Causes of Enrons Failure-Bankruptcy - Essay Example

ENRON’S SCANDAL TABLE OF CONTENTS 0 EXECUTIVE SUMMARY 4 2.0 INTRODUCTION 4 3.0 CAUSES OF ENRON’S FAILURE-BANKRUPTCY 3.1 Introduction 5 3.2 Mark-to- Market technique 5 3.3 Use of special purpose entities (SPEs) 7 3.4 Executive Compensation.........................................................................................7 3.5 Manipulation and Fraud 8 4.0 SOCIAL AND ENVIRONMENTAL IMPACTS OF ENRON’S SCANDAL 4.1 Introduction 9 4.2 Reputation loss 9 4.3 Loss of employment 10 4.4 Loss of investors’ wealth 10 4.5 Loss to suppliers and creditors 10 4.6 Loss of confidence in financial market 11 5.0 RESPONSES TO THE ENRON SCANDAL 5.1 Introduction 12 5.2 Transparency 12 5.3 Audit 13 5.4 Off Balance Sheet Transactions 13 5.5 Campaign Financial Reforms 13 5.6 Board of directors 14 5.7 Executive Compensations 14 5.8 Ethical Policies 14 6.0 CONCLUSION 14 7.0 BIBLIOGRAPHY 16 8.0. EVIDENCE PORTIFOLIO 18 1.0 EXECUTIVE SUMMARY Enron was an American energy company based in Houston, Texas. The Enron Scandal was revealed in 2001 and led to the bankruptcy of the Enron Corporation and the dissolution of Arthur Andersen, which was one of the largest audit and accountancy partnership in the world. Managers and accountants at Enron deliberately used their knowledge of accounting rules to manipulate figures they reported. They fail to adhere to the standards and principles of accounting and reporting that are set by the Financial Accounting Standard Board (FASB). The financial statements provide information that is used by different parties to make economic decisions and to analyze the performance of managers. Users of Enron’s financial information assumed that the information availed was factual, reliable and could be used for sound decision-making. Enron scandal is the biggest audit failure and the largest bankruptcy reorganization in the American history. It is also the company that went down very fast and is the most known company in the world for its audit failure. This research seeks to analyze the causes of its failure and its consequences. When the Enron scandal was revealed, confidence in the capital market went down, careers of people were destroyed, and lead to bankruptcy, economic loss, and erosion of public confidence and trust in the audit profession. 2.0 INTRODUCTION Corporate managers are expected to maximize shareholders’ returns and increase business value. They have a responsibility to present the true picture of their organizations to the public, shareholders, employees, and the government. Businesses follow ethics in presenting their financial information. Business ethics are a set of rules and precepts required in the preparation and reporting of financial information. They are set by the American Institute of Certified Public Accountants and include professional behavior, integrity, objective, confidentiality and professional competence and due care. However, they are not always followed and the financial information is sometimes manipulated. Several organizations have been in the news manipulating financial information and reporting it instead of the true information. Such organizations include Enron, Lehman Brothers, WorldCom, and South Sea Bubble. 3.0 CAUSES OF ENRON FAILURE 3.1 Introduction Responsible management is important to ensure the success of an organization. The management has a role on implementing internal controls in the organization to prevent financial loss and frauds. It prevents embezzlement, asset misappropriation that could lead to loss of reputation, erosion of shareholders’ confidence, and collapse of the organization. However, Enron’s management was not responsible and lead to its collapse. It was dishonest and employed techniques that were aimed at benefiting the executives at the expense of the shareholders and the organization. These techniques include use of mark-to-market technique, special purpose entities, and huge compensation packages for employees, fraud, and manipulation of financial statements. 3.2 Mark-to-market technique Skilling joined Enron’s management and demanded that his division adopt mark-to-market technique such that long-term gas delivery and other trading contracts would be valued at market or fair value instead of historical cost. It was approved by the board of directors and the SEC. Mark-to-market technique is a method of financial instruments where a well developed market exists and there are specific closing prices. Fair values are recorded on the balance sheet and gains and losses immediately recognized in the income statement. Enron expanded the use of mark-to-market and used it generate huge earnings and earning manipulations (Collins, 2006). Enron was recording long-term contracts using this technique. It used the technique to predict gas prices and recorded gains before any gas changed hands. Traders’ incentives were based on the values of the trades and not on actual deliveries giving them optimism. Enron could use mark-to-market technique to recalculate contracts. Investors were given misleading information because of the deviations in the estimations. Enron also recorded cash as ‘cash from operations’ to imply that earnings were related to cash performance instead of ‘cash from financing’ (Mulford & Comiskey, 2005). It could give loans to gas producers through the Gas Bank and then use the mark-to-market technique to record expected earnings although no cash was realized. Enron would also contract offshore entities to supply gas in the future and be paid cash, which was recorded as ‘cash from operations’. However, these entities had been set by Enron’s bankers to imply there were genuine sales yet they were loans. These amounts would be in billions of dollars and were used to hide the problem of cash flows yet it was reporting huge earnings. Besides, it did not report the obligation for the cash received as a liability on the balance sheet. It also used the mark-to market technique to overstate profits (Salter, 2008). It was also involved in speculating commodity prices but it succeeded in hiding the losses incurred. 