Enrons Gas Trading Business - Case Study Example

ENRON CASE STUDY Student’s name Code & Course Professor’s name University City Date Enron Case Study Investors and the general public witnessed what had seemed to be a profitable company with a market capitalization of about $ 62.5 million and revenues in excess of $ 100, collapse in just a few months. Its declaration of bankruptcy was fuelled by the unwinding partnership focused to hedge its risk, with a primary focus of managing its balance sheet. Through its incorporation of an “asset light’ strategy, the company significantly gained profits as an energy trader as opposed to a gas producer (Blue Ribbon Committee, 1999). Enron’s success was based upon the servicing of its partnership’s off-balance sheets with respect to the rising stock prices. After a consequent peak in 2000, the company’s stock plummeted steadily in 2001. The company’s management soon realized that the debt burden exceeded the acceptable levels. Ultimately the company failed and filed for bankruptcy. Enron’s collapse was as a result of ineptitude of its Board of Directors and management. Senior leaders traded its shares publicly, as they unloaded their personal stakes in the firm. Its board of governors were accused of laxity in unquestioned proceedings. The audit committee was incompetent in realizing the firm’s unethical practices. Enron’s Success Prior to the year 2000, the company had diversified its investment strategy that impelled it as one biggest gas trading company. Its diversification strategies spread beyond its subsidiary pipeline business into the trading of natural gas products. Its extension of the natural gas model to a financial trader improved its propensity to divulge into coal, steel, power, paper and fibre optic cables. Accordingly, by the 2001, the company had become a conglomerate extending its products and services throughout various market levels. A number of factors fuelled the company’s success. The deregulation of the gas resulted to its increased supply and lower pricing; therefore an increase price volatility was realised. Additionally, the standard contracts permitted the suppliers to interrupt the gas supply, devoid of any legal implications. Taking advantage of the situation, Skilling comprehended that the company could help bridge risk associated with such dealings. The “gas bank” would play a mediating role between the buyers and the suppliers. As a result, the company offered long-term fixed prices for the commodities. Enron’s gas trading business contributed immensely to the company’s increased revenue amounting to about $ 122 million. The creation of EnronOnline championed further in development of managing its liabilities and associated risks. Evidently, by the end of the fourth quarter the online portal facilitated a half of its major transactions. A refinement of its trading model boosted its success in the market. Enron maintained its “heavy assets” in a position that it would explicitly generate information. Accordingly, Enron divested into the “heavy” assets in pursuit of asset “light strategy”. The company’s extensive gas pipeline network facilitated its strategic position as a mediator between utilities and producers. Compounded by expertise who could effectively manage physical logistics of gas delivery; it essentially championed in managing the associated risks (Munawer, 2012). Unmistakably, the associated risks emanated from gas spot market volatility, fluctuations of gas production, reserve risks and counterparties risks. Barrier of entry to the gas business enabled single players such as Enron to take advantage of the market; typified by a lack of market knowledge by other players the firm was well-positioned. Energy Contracts In utilizing its investment strategy, the company extended its gas model into markets characterized by complex distribution systems, fungible commodities and opaque pricing. Such market consisted of coal, electric power, pulp and paper. It majored into the electric power market where it identified the need to meet energy requirements during peak operations (Munawer, 2012). Merchant Investments The company had invested in merchant investment portfolios. Additionally, it transformed its monetized contracts into delivery services. Reliable market was not available at the time. Hence, Enron was compelled to assign values that allowed it to records the earned revenues (Munawer, 2012). International Expansion Enron outstretched into international borders where it created a subsidiary Enron International which was focused at the construction and management of energy assets. Tentatively, it entered into international contracts in Africa, Middle East, China, India, Eastern Europe and South and Central America. Enron’s Rise and Fall Enron’s success was speared-headed by its competent employees who successfully managed the company’s resources and utilized proffered management practices. Its facilitation was garnered by the innovation built by the company constituting a culture of recruiting suited candidates. Attractive bonuses lured business students into the company; following a massive competition by leading investment banks. This created a dependable workforce through which the company would