Risk Management: Major Lose in ENRON - Case Study Example

Tables of Contents Introduction……………………………………………………… 2. Risk Management Cycle…………………………………………. 2 Risk Identification…………………… 2.2- Risk Measurement……………………. 2.3- Risk Analysis…………………………. 2.4- Decision-making……………………… 2.5- Implementation………………………. 2.6- Monitoring…………………………… 2.7- Policies……………………………….. 3. Risk Strategy and Recommendations for Future………………… 4. Conclusion………………………………………………………... Risk management and major lose in ENRON, and how to avoid it in the future. 1. Introduction Enron was a US based company, mastered in trade and distribution of power / energy. Indeed, the company was believed / considered as a big giant because it was apparently among the top ten US firms before its shameless debacle in 2002. The major reason behind the failure and subsequent bankruptcy of Enron Corporation was that the accountants and audit committee members hid company’s debts and financial obligations. The company was not actually very liquid and profitable but amendments in financial statements made that possible. However, the disclosures of clandestine measures and illicit practices later reduced the credibility, reputation and goodwill of company followed by steep decline in value of shares. Consequently, Enron became the biggest corporate failure in US history having more than $1 billion debts and financial obligations to creditors (Puscas 1, 2002). This paper will first throw light over the Risk Management Cycle of Enron Corporation before its collapse followed by a discussion on key elements of a risk management strategy aimed at ensuring more effective management of the risk in future. Finally, a conclusion will be presented to summarise main findings and scope of new risk management strategy that could help averting corporate failures like Enron. 2. Risk Management Cycle of Enron Corporation before Collapse 2.1 - Risk identification As far as the risk identification is concerned, it should be mentioned that Enron had a comprehensive risk management policy that aimed to reduce all market, operational, credit, capital, funding, currency fluctuation, interest rate and portfolio risks so that the global producer would maximise its profits and wealth of shareholders. Indeed, Enron Company had a Global Risk Management Operations (GRMO) business function of which the sole responsibility was to identify all potential small and larger risk factors through implementation of a proactive approach. As a result, Enron would be able to eradicate such potential and actual risks that had ability to impact revenue streams, profitability, liquidity and debt management (CEE Report, 2002). 2.2 - Risk measurement It is worthwhile to mention that company had separate risk measurement tools to analyse and evaluate market and credit risks. For instance, the company used to measure its market risk that refers to changes in market circumstances, forces and factors. Indeed, Enron had established a separate business function that was known as Global Risk Management Operations (GRMO). For instance, this unit was responsible for gathering data and transforming into pertinent information through of statistical models and tools. In simple words, the market risk was measured through use of CAPM model and calculations were interpreted to evaluate the increasing or decreasing trend in marketing risk factors. Enron Corporation also tended to use Value-at-Risk (VaR) statistical tool so that it could indicate the fluctuations in market and impact of negative factors on Enron external business environment. The global energy distributor and supplier used to measure VaR by considering level of significance (alpha value) = 5% or 0.05 while the corresponding confidence interval was 95%. In addition, the Delta and Gamma symbols were also used to indicate ‘positions’. For instance, statisticians at Enron were using Monte Carlo Simulation followed by probability distribution tools and methodology. It is worthwhile to point out that risk management methodology was similar for all business functions and divisions of Enron Corporation as part of its globalisation strategy. In addition, Enron was also indulged in testing stress that would mainly result because of unpredictable events and fluctuations in the marketplace. Indeed, the measurements and results obtained from stress testing were separate from that of VaR because of technical reasons. Other than the above mentioned, the company also used different variables such as ‘price, basis, liquidity and volume’ to conduct scenario analysis. Nonetheless, the major reason behind conduct stress and scenario analysis was evaluation of risks associated with product portfolios of Enron Corporation (CEE Report, 2002). 2.3 - Risk analysis Enron Corporation had also established a separate business unit named Risk Assessment and Control (RAC) that was solely responsible for analysing and interpreting the results / findings and scope of calculations. For instance, the purpose of RAC was to prepare reports on the basis of calculations and submit them to Risk Management Committee. The committee, in turn, would develop and implement risk management strategies and contingency plans so that organisational resources (especially capital assets and investments) could be utilised in an efficient and effective manner (Ferill & Ferill, 2005). 2.4 - Decision Decision – making was done with mutual collaboration between The Risk Management Committee and the Chief Executive Officer (CEO). Indeed, it should be noted that chief risk officer and his subordinated used to provide appropriate suggestions and highlight available alternatives for effective risk management. For example, both RAC and CEO first had to define VaR limits for various business functions, market and credit risks, commodity and portfolio risks after which decisions were made and approved by CEO. It should be mentioned that Enron had devised a risk management policy according to which employees and associated members were informed about the company’s strategic position in the external environment in comparison to its competitors. In this way, the workers were remained aware of weak areas of Enron and they were expected to portray top performance so that Enron could become a sustainable business corporation (Moncraz et al, 2006). 2.5 – Implementation Once, the VaR limits were defined and strategies to managing those risks were communicated, the associated risk management officers and business executives at all divisions / business units of Enron Corporation had to follow the instructions and implement the policies defined and instructed by strategic planners. In this way, not only the market and credit risks had been reduced but also the credit rating, authenticity, strength and credibility of company was enhanced in the external world (Ferill & Ferill, 2005). 