3.3 Use of special purpose entities (SPEs) Enron also collapsed because of use of special purpose entities (SPEs). Multiple SPEs were created to hide losses and manipulate earnings. There were SPEs that included Chewco, LJM1, LJM2, and Raptor (Brooks & Dunn, 2011). Enron began to collapse when it was revealed that it was hiding debt and consequently SPEs began to fall because of the decreases in the share price of Enron. There was a legal requirement that an SPE must have at least 3% of its equity coming from external investors, could not be controlled, and the company was not responsible in case of losses. However, it was revealed that the SPEs had equity from Enron, were controlled by Enron, and Enron was liable for the losses. They were not independent of Enron because they were run by its employees. 3.4 Executive compensation Enron’s management designed a compensation package that put a lot of pressure on employees to meet target to get huge rewards. The reward system allowed manipulation to achieve target while management remained silent. Enron entrusted the chief operating officer, Skilling, to ensure that it meet its earnings targets forecasts. It was mainly done through manipulation because of compensation packages for the executives who met their targets (Walton, 2012). Earnings were based on stock price performance. The executives would receive options for hundred of thousand of shares. They would manipulate share and it was uncommon for the company to miss its targets. They would not issue profit warnings but would find additional earnings. If targets were not meet before the end of the period, the executives would close deals to generate revenues or delay recording the losses. It would also conceal losses by revaluing physical assets or use SPEs to record earnings. For instance, in 1996 when Enron traders speculated on gas prices and lost $90million instead of a profit of $100million, they used the mark-to-market to revaluate investments in JEDI (McLean & Elkind, 2013). In 1998, when Enron made a $310 million investment in a small internet company called Rhythms NetConnections, and went public in 1999. On the day of the IPO, the stock of Rhythms NetConnections rose to $69 per share. Enron recorded the entire $290million gain and locked it by setting up a complex set of SPEs called LJM, which later was found to be fraudulent (Giroux, 2008). The huge compensation package acted as an incentive for executives to engage in manipulation of financial statements to earn huge compensations while management remained silent. 3.5 Manipulation and Fraud Enron was also involved in manipulations and fraud. It acquired other companies to venture into electric utilities, finance, risk management, and telecommunications yet it did not have any experience in the areas. However, some of these areas were not profitable but they used SPEs manipulations to hide the losses and record nonexistent profits. It had different SPEs to quickly provide accounting benefits in form of increasing profits, concealing losses, removing debt from the financial statement, and showing operating cash flows. The board of directors waived the conflict of interest requirement while the auditor David Duncan allowed it. Fastow would make big profits for himself. The SPEs were mishandled and Fastow manipulated them while auditor Arthur Andersen and law firms did not oppose. Enron also used political pressure to bully anyone including auditors, investment bankers and analysts, and politicians. It used cash as its main influence, for instance, through spending on investment banking deals, political contributions. It contributed to both parties and contributions only became bigger. Lay and his wife also contributed to politicians and political parties (Biggs & Helms, 2014). He chaired the 1992 Republican Convention in Houston. In return, Enron received billion of dollars in loans and other benefits for its international projects. It received over $7.2 billion for its projects from about 20 government agencies such as the World Bank. 4.0 SOCIAL AND ENVIRONMENTAL IMPACTS OF ENRON’S SCANDAL 4.1 Introduction Responsible management is crucial for the health of an organization and economy. However, violation of responsible management has negative impacts of the organization, society, and environment. Failure of responsible management in Enron led to severely damage of its reputation, loss of employment, financial loss to suppliers and creditors, loss of investors’ wealth, and loss of confidence in the financial market. 