garner considerable skills in work ethics and practice. Through its diversification strategy, the company was able to manage its investment effectively across various platforms. The extension of the gas model facilitated the exploitation of new markets. Skilling affirmed the importance of innovation in achieving high levels of employee decentralization indecision-making process and mobility. RAC’s formation fronted the company’s responsibility in analyzing its transactions, projects and businesses. VAR’s incorporation offered an oversight of the company’s gains and losses in a given trade. Additionally, RisktRAC was indispensable in the separation of the contracts and trade into 1217 different portfolios (Kaminski, 2001). Adequate evaluation of business ideas was significant since RAC evaluated existing core business in relation to value-at-risk analysis. In essence, it offered probable risks and recommendations for the company. Tentatively, Enron’s 64-page code of ethics dispelled the company’s ethical practice in its business dealings. Employees had to guarantee their acceptance to the company’s code of ethics in all aspects (Salter, 2002, p18). Fall Governance and intermediation failures The company’s demise was based on the auditor’s failure in recognizing the impending accounting problems (Salter, 2002). Additionally, the sell side analyst contributed to the company’s failure given the research availability on the professional and retail investors. As opposed to the expected auditor’s functionality, their incompetence in determining unethical business practice largely contributed to Enron’s failure. High Risk associated with SPEs It is apparent however that the credit raters were late in the identification if the company’s associated risks. Questionably, the review process appears to be susceptible to abuse since, the credit raters were paid by the firms, they were ratings. Accounting failures Inefficient and incompetence business practice mostly contributed to Enron’s fall. The company’s special entities involved certain risks affiliated to certain assets (Hartgraves, 2002). A number of special purpose entities were however incorporated in the achievement of Enron’s reporting purposes. Lack of consolidation in Chewco’s transaction did not incorporate joint ventures in its reporting (Taplin, 2013). Balance and Checks The various conflicts of interests could have been fundamentally highlighted in Enron. However, ineptitude in governance and lack of the board’s oversight in such conflicts prevented the realization of such conflicts. After an approval of the transaction, the board of directors were tasked with monitoring of the company’s policies and procedures. Despite the importance of such practices, the board did not protect Enron’s interest. Effectivesystems of control could have adequately safeguarded the company’s checks and balances at Enron. Nonetheless, the systems of controls were not efficient enough to protect the company’s interest, and their oversight and implementation were inadequate at various board and management levels. Buy and Causey had a narrow interpretation of their roles in the understanding the transactions and did not offer an adequate level of scrutiny, resulting to the reduction in shareholder’s equity and earnings restatement. Essentially, the finance committee would have been vigilant in the examining and monitoring the company’s transactions. Their roles majored in the approval of transactions that met or exceeded $ 75 million in 2001. However, it is concluded that the committee failed in itsmonitoring process, especially recognizing the nature of related transactions. Enron’s Compensation Committee did not analyse its plans and policies regarding employees, directors and officers. Had Kopper’s, and Fastow’s reviewed, it would have been evident on the abuses and conflicts linked with the transactions. Continuous Auditing A continuous audit is imperative in the determination of an up to date analysis of a company’s progress. Continuous audit models could allow the companies to offer descriptive summaries ofits reports over a specified range of flow-related variables to the government and the monitoring of key processes within the company. Its position, therefore, could be based on the government as a key stakeholder in the reporting its finance tailored at the supervisory levels. The company’s transactions with its special entities appeared unwarranted and were easily detectable. For instance, Enron’s ratios would have paralleled its competitor’s as such triggering investigations into its dealings. Tentatively, an end-to-end flow analysis, in addition to its component value additional would not have reconciled, necessitating for an audit. Whilst the conflict of interest emanating from this practices, the company supported SPEs without further research on its subsequent implication. Contrariwise, the board of directors approved Fastow’s transactions subject for monitoring by the company’s chief accounting officer. The audit and the board’s failure to passably monitor the SPEs was conducted unprofessionally. Excessive compensation The board of directors did not understand the cumulative cash drain realized within the company hence, failed to