arm was held up in a complex deal with UBS Warbag. Accounting Irregularities in auditing There were accounting irregularities which caused the media to observe Andersen who was the auditor keenly. Since Arthur Andersen was the auditor, he had an impact on the client market prices. In 2001, it was found that the clients of Arthur Andersen had destroyed documents and correspondence regarding their involvement with Enron (Salter, 2008). This damaged the reputation of Arthur Andersen. Andersen’s Houston’s office clients where the headquarters of Enron was located experienced the most negative market reaction when compared to those who were not the clients of Andersen. This implies that the shredding announcement had a major impact on the quality of audit conducted by Anderson. Consequently, this had an impact on the market value of the firms and other clients. Accounting fraud Enron was a public company, it was thus subjected to external sources of governance which are market pressures, oversight by regulators of the government, oversight by private entities including the auditors and equity analysts and credit rating agencies. In order to create a profiting situation in the company, and appeal to the investors, the traders in Enron had to forecast very high values of future cash flows and very low discount rates on the long-term contracts. The difference between the net present value and the previous disbursed value was taken as the profit of Enron. They used the mark market method so as to pump the stock prices to cover the loss they had and allow more investments. Nonetheless, it was impractical to gain in the long run with this method as it is immoral and illegal (Markham, 2005). Surprisingly, the securities exchange allowed Enron to use this accounting method, this significantly contributed to the Enron scandal since it did not allow disclosure of material information. In addition, the accounting rules allow a company to exclude a special purpose entity from its financial reporting only if an independent party has control over the special purpose entity plus he owns about 4% of the entity. Enron used this platform in order to hide some of its debt since high debt would lower their investment grading and would further help banks recall their loans or money. Using Enron’s Stock as collateral, the special purpose entity whose head was Fastow borrowed huge sums of money. This money was later used to balance Enron’s overvalued contracts. This enabled the company to convert loans and assets burdened with debt obligations into revenue. Moreover, Enron used the special purpose entity to transfer some of its stock. However, the debts and assets purchased by the special purpose entity with a loan were never reported on Enron’s financial statement. The shareholders were thus informed that revenue was really increasing while debt reduced but that was not true. Moral irresponsibility Since corporate acts originate from the choices and actions of human beings, it is the human beings who should be morally responsible. Kenneth Lay the chairman and the CEO Skilling allowed Fastow to start a private corporation secretly and he also transferred the property illegally. As a result, Fastow violated the professional ethics and took the crime of malfeasance. Kenneth Lay and Skiing who was the CEO gave orders to employees to carry an act that both of them new was wrong; these employees are also held morally responsible for the collapse of Enron. Enron senior management are also morally irresponsible since they failed to disclose material matter. Additionally, they lacked integrity .This damaged Enron’s reputation due to failure to observe ethical behaviour in the organization. Further, the board and shareholders did not pay attention to the decisions made by the chief executive officer, and financial officers when they were deciding on stock prices. This scandal could have been avoided if they were keen. Social And Environmental Impact of Enron’s Scandal Enron had grown to be the top best company in America. It moreover had published a report concerning the social and environmental aspects which took into account the overall effect of the organization on the environment and how it also impacted the employees who worked for it. For instance, there were policies on employee relations, policies on corruption and bribery. It also had programs on community relations. The values such as respect, integrity and excellence were emphasized in the report (Eichenwald, 2005). One of the main impacts of the Enron scandal was that about 5600 individuals lost their jobs as a result of a morally irresponsible management who could not adhere to the ethical standards. Some of these employees were highly skilled and had just been employed a few months before the scandal. Next, the scandal led to the death of the former chairman of the company as he decided to commit suicide. Enron’s reputation was tainted since the values which were being emphasized such as integrity, disclosure, respect and excellent performance came out as lampoon. In addition, Enron’s employees who had invested their shares in Enron using their retirement money lost everything as they were prohibited from selling their stocks. They realized that the social and environmental programs that had been created were merely a dupe so as cover the truth about the company. Finally, Enron which