4.2 Reputation loss Enron had grown to be the best company in America. It was also considered the best place to work. It had policies on employee relations, policies on corruption and bribery. It also had programs on community relations. It also emphasized values such as respect, integrity, and excellence (Eichenwald, 2005). However, after the scandal, its reputation was tainted since the values which were being emphasized came out as lampoon. No individual wanted to be associated with it after the scandal. Arthur Athersen also lost its reputation as one of the greatest audit firms in the world (Nelson, Price, & Rountree, 2008) 4.3 Violation of labor rights of employees About 5600 individuals lost their right to employment and employment benefits because 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 (Herrick & Barrionuevo, 2002). In addition, the right of Enron’s employees to retirement benefits was denied because they were prohibited from selling their stocks. Employees were laid off affecting their families and their welfare. They lost their source of income leading to psychological effects such as depression. 4.4 Loss of Investors’ wealth It led to the fall of stock prices. Investors, customers, suppliers, employees filed many lawsuits against Enron. Investors saw a decline in the share prices of Enron making their investments unprofitable. After Enron went bankrupt, shareholders and other investors were left with no value in the company. 4.4 Loss to Suppliers and Creditors Suppliers and creditors did not get factual status on the financial status of Enron and made wrong economic decision on its ability to repay its obligations. Suppliers and creditors were affected because they incurred losses that they have not planned for since they do not have the true financial value of the company. 4.6 Loss of confidence in financial market The confidence of the public to an economic system is dependent on its integrity and reputation. People hardly invest in an economic system that has companies suspected of financial manipulation. In addition, it is important for people to trust their financial market for them to commit their finances in it. The Enron Scandal led to people losing confidence in the financial market. People began to lose trust in the financial information given by companies (Deakin & Konzelmann, 2003). They also lost confidence in the capital market because they lost their investments. Regulatory bodies such as New York Stock Exchange, NASDAQ, and American Stock Exchange were seen as not having enough corporate governance rules in their listing requirements. Besides, people also lost trust in the audit profession because they could no longer be relied to provide true and fair financial view of a company. Arthur Andersen was one of the largest audit companies in the world, but had failed to inform shareholders of financial manipulations in Enron Corporation. Many people also withdrew their investments from the financial market because of the fear of losing them. 5.0 RESPONSE TO ENRON SCANDAL 5.1 Introduction The Enron Scandal led to the collapse of the organization. The government responded through legislation to prevent similar scandals in future. It enacted legislation and regulations that aim at deterring and detecting fraud. The legislation is known as Sarbanes and Oxley’s Act, SOX, and was passed in 2002 (Wade, 2002). It has been successful in preventing similar scandals that could have resulted from failure of responsible management. The Act prevents Enron-like scandals by increasing criminal and civil liability for securities fraud, placing oversight of the accounting professionals under a regulator, and restricting the ability of accounting firms to engage in certain non audit services. It also requires certification of firm’s financial statements by the CEO and the financial officer, and disclosure of off balance sheet activities. SOX introduced several reforms on several areas that include transparency, audit, off balance sheet transaction, campaign financial reforms, executive compensation, and ethical practices. 5.2 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 and the cost that the organization will incur. There are also transparency issues that can affect the future such as off balance sheet debts and tax havens, and they should be disclosed. 5.3 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. 5.4 Off Balance Sheet Transactions The investors should examine the balance sheet carefully so as to detect some of the transactions that are missing or hidden. This is because companies that are performing well and according to the stipulated rules and regulations cannot hide anything from the public or shareholders. 5.5 Campaign Financial Reforms Investors can now ask companies to reveal their contribution to campaigns of political parties and individuals. 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. 5.6 Board of directors The board of directors should be independent and free from the conflicts of interest. 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. 5.7 Executive compensation The Act 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. 