The Importance of Strict Adherence to Ethical Standards - Term Paper Example

ENRON CASE STUDY Name Institution Professor Course Date Abstract Accounting regulations and rules exist to make sure that financial statements are valuable to their users in financial decision-making. For financial statements to be valuable, their information must be faithful and accurate to the financial situations. Poor accounting practices do not only instigate criminal activities incidences, but also damage a company’s image and survival. Integrity and ethics are essential for sustainable business growth and success. Even with the smartest leaders in the company’s management, Enron filed for bankruptcy in 2001. The failure of Enron represents the largest business bankruptcy in the business history of America. In the 2001 winter, Enron was the seventh biggest corporation in the United States according to Fortune rankings. The company’s leadership played a great role in the collapse of the company through their aggressive and dubious accounting practices as well as unpractical partnerships. The firm’s substandard business activities that were supported by advisors and bankers promoted the demise of the firm in 2001. The fall of Enron was a sad ending for the country’s economy, shareholders and stakeholders including the employees who had to lose their jobs. This is an indication that unethical accounting practices come with personal, legal and business consequences. Drawing from the information provided in the Enron Case Study and extensive literature review from credible sources, this paper assesses the rise and fall of Enron. The focus of the paper is one the implications of unethical accounting standards to a firm and its stakeholders and shareholders. The paper demonstrates the importance of strict adherence to ethical standards. Unethical standards do not only inflict damages on a firm’s reputation and its survival but also the reputation of its leaders. In the case of Enron, most of the firm leaders including the CEO were charged with criminal offenses. Introduction Until 2000, Enron, a natural gas pipeline company, was doing well but in 2001, the image and reputation of the firm faded. Scores of the firm’s leading senior executives resigned with the firm owing up to contraventions of accounting regulations and rules. Unethical accounting practices employed by the firm’s senior executives set the basis for the collapse of the firm. Within a year, Enron stock became valueless an aspect that compelled the firm to file for bankruptcy. The company’s leadership tasked with overseeing and evaluating the firm’s strategy, internal controls, financial reporting and management failed to anticipate the risks facing the firm and taking corrective actions. The public, employees and investors were appalled to ascertain that one of the highly performing and respectable energy firms had collapsed within a year. Numerous investment partnership established by the company prompted the collapse of the firm. The firm adopted an asset-light policy of being an energy trader instead of being an energy producer drawing the firm profits and income from the trading practices. The firm use of special partnership to window-dress its financial statements negatively affected the firm. By the end of 2000, Enron stock declined and by 2001, the debt burden on the partnership became unbearable. Enron downfall was a combination of failures of the firm’s leadership, professionals and the board of directors. Different professional who include credit raters, lawyers, financial analysts, accountants, consultants and investment bankers had a major role to play in the collapse of Enron. Enron had an intricate business model that included scores of products such as trading operations and physical assets across national boundaries. The trading business entailed intricate long-term contracts. Estimating the cost of fulfilling contracts was not easy for the firm because some contracts were secretly negotiated and not standardized. More so, estimating the contracts’ cost was further made difficult by the fact that scores of states had not deregulated energy thereby requiring the firm’s traders to anticipate the timing and probability of prospective deregulation. Another major challenge that faced the firm was financial reporting for special-purpose entities (SPEs). In addition, the firms failed to implement risk-management practices. The decentralised decision-making and the high levels of workers’ mobility called for powerful risk-management systems. Precisely the firm failed because of its dishonest and arrogance culture and poor corporate governance. The firm’s corporate culture did nothing to foster the values of integrity and respect. The firm’s management undermined the values of integrity and respect through the focus on decentralisation, compensation programs, and performance of employees. The firm’s culture and governance prompted staid unethical practices and conflict of interests. The financial professionals failed to abide by the ethical principles of accounting. The case study demonstrates the importance of adhering to ethical standards because unethical firms get exposed eventually. Corporate codes of conduct are not sham, but they are constructive approaches to daily