was considered the best place to work by individuals in the society turned into something else uglier that no individual would ever want to be associated with it. Responses to the Enron Scandal Initially the political response to Enron’s implosion was muted. The Bush administration deflected regulatory impulses with a bad apple that any system however robust is subject to exploitation by those bent on perpetrating fraud. After Enron’s scandal, the government decided to respond. They had to enact Sarbanes and Oxley’s act popularly known as SOX which was passed in 2002 without dissent. The act increases criminal and civil liability for securities fraud, it places oversight of the accounting professionals under a new regulator called the public company accounting oversight board, it restricts the ability of accounting firms to engage in certain non audit services, it requires certification of firms financial statements by the CEO and the financial officer, and disclosure of off balance sheet activities (Hadjatry-Tarzaban, 2007). Other social responsibility reforms made by the traditional financial and political communities (ironically the bedrock of investor protection in the United States) played a large role in placing the standards of corporate governance on a collision course. The reforms included: Transparency There is need for individuals to work in an organization which is transparent in all the dealing that it undertakes (Rapoport, 2004). Transparency could only be enhanced if a corporate organization discloses all the relevant information including the overall policies, that the company will adapt, the cost that the organization will incur among others. There are also transparency issues that can affect the future such as off balance sheet debts and tax havens. These are material and they should be disclosed, the financial community requires that the security exchange commission to ask companies to disclose about their environmental liabilities. Audit The auditors should be independent. Moreover, the auditor’s reputations should be reinstated. This is because the market of stocks relies much on the auditor. Additionally, the auditor should not own any stock in the corporation or act as a business consultant since there will be a conflict of interest. Off Balance Sheet Transactions The investors should examine the balance sheet carefully so as to detect some of the transactions which are missing or the ones that are hidden. This is because companies which are performing well and according to the stipulated rules and regulations cannot hide anything from the public or shareholders. Campaign Financial Reforms Reforms on finance should be conducted such that after this law has passed, the responsible investors can now ask the companies to reveal some of their contribution. It does not matter the kind of contribution made even if it was meant for political reasons such as financing politicians or their parties. This was considered important as it will avoid the obscuring of the profits made by an entity. This will contribute to greater level of integrity in the corporations. Board of directors Enron’s collapse was facilitated by a simultaneous breakdown of key mechanisms designed to alleviate the agency problems of shareholders and managers who contributed to misleading financial disclosures. The board of directors should be independent and free from the conflicts of interest. Also, it should be diverse and avoid the double role or interlocking positions. Concerning the compensation of the board, the package should not be too much as it will discourage others from questioning the board members in a meeting. In addition, the Chief Executive Officer should not take charge in board meetings as the chairperson. Executive compensation Equity based executive compensation got unintended boost from the congress, concerning excessive compensation for the executive, the congress amended the tax code to eliminate the corporate deductions for cash compensation greater than one million, unless it was tied to performance goals that are established and monitored by the directors. The management at the top is normally paid too much due to the complicated packages of the share valuation. Therefore the payment of the top management personnel’s should not be associated with the valuation of shares in the short run since this forces the company to overlook the future of the company and consider the short run benefits that the top management should have. Ethical policies The ethical policies of a corporate organization should be formulated and followed to the latter. Some of the matters which are considered crucial should be discussed in the board (Arbogast, 2008). A follow up should be made so as to determine if these corporations are adhering to the set policies and regulations Tax policies The structure of the tax should be changed such that it will consider the long-term stockholding and not only the short term gains which involve capital gains (Niskanen, 2007). Although the short term gains are also encouraged as they help manage the earnings of a company thus attracting more investors in the organization. Conclusion A company should have a healthy corporate culture. This is because Enron’s corporate culture contributed to its collapse since they believed that Enron should actually be the best in everything. This led it to be