5.8 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 6.0 Conclusion A company should have a responsible management. Enron’s failure of responsible management led to its collapse because it engaged in practices that are dishonest. It used dubious techniques that led to loss of finances, poor financial decisions, and collapse of the organization. The management also manipulated their financial statements to maintain its image. However, the financial statements became so distorted that it was hard to make proper corporate decisions. The government responded to the collapse of Enron by enacting the SOX Act that provides guidelines on responsible management and practices. A responsible management must enact proper internal controls to deter and detect fraud and financial manipulations. All practices in the organization must be as per financial principles. 7.0 Bibliography Arbogast, S. V., 2008, Resisting Corporate Corruption: Lessons in Practical Ethics from the Enron Wreckage, M & M Scrivener Press. Biggs, S., & Helms, L. B., 2014, The practice of American public policymaking, Routledge. Brooks, L. J., & Dunn, P., 2011, Business & professional ethics, Cengage Learning. Collins, D., 2006, Behaving badly: Ethical lessons from Enron, Dog Ear Publishing. Deakin, S., & Konzelmann, S. J., 2003, Learning from Enron. Cambridge Centre for Business Research Working Paper, (274). Giroux, G 2008, What Went Wrong? Accounting Fraud and Lessons from the Recent Scandals, Social Research, 75, 4, pp. 1205-1238, Academic Search Premier, EBSCOhost, viewed 30 June 2015. Herrick, T., & Barrionuevo, A., 2002, Were Enron, Anderson too close to allow auditor to do its job, Wall Street Journal, January, 21, C1. McLean, B., & Elkind, P., 2013, The smartest guys in the room: The amazing rise and scandalous fall of Enron, Penguin. Mulford, C. W., & Comiskey, E. E., 2005, Creative cash flow reporting: uncovering sustainable financial performance. John Wiley & Sons. Nelson, K. K., Price, R. A., & Rountree, B. R., 2008, The market reaction to Arthur Andersens role in the Enron scandal: Loss of reputation or confounding effects?. Journal of Accounting and Economics, 46(2), 279-293. Rapoport, N. B., & Dharan, B. G., 2004, Enron: Corporate Fiascos and their Implications, Foundation Press. Salter, M. S., 2008, Innovation corrupted: the origins and legacy of Enrons collapse, Harvard University Press. Wade, CL 2002, CORPORATE GOVERNANCE FAILURES AND THE MANAGERIAL DUTY OF CARE, St. Johns Law Review, 76, 4, p. 767, Academic Search Premier, EBSCOhost, viewed 1 July 2015. Walton, P., 2012, The Routledge companion to fair value and financial reporting, Routledge. 8. EVIDENCE PORTIFOLIO 1. Deakin, S., & Konzelmann, S. J., 2003, Learning from Enron. Cambridge Centre for Business Research Working Paper, (274). This article offers solutions to avoiding failures of corporate organizations learning from Enron. It offers solutions to prevent Enron types of scandals in the future. It identifies conflicts of interests of senior managers and need for oversight by the board of directors. It stresses the importance of the independence of the board of directors and auditors to align the interests of managers and shareholders. 2. Giroux, G 2008, What Went Wrong? Accounting Fraud and Lessons from the Recent Scandals, Social Research, 75, 4, pp. 1205-1238, Academic Search Premier, EBSCOhost, viewed 30 June 2015. This article helps to understand the level of the accounting fraud and manipulation in Enron. It describes how Enron applied and used the mark-to-market technique to conceal fraudulent activities. It shows how Enron succeeded in manipulating the SPEs to commit fraudulent activities. It shows how the company overstated profits, concealed losses, and broke accounting principles. It also includes how compensation of executives encouraged manipulation of accounting principles for them to earn bonuses and huge pays. 3. Nelson, K. K., Price, R. A., & Rountree, B. R. (2008). The market reaction to Arthur Andersens role in the Enron scandal: Loss of reputation or confounding effects?. Journal of Accounting and Economics, 46(2), 279-293. This article helps to understand the impact of Enron scandal on Andersen. It led to the loss of reputation for not only Enron but also Arthur Andersen. Andersen clients experienced negative stock market reactions after it acknowledge taking part in the Enron scandal. Its reputation is important for public trust. The Enron scandal also caused regulators and media to focus extensive attention to Andersen. This huge attention made a big impact on the reputation of the auditor. 4. Salter, M. S. (2008). Innovation corrupted: the origins and legacy of Enrons collapse. Harvard University Press. It helps to trace the setting up of Enron, its growth, and collapse. It details the behavior of management and practices that led to the collapse of a once technology giant. It also shows how the management engaged in fraudulent activities while the board of management failed to detect the ethical and fraudulent activities. It also details how external watchdogs such as regulatory bodies, auditors, and lawyers failed to act on Enron. 5. Wade, CL 2002, CORPORATE GOVERNANCE FAILURES AND THE MANAGERIAL DUTY OF CARE, St. Johns Law Review, 76, 4, p. 767, Academic Search Premier, EBSCOhost, viewed 1 July 2015. This article is important because it helps to understand the failures of corporate organizations and finding solutions with the enactment of the Sarbeous-Oxley Act of 2002. It describes the Act and what it seeks to achieve. They include civil and criminal liability for fraud, oversight of accounting professionals under a regulator, disclosure policy, and restriction of auditors. Read More