monitor the abuse of powers by the board’s chairman. Despite Enron’s significant rewards, they failed to recognize the associated risks. Consequently, the board of director allowed the company to operate in many off-the-books activities – against the ethical business practices. They failed to present undisclosed information to the general public and attest for its financial reports. Independence was instrumental in the realization of the firm’s operational practices. Their independence was compromised by the fact that the existent financial ties between the board members and company were questionable. The collaboration for effective business practice was unfathomable. Setting Enron’s Policy The board of directors was instrumental in the creation of ethical business practices in the company through the incorporation of policies and strategies that would have alleviatedEnron’s demise. As the company’s directors, the provision of an ethical business environment that employees would have emulated. The board relied extensively on the auditors in the acquisition of reports that fulfilled the duty of ensuring the auditor’s independence. As such, the managers should not have been too lenient on its trust. In essence, Enron’s boards of governors are entitled to depend on the management and experts to a reasonable and appropriate level. The board of directors could ensure that external auditors do not function as consulting services as witnessed in Anderson’s case. In this regard, the auditor’s independence should be steered in the provision of effective audit process. Contrariwise the directors should not be financially tied to the company’s processes and initiatives such as SPEs Accounting and Ethical Breaches GAAP Violations It is believed that the shortcoming of Enron’s business model propelled the company in realizing its success. The GAAP model dispels accounting rules, which seems to have permitted Anderson procedural acceptance that violated accounting procedures. Principally, the company transferred funds that facilitated 3 % independent owners to recover their investment, guaranteeing SPE’s liability. Tentatively, its fair value requirement increased its reported asset and net income, hence concealing its financial losses. As such, more investors were attracted to invest in the company. Evidently, it appeared as though Anderson violated such accounting rules. Adequately, Anderson allowed the company to violate specifications presented by FASB. FASB dictates that the indebtedness and other losses should be disclosed in an appropriate manner. The disclosure included the nature and amount of guarantee used. Tentatively, Anderson did not apply GAAP requirements in the recognition of FAS 121. The company’s losses were not accurately documentedbecause its SPEs lacked sufficient assets. GAAP (FAS 57) postulates that a relationship linked to related parties is not favoured. In this regard, free market may not be realized under such dealings. Fastow was undoubtedly a related party in this reverence; hence, Anderson did not meet these obligations. GAAS Violations Evidently, SAS 85 condemns that auditors should not rely on representations regarding liabilities. Consequently, this policy describes the information that can be obtained in measuring the management used in fair values of the company’s assets. Accounting Lessons In alleviating the pressure to behave in an unethical manner, it is significant that the consensus that a company’s ethical culture is instrumental should persist. An ethical culture within the organization prevents the complacency through training, conduct and identification of the probable ethical issues that may affect the development of dependable systems (Mark, 2002). Management of Mark-to-Market Accounting and Earnings In the U.S., it is imperative that marketable securities, financial contracts and derivatives are reported on the balance sheet with respect to the current market value. MTM necessitates for changes in the market value for the reported asset. It is essential,thereforethat accounting professionals consider the recognition of the value with MTM in offering an understanding of MTM manipulation (Krugman, 2002). While the robust conceptualization in support of MTM accounting, Enron’s demise dictates the need to revise and re-evaluate the present accounting rules that report the transactions and assets dependent on MTM values (Mark, 2002). SPEs Consolidation The exponential growth of the SPEs has resulted to a debate among auditors, managers and other accounting professionals regarding its consolidation in business practice. The sponsoring company ought to keep its SPE ownership as low as possible so as not consolidate itsSPEs. From the desertion of the three percent rule, it is evident; therefore, that SPE consolidation needs to be fixed. Effective Corporate Culture A company’s corporate culture dispels the organization’s relationship with respect to business practice. Corporate culture promotes a healthy business practice; as such the disclosure of Enron’s losses would have been highlighted in the company’s financial reports. In the event that the company reported trusted information to the general public and investors, it would have significantly