over optimistic about the company. They covered any loss that existed in the company so as to preserve their reputation. Therefore, a system should be put in place to supervise the executives and directors and get the idea on how the company is operating in order to avoid such scandals in the future. Also, an accounting system which discloses all the information should be used in order to avoid fraudulent acts in corporations. Finally, investors a have a lesson to learn, they should never trust corporations that have abnormal growth and profits. In addition, the crediting rating agencies and the regulators should give such a company benefit of doubt and conduct thorough investigations on it. References Arbogast, S. V. (2008). Resisting Corporate Corruption Lessons In Practical Ethics From The Enron Wreckage. Salem, Ma, M & M Scrivener Press Eichenwald, K. (2005). Conspiracy Of Fools: A True Story. New York, Random House Large Print. Hadjatry-Tarzaban, K. (2007). Accounting Fraud: How Sarbanes-Oxley Could Have Prevented Enrons Corporate Scandal. Thesis (Honors)--University Of Oregon, 2007. Markham, J. W. (2005). A Financial History Of Modern U.S. Corporate Scandals: From Enron To Reform. Armonk, N.Y. [U.A.], Sharpe. Mclean, B., & Elkind, P. (2004). The Smartest Guys In The Room: The Amazing Rise And Scandalous Fall Of Enron. Niskanen, William A. (2007). After Enron Lessons For Public Policy. Rowman & Littlefield Pub Inc. Quires, S. E. (2003). Inside Arthur Andersen: Shifting Values, Unexpected Consequences. Upper Saddle River, N.J. [U.A.], Ft Prentice Hall. Rapoport, N. B. (2004). Enron: Corporate Fiascos And Their Implications. New York, Foundation Press. Rapoport, N. B. (2009). Enron And Other Corporate Fiascos: The Corporate Scandal Reader. New York, Foundation Press. Salter, M. S. (2008). Innovation Corrupted: The Origins And Legacy Of Enrons Collapse. Cambridge, Mass, Harvard University Press. Sterling, T. F. (2002). The Enron Scandal. New York, Nova Science Pub. APPENDIX A. Kienitz, P (n.d). ENRON: THE SMARTEST GUYS IN THE ROOM (2005). Retrieved from http://paulkienitz.net/enron/smartest-guys.html This documentary offers a brief background and the strategy undertaken by Enron. It implies that Enron’s strategy in the late 1900s was to buy an asset, usually energy related, and expand it by building a business around the asset. In carrying out the strategy Enron faced problems since each of the investment required a large capital outlay characterized by a long-term payback period. Additionally, the article/documentary describes Lay’s character. It was vital for the essay since the article stresses the importance of regulations in business. Some people if not regulated will look for any loophole to perform unethical activities. B. FindLaw (n.d). Enron And Specul Purpose Entities. Retrieved from http://news.findlaw.com/wsj/docs/enron/sicreport/chapter1.html This article is vital to the construction of the essay since it shows Enron’s activities before its downfall. In summary, given its choices, Enron developed the following ways to supplement its strategy; it would look for outside investors who will subsequently finance its investments and activities. Secondly, the firm would seek for ways and methods to retain and hold the risks it thought it could manage. At the same time, it would create a joint venture or a special purpose entity (SPE) to which outsiders and investors could contribute resources. The entity could also borrow from the credit market, possibly with guaranties or other credit support from Enron. In forming a joint venture or SPE, Enron faced the choice between consolidating the entity into its balance sheet or moving it to be off balance sheet. However, it decided to choose the off balance sheet method. C. Pbs, (June 20, 2002). Bigger than Enron. Retrieved from http://www.pbs.org/wgbh/pages/frontline/shows/regulation/etc/synopsis.html This article focuses on the kind of transactions that Enron relied on. It lists down some company’s what were involved in the transactions with Enron such as the Chew co Investments limited L.P which was formed in 1997, as limited partnership, the LJM partnerships special purpose entry set up in 1999 under Andrew Fastow’s management, and lastly the Rhythms net connections, of which the Enron invested 10million in it, in 1998 . Moreover, the failure of corporate watch dogs is highlighted in the article. This shows how various entities were responsible for the failure of Enron. D. The Economist, (Jan 24, 2002). The fall-out from Enron. Retrieved from http://www.economist.com/node/954494 This report shows how the general public, customers, shareholder and creditors reacted to the scandal. It briefly outlines the social and environmental impact of the Enron scandal. Importantly, the report stresses how the market reacted to the scandal. E. The Bbc, (Thursday, 22 august, 2002). Enron scandal at-a-glance. Retrieved from http://news.bbc.co.uk/2/hi/business/1780075.stm The reports in this newsletter, explains how the government and investigators responded to Enron’s scandal. Also, the report is vital for the essay because it lists the major players in the scandal. Further, the report shows the ties Enron had to the white house. The firm provided millions of dollars to President Bush for his campaigns. However, President Bush has distanced himself from the firm. Read More