operations while meaningful cultures compel staff to undertake the right thing. Such systems help firms in addressing issues in a holistic manner to guarantee sustainability, growth and potent ethical health. Why was Enron an admired company prior to 2000? Enron was a natural gas pipeline firm established in 1985. The firm surfaced as pioneer in the deregulated energy business. Within fifteen years, Enron developed leading markets in energy trading and global energy-asset construction. In 2000, Enron ranked as the most innovative big company for the 6th year in a row (Healy & Palepu 2013, p.1). Prior to 2000, Enron was an admired company because it was a pioneer of deregulated energy market. The company was doing quite well and had become the leading firm in energy trading and global energy-asset production. The firm reported attractive operating revenues. For instance, in 2000, Enron reported earnings of 979 million dollars and operating revenues of 100.8 billion dollars. The firm had smart leaders who pushed the firm into a well performing firm. From the outstanding performance of the firm, the leaders appeared to be responsible and accountable for all the firm’s operations. Enron epitomized the evolution from production to the knowledge financial system. By 1990s Enron, implemented constant value innovations and lowered the cost of electricity and gas to customers by 50% (Healy & Palepu 2013, p.2). Enron was engaged in energy supply chain including coal mining and coal trading. The firm made a major mark in the industry and transformed the trading of energy and coal. What Led to the Rise and fall of Enron The rise and fall of Enron is linked to the accounting professionals, board of directors and executives employed by the firm. The rise of the company was largely drawn from constant and important innovations that entailed hedging against risks and financing its operations. The company used partnerships which promoted increment of return on assets and leverage without having to report debt on the firm’s financial statements. The firm used its accounting limitations in controlling its balance sheet and earnings to depict a favourable image of its performance. The firm made major investment in America and abroad. However, the rapid assets accumulation financed through debt instigated a high debt-to-equity ration that was partly hidden from investors through SPEs. The firm made huge profits from its trading practices because it was a dealer and a major market participant an aspect that made the firm to gain market power. However, manipulation of the firm financial statements led to the collapse of the firm. Enron fall demonstrated the greatest failure of accounting professionals in the history of American business world. The fall had major effect on financial markets because it prompted significant losses to pension funds, insurance companies and banks that invested directly in the company (Nanda 2003, p.1). Other large and small investors were also affected by the collapse of the company. The collapse of Enron instigated the necessity of ensuring soundness of financial reporting and the role of accounting professionals. Enron rose to become the most innovative firm in the United States but it collapsed within months. The firm’s management, banks, regulators, analysts, consultants, auditors, credit raters and standard setters contributed to the historical collapse of Enron. Following the collapse, scores of major issues were analysed and they involved the need for apparent and unequivocal auditing and accounting standards. Apparently, the firm fell because of the conflicts of interests that arose between the firm and the involved professionals. Firms that expected to assess and address mismanagement and unethical practices failed on their part. Every professional who worked with Enron appeared to have ignored or missed the sign of an imminent collapse. The firm’s auditor, failed to review and report the company’s accounting irregularities. The auditing firm failed to maintain its role as the representative of the investors through failing to ensure sturdiness of the firm’s accounting systems. The auditors failed to verify the accuracy of the accounting reports and, as such, the auditor helped in concealing the firm’s liabilities and loses (Knapp 2012, p.15). The accountants, therefore, contravened the spirit of clear exposé of accounting performance. With respect to the analysts, they failed to disclose the company’s flaws. As a result, the analysts failed in generating earning forecasts and comprehensive research reports thereby failing to warn the investors of the potential risks and the imminent collapse of the firm. The analysts were uncritical in their recommendations as they were inspired by the fees that their investment banking colleagues were making from Enron and not the desire to assess the firm’s basics. The investment bankers played a crucial role in channelling a lot of money to Enron via its partnership an aspect that allowed the firm to borrow clandestinely. The investment bankers gained through collecting interests from loan and fees from underwriting of transactions. The firm’s leadership had promised to underwrite business to banks to gain in investing in Enron partnership. The role of investment bankers