alleviated Enron’s demise. As a result, the board of directors should safeguard the company’s integrity through the provision of accurate reports. Effects of Unethical Business practice in the Society Loss of investor Confidence and General Public Investor confidence is imperative in increasing a company’s shareholders capacity. In the case that a company is subject to unethical business practice, the general public cannot trust affected companies. The lack of trust from the general publicmay have a detrimental effect on the company’s success thereby instigating malicious practices in the overall outcome. Most individuals in the societies have pension schemes side-lined in the various publicly traded companies. The effects of unethical business practices will ultimately affecttheir confidence in such organization. Quality of Life The negative impact of unethical business practice may have adverse effects on the quality of life that may eventually affect the society as a whole. More often than not, companies alleged to participate in unethical business and accounting practices end up bankrupt because most investors pullout from the affected company. Evidently, a company’s declaration on bankruptcy will be detrimental to the company’s employees. A company’s foreclosure, as witnessed by Enron, will result in job insecurity and joblessness among the affected individuals. Accordingly, most companies are not inclined to re-hiring employees who have previously worked for the company that engaged in unethical business practice. Loss of job will adversely affect the society as a whole since jobless individuals are a burden in the society. Economy Large corporations that control an enormous proposition of a country’s market may negatively or positively affect the country’s economy. Given an investment involving multiple organizations and investors will negatively affect a large proportion of affiliated parties. In the long run, a collapse in the company as witnessed in Enron’s case will be faced to counter losses. Recommendations In the provision of ethical business practice, accounting professionals are advised to adhere intensely to the codes of ethics set by the governing body and associated company policy. As such, managers should oversee the continuance of ethical practice in safeguarding the company’s integrity. Financial reports are aimed at presenting information to the general public and affiliated investors. In this reverence, it is important that auditors conduct duties in a professional manner garnered at advising a company on safe business practices. Conclusion A general acceptance thrives are suggesting that judicial systems, public policy decision makers and CEOs are responsible for the decisions affecting the company’s business functionality. Principally, organization leaders are essential to the accountability of an organization’s decision and legal performance. As witnessed through Enron’s demise, its corporate governance led to the Company’s demise given the factors that fuelled the unethical business practice. It is advised, therefore that the accounting professional should engage in strict operational conduct throughout the functioning of a publicly traded company. The accounting profession has a profound effect on a global scale given the dynamics involved in society and the world as whole. It is imperative, therefore, that adopters expendtheir duties in a manner that promotes safe business operation and general compliance with accounting rules and regulations affecting the company’s success. Professional relationship between auditors, employees and the entire organization should be guided through various ethical compliance levels. Reference List Blue Ribbon Committee, 1999. Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. Brian, Hall and Knox, T 2002, “Managing Options Fragility.” Harvard Business School Working Paper, Series No. 02-100. Hartgraves, Al L., Benston, G.J., 2002. The Evolving Accounting Standards for Special Purpose Entities (SPEs) and consolidations, working paper, Goizueta Business School, Emory University. Enron: The Joint Committee on taxation’s Investigative Report, Hearing Before the Committee on Finance, U.S. Senate, One Hundred Eighth Congress, First Session, February,13, 2003 p.17. Kaminski, V, & Martin, J 2001, “Transforming Enron: The Value of Active Management,” Journal of Applied Corporate Finance, Vol 13, No. 4, p. 45. Krugman, P 2002, “Cronies in Arms,” New York Times. Mark,N, Eliott, J and Tarpley, R 2002, “Evidence from Auditors about Managers’ and Auditors ‘Earnings-Management Decisions. “Accounting Review. Munawer, Z, Yahya, S, Siti-Nabiha, A 2012, “Sell-side Security Analysts: Re-reporting of Enron Corporation Fraudulent Financial Data,” Procedia - Social and Behavioral Sciences Vol 62, pp. 749-760. Powers Report, 2002,Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp., William C., Jr. Chair, Raymond S. Troubh, Herbert S. Winokur, Jr., February 1. Salter, M, L & Ciampa, M 2002, “Innovation Corrupted: The Rise and Fall of Enron,” Harvard Business School Working paper No.02-102. Taplin, R, Zhao, Y, Brown, A 2013, Failure of auditors: The lack of compliance For business combinations in China.Regulation & Governance. Read More