2.6 - Monitor As far as the monitoring process is concerned, it should be pointed out that Enron’s Risk Management Committee was directly responsible for monitoring purposes. For instance, the concerned managers of Enron were liable to immediately bring inform RAC about the decrease or exceed to VaR limits defined by Risk Assessment and Control unit and CEO. If VaR limits were exceeded, it was considered as violation and remedial measures had to be taken by concerned risk management officers and strategic planners to maintain efficiency, effectiveness and organisational performance (Moncraz et al, 2006). 2.7 - Policy Enron had formulated and implemented certain strategies so that it could portray itself to be socially responsible and answerable to all shareholders and stakeholders. Therefore, it developed the risk management committees that would assist in strategy formulation and communication with employees, members, partners, customers, distribution channel members and shareholders. For instance, Enron also had an in-depth risk management conceptual framework that would ensure that risk management process is in-line with business initiatives and growth policies. In other words, the global giant was also interested to ensure right use and utilisation of ‘risk capital’. Also, Risk Assessment and Control (RAC) is also answerable to board of directors and works under its supervision and guidance. The main duties of this Enron’s board regarding risk management are as under: 1) The board was directly responsible to check the validation of risk management initiatives. In fact, the potential risks were identified and reviewed thoroughly after which remedial measures were assessed. Finally, the best alternatives that lead to greater risk alleviation and management were accredited to maximise company’s profits and shareholders’ wealth at the same time. 2) The Board of Directors was also responsible to expand VaR limits system so that the risk management process would comply with guidelines provided by members of board for risk – bearing. 3) Another duty of Board of Directors was to ensure the smooth functioning of Transaction Approval Process. Indeed, executives were also not allowed to conduct certain transactions of strategic importance without Board’s formal permission. 4) Board was also responsible to evaluate the scope, viability and benefits of all suggestions provided by Risk Management and other organisational committees. Without the formal approval of recommendations, the executives were not permitted to implement (Roper, 2002). 3. Key elements of a risk management strategy and recommendations that aimed at ensuring more effective management of the risk in future In order to avoid any other corporate failure like Enron that astonished global companies, industry analysts, employees, customers, governments, shareholders and other stakeholders worldwide, the researcher will provide following risk management strategy: The government authorities worldwide should formulate and implement strict audit laws, rules and regulations that will not allow any accountant or auditor to hide business accounts and provide illicit guidance and counselling to hide business debts and financial obligations, costs and actual profitability. In this way, the probability that a company may indulge in any illicit activity and prohibit international accounting laws will reduce. In addition, the risk management strategy of companies should also be developed and complied with this above mentioned suggestion. For instance, it should be made mandatory to disclose all relevant financial information and notes so that customers and shareholders of business giants could not be misled (Moncarz et al, 2006). In fact, there should be sufficient so that they could personally identify what risks are associated with changes in market factors, credit terms, commodity trade, currency and interest rate fluctuations etc. It should be mentioned that use of statistical models are an appropriate technique for risk identification, measurement and analysis is appropriate; however, qualitative models and frameworks should also be included in above mentioned process. Indeed, this will provide better insights on risk assessment and measurement to workers that do not have proficiency in understanding statistical tools, applications and calculations (Clayton et al, 2002). Another key element for effective risk management is to enhance number of regulations, laws and obligations on power and energy sector giants. This is because there is limited competition in this business sector, which leads to either oligopolistic or monopolistic nature. Hence, firms could manipulate in absence of very stringent criteria. In order to avoid the debacle like Enron, the check and balance has to be enhanced and firms have to be forced that their risk management strategies are in compliance with legal constrictions. Finally, there is need to empower workers and increase their contributions in risk management so that they could identify if employers have violated any legal matters and adopted unfair practices to mislead and delude shareholders, employees, customers and other stakeholders (Bharan, 2002) ; Czerniawska, 2003). Also, the case of Enron had directly affected employees because the funds allocated for retirement plans were wasted and misused by top executives and policy – makers. In short, empowered workers could definitely speak against such illegal surreptitious practices and implicit arrangements (Ferill & Ferill, 2005). 4. Conclusion: In a nut shell, Enron was a billion dollar business that seemed highly growth – oriented, sustainable and profitable on financial statements and company reports. However, the violation of international accounting standards and regulations by company’s accountant and auditors led to the collapse of Enron, which today is also known as biggest corporate sector failure. Enron did have a comprehensive risk management system as it endorsed the use of different statistical models, tests and tools for risk measurement and calculation, but still the lower and middle level employees were mostly unaware of hidden number game and subsequently they fail to identify the violations (Puscas 2, Darren, 2002). The disclosures by some informed personnel although unearthed the scandal; however, it has raised serious questions about implementation of international accounting and regulatory standards. Therefore, much have to be done to increase check and balance in the corporate world as this would prohibit the companies in misleading their shareholders and stakeholders. For instance, audit laws should be redefined so that auditors would no longer favour organisations even if bribes and presents are offered for any illegitimate activities (Wilson et al, 2002). References Clayton, Ronnie, William Scroggins and Christopher Westley (2002). Enron: Market Exploitation And Correction. Financial Decisions, Article 1. Puscas 1, Darren (2002). A guide to the Enron collapse. Corporate Profiles, Vol. 1 No. 2 Wilson, Arlette, G. Key and Ronald Clark (2002). Enron: An In-Depth Analysis Of The Hedging Schemes. 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Committee on Energy and Commerce, Serial No. 107–83 Roper, Barbara (2002). Investor Protection Lessons from the Enron Collapse and an Agenda for Reform. Consumer Federation of America Read More