as underwriters and investors exposed the banks to conflicts of interests. Scores of Enron partners were accounting gambits instead of true financial hedges. While the partnership received financial rewards, they failed to protect the firm from risks. The lawyers employed by the firm failed to question the legal propriety of the numerous partnership into which the firm was joining. The management consultants failed to provide constructive advice to the firm’s management while the credit raters failed to assess the creditworthiness of securities issuers and other monetary obligations. The credit raters were also late to discover the firm’s credit risk. The asset-light strategy, the off-balance-sheet financing and SPEs were the root cause of the Enron collapse. In addition, the board of directors’ conducts in suspending the firm’s codes of ethics twice in 1999 to pave way for creation of SPEs jeopardised the ethical stance of the firm. Why Enron’s Internal and External Checks and Balances System Failed To Prevent Its Demise? Audit committees met a few times in 2000 (Healy & Palepu 2013, p.4). The auditors depended so much on the information from the firm’s management and the external and internal auditors. While the audit committees had members self-effacing background in finance and accounting, there were member with powerful financial experience. Several audit presentation by external auditors demonstrated risks linked with Enron accounting practices. However, the audit committee acknowledged that the firm was involved in business practices that no other firm in the world engaged in and therefore its accounting was a leading edge. Arthur Anderson ignored the deceptive accounting practices in the firm. The external leadership plays a crucial part in ensuring the success of the firm through promoting organisational reliability. However, in the Enron case, Anderson, the firm’s external auditor failed to disclose the firm’s judgement and instead authorised the firm’s dubious financial statements (Knapp 2012, p.15). It was the auditor’s role to ensure that the entries made in the firm’s accounting books were correct for safeguarding the stakeholder’s interests. However, the close link between the Anderson auditing firm and the Enron discouraged the auditors from whistle blowing. The external auditors feared to lose one of their biggest clients. The external auditors earned more money from consultations fees instead of the auditing role. The close relationship between the firm’s internal management and external auditors made Anderson to ignore the faulty financial statements. Enron’s internal and external checks and balances system fail to prevent its demise because of the irresponsible actions of Anderson who chose to retain their close relationship with the firm’s management. The firm’s senior management cashed their own stock and made the firm seem successful on papers. The firm’s management failed to asses their violations of trust. They signed inaccurate financial statements approved by the external auditors. Had Anderson inspected the firm’s audit appropriately and kept aside their link with the firm, the failure of external and internal balances and checks would have been prevented. Both the internal and external auditors violated different accounting guidelines. The external auditors, Arthur Andersen, eventually destroyed the firm’s accounting documents. In so doing the, Anderson contravened C.P.A (Certified Public Accountant) ethics and standards. Enron management failed to include essential data in the firm’s financial statement thereby contravening ethical rules. Anderson was central to the fall of Enron. The auditor’s conducts allowed and encouraged the fall of Enron (Christopher 2003, p.575). Would continuous auditing have prevented the Enron? A well- conducted conventional audit would have identified scores of Enron’s operational issues. A continuous audit would have brought any irregularity to light if the parties involved had nothing to hide (Plessis, Hargovan & Bagaric 2010, and p.228). While many people believe that continuous auditing would have prevented the fall of Enron, I believe that constant auditing would not have prevented the demise. This is because the auditors were safeguarding their interests in the firm and they did not want to lose their client. As a result, constant auditing would not have done much to save the firm because there lacked concern or intention of undertaking a good audit engagement. The firm’s external auditors had an interest in the management fraud. With fraudulent collusion, it is plausible that the auditors and client could have tampered with the constant audit system; and hide warnings and alarms (Garsten 2008, p.106). Continuous audit would have been vulnerable to interference; hence, it would no have prevented the demise of Enron. However, if there were no conflicts of interests, continuous auditing would have brought more anomalies to light thereby augmenting the deterrence worth of audit. The fact that Enron’s accounting systems were inaccurate and Arthur Anderson fail to question the firm’s management, demonstrate the collusion between the auditing firm and Enron. For instance, Anderson asserted that SPEs employed by the firm complied with GAAP, but this was not the