In October of 2001, the country was besieged with a scandal from Enron, an energy company, headquartered in Houston, Texas. The accounting company of Arthur Andersen was also involved due to their poor auditing practices. Company executives were part of an elaborate scheme called pump and dump. The scheme involves deceptively inflating a stock price through misleading or fabricated statements so that cheap stocks are sold at a higher price. Once these shares are “dumped” onto unsuspecting buyers, prices fall resulting in investors losing money. Enron’s downfall was attributed to its complicated financial statements that confused both shareholders and analysts alike. Executives also misrepresented earnings and altered accounting ledgers in order to indicate favorable company performance.
Mid-year of 2000, Enron’s stock price reached a record high of $90 per share and plunged to less than $1 by November of 2001 and it was estimated that shareholders lost about $11 billion. This prompted an investigation by the US SEC (Securities and Exchange Commission). Enron executives were sentenced to prison.
The concept of materiality is particularly crucial in the field of accounting. The SEC chief accountant Turner stated that “The real test is whether the information would make a difference when considered by a reasonable person” (Turner, 2000). Meanwhile, in professional accounting, items that are indicated within financial statements are also determined by their materiality.
There is a need to include materiality levels in order to facilitate transparency within the field of accounting and auditing, whereby shareholders also have access to this information. Such requirements would have deemed the $51 million as material during the Enron case.
Turner, L. (2000). A QT report card for high quality financial reporting. Remarks at the Hylton Lecture Series in Accountancy: Critical Issues in Accounting Forum, Wake Forest University, Winston-Salem, NC, April 25.