case. Why did the Board of Directors fail to prevent Enron’s demise? The role of board of directors is to act on behalf of a firm’s shareholders. The board of directors run the daily affairs of a firm and they are accountable to the firm’s shareholders. Their key role is to guarantee prosperity of a firm through directing affairs of the firm and attaining the correct interests of a firm’s stakeholders and shareholders. The board of directors set structure and strategy of a firm through evaluating current and prospects opportunities, risks and threats and determine strategic options (Plessis, Hargovan & Bagaric 2010, and p.230). Directors are responsible for making sure that correct books of accounts are maintained. With respect to accounting and financial reporting responsibilities, the board of directors is required to disclose with feasible accuracy the financial stance of the firm. It should make sure that any account must comply with the Companies Act (Knapp 2012, p.19) The board of directors should have ensured sufficient control of the company’s accounting records and transactions to prevent the demise of Enron. This includes creditors and debtors, cash, work in progress and stock, major contracts and capital expenditure. However, the board of directors failed to prevent the demise of Enron because members were not considerate of the temperament of the off-books entities. The board also failed to monitor the entities after their approval. The board also failed to monitor employees and their excessive compensations. The board failed to protect the interests of the firm’s stakeholders and shareholders through allowing the firm to get involved in high-risk accounting. It concealed off-book actions, unsuitable conflict of interest transactions and executive compensation. The board of directors witnessed several indications of dubious practices by the firm’s executive but it ignored these practises at the expense of business associates, employees and shareholders. The board also failed to prevent unsuitable conflict of interests by allowing the firm’s chief financial officer to operate the LJM private equity funds (Healy & Palepu 2013, p.7). The LJM profited at the expense of Enron. As a result, the board exercised insufficient oversight of LJM, hence failing to protect the firm from unfair dealings. In addition, the board allowed the firm to undertake billion of dollars in off-the-books practices to make its financial position appear good. The board failed to disclose to the public the off-the-books liabilities besides approving excessive compensation of the company’s executives. It failed to prevent abuse by the board Chairman and CEO, Lay Kenneth who financed multi-million dollar private credit line. The board also failed to establish the independence of the firm’s auditor through permitting Anderson to offer internal audit and consulting services while acting as the firm’s external auditor. Breaches of Accounting and Ethical Conduct That Occurred within Enron A firm cannot succeed without maintenance of accounting ethics. Accounting ethics include both external and internal guidelines that keep a firm form formulating incorrect financial reports or misrepresenting a firm’s financial position. The executives, the auditors and the board of directors breached accounting ethics. They failed to demonstrate a level of competence, honesty and integrity. The firm’s accountants use deceptive techniques to disclose its complex financial dealings (Garsten 2008, p.106). The management defrauded the market with sham reporting and manipulating accounting regulations and rules. The financial management of the firm lacked transparency in reporting the firm’s financial dealings. The financial management omitted losses and liabilities in its financial reporting. Poor financial stewardship contravened accounting ethics and took the firm to the edge. The accountants failed to report the firm’s accounting irregularities. Anderson was supposed to guarantee the strength of the firm’s accounting systems besides verifying the correctness of the accounting reports. Instead, the accounting firm helped in concealing the firm’s loses and liabilities. According to Knapp (2012, p.17), licensed accounting professionals are expected to do more than making numbers add up. They are required to check inventory, contact clients and perform other tests before approving reports that present a firm’s financial results. The accountants colluded with the firm’s management to violate the accounting ethics. The breach of accounting ethics made Anderson to surrender its accounting licenses. Lessons Learnt as an Accounting Professional From the case of Enron, it is important that accounting professional demonstrate honesty, integrity and competence. The operations and success of any firm depends on its financial position and hence accounting professionals must present correct accounting information to ensure growth of a firm and investors confidence. Secondly, I have learnt that failure to uphold accounting ethics by accounting professionals come with serious legal and professional implications. For instance, Anderson faced criminal suit and its licenses were revoked leading to the fall of Arthur Anderson, one of the biggest audit companies in the globe. Thirdly, I have learnt that accountants should perform their duties independent of a firm’s management. This is because colluding with a firm’s management in matters relating to financial reports may jeopardise the credibility of a professional accountant. Accountants should be open and reveal all the accounting practices of the firm other than concealing them. Finally, accounting professionals must adhere to the set accounting ethics and principles. Had the auditing firm adhered to the accounting ethics and codes of conducts, the collapse of Enron could have been prevented. Accounting problems should be solved through enhanced transparency and adherence to accounting standards. It is important that accounting professionals focus on integrity of their roles rather than engage in consulting work to get hefty fees. There should be a separation of the consulting and auditing functions. In addition, transparent and effective self-regulation systems subject to SEC’s monitoring are essential. Effects of Unethical practices on Society and Community Unethical conducts do not only affect a company but also its employees, shareholders, stakeholders and the society as a whole. Most of employees at Enron testified that they had retired with between 700, 000 to 2 million dollars in Enron stock but they were left with nothing after they were restricted from selling their stock (Uma, Dickes & Caines 2002, p.12). The unethical conducts of Enron’s management and auditors led to the collapse of the firm. It also acted as a big shock to the USA economy. The greed and unethical conducts of some individuals left so many people jobless besides a huge loss of money. The pension fund of the employees was damaged while Arthur Anderson, one of the biggest auditing firms also collapsed. The investors and shareholders lost their money. Due to unethical conducts, the firm management and board of directors failed to safeguard the interests of the employees, stakeholders and shareholders as well as the interest of the entire community. The effect of unethical conducts established a shockwave throughout the US economy. According to Uma, Dickes and Caines (2002 p.13), the unethical conducts of professionals in Enron case left so many employees jobless. While Enron employees lost their jobs, employees at Arthur Anderson auditing firm also lost their jobs. Anderson partners lost their life savings and faced law suits. Conclusion The fall of Enron was an inopportune incident that could have been prevented had the professionals involved acted ethically. The management, in collusion with the accountants tried to depict a positive image of the firm through hiding the firm liabilities and losses during financial reporting. This strategy aimed at wining the confidence of investors but it eventually instigated the demise of the firm. The management demonstrated a culture of arrogance that made the firm to believe that it could address greater risks. The board of directors, the analysts, auditors, credit raters and the team of executives had a major role in the collapse of Enron. The fall of Enron challenges professional to act ethically and to adhere to the set standards of their professions. Accounting professionals should act with honesty, competence and transparency to avoid unethical conducts. Employees at all levels should report violations of ethical codes of conduct while board of directors and auditors should demonstrate extensive transparency and experience in corporate financial management. Adequate oversight should be conducted in a firm to prevent malpractices that could negatively affect a business. While unethical conduct in Enron benefited some of the company leaders with Arthur Anderson maintained its biggest client by concealing the Enron’s unethical conducts, the negative effects of the unethical conducts were erroneous compared to the benefits. Some of the leaders were jailed while Anderson collapsed following the withdrawal of its licenses. To prevent such occurrences, directors of a firm tasked with safeguarding the interests of shareholders, employers, investors and other stakeholders should strengthen their oversight. They should prevent accounting activities that put a firm at high risk, prevent conflict of interest and off-the-books practices that make a firm financial position appear appealing. The compensation of executives and other employees should be monitored and external auditors should not be allowed to offer consulting services and internal auditing. Independence of the auditing firms should be strengthened to avoid collusion with a firm’s executives. Reference List Christopher, G 2003, ‘ The real world of Enron’s auditors’, Organization, vol.10, no.3, pp.572-576. Garsten, C 2008. Ethical Dilemmas in Management. UK: Cengage learning. Healy, P & Palepu, K 2013, ‘ The fall of Enron’, Harvard Business School, pp.1-22. Knapp, M 2012. Contemporary auditing. USA: Routledge. Nanda, A 2003, ‘ Broken trust: The role of professionals in the Enron Debacle’, Harvard Business School, pp.1-17. Plessis, J, Hargovan, A & Bagaric, M 2010. Principles of contemporary corporate governance. UK: Cengage Learning. Uma, S, Dickes, V & Caines , R 2002 ‘The social impact of business failure: Enron’, American Journal of Business, vol. 17, no.2, pp. 11-22. Read More