The Enron Scandal Assignment, Research Paper Example

Overview

The Enron scandal was exposed in October 2001 and it involved Enron, an energy company, auditing, accounting and consultancy partnership belonging to Arthur Anderson. This famous scandal resulted in the downfall of Enron which marked one of the largest bankruptcies in the history of America at that time; Arthur Anderson was also dissolved, which was rated amongst the 5 largest accounting firms globally.

Kenneth Lay formed Enron in 1985 following a merger between InterNorth and Houston Natural gases (these were two companies dealing with natural gas pipeline).  After a number of years, Jeffrey Skilling was recruited and he then developed personnel of executives that, took advantage of the special purpose entities, poor financial reporting and accounting loopholes, were in a position to conceal many billions in debt emanating from failed projects and deals. The company’s top executive including Andrew Fastow who served as the chief financial officer were in a position to pressure Anderson to assume this issues and mislead the audit committee and the board of directors for Enron of high risk accounting concerns.

In the mid 2000, Enron’s stock price had hit a mark of $90 per share, caused the investors to lose almost $11b when it fell below a $1 by the close of November 2001. An investigation to the unanticipated poor performance was initiated by the United States Securities and Exchange Commission (SEC). Another firm by the name Dynegy offered to acquire the firm at an extremely discounted/fire price. On December 2, 2001, Enron filed for bankruptcy under Chapter 11 of the U.S. bankruptcy code. By the time it filed for bankruptcy, an agreement to be acquired by Dynegy had been reached; with its assets amounting to $63.4b, it was put forward as the leading corporate bankruptcy in the history of United States by then.

Following the bankruptcy of Enron, a number of its executives were indicted for a diversity of charges and soon after they were imprisoned. Arthur Anderson, who was the auditor for Enron was found to be at fault in a state court. By the time this ruling was reversed at the supreme court of United States, Enron had already shut down following a loss of its key customers. Shareholders together with the Enron employees lost a lot of billions in stock prices and pensions in addition to inadequate returns in lawsuits

Causes of Enron Downfall

Enron maintained a complex business model that stretched the accounting limits, that requires every company to utilize accounting limitations in the management of its earnings and the modification of the balance sheet so as to portray a constructive representation of its performance. The financial statements for Enron Corporation were non-transparent and thus failed to clearly specify its finances and operations with analysts and shareholders. Starting from late 1997, until Enron collapsed, its accounting and financial transactions were primarily motivated by the objective of keeping the reported asset values inflated, cash flow up, plus liabilities off the company records/books (Healy & Palepu, 2003). The Enron scandal slowly developed from a constant accumulation of values, actions and habits that started a number of years before and which finally ran beyond control (McLean & Elkid, 2004).

Majority of these transactions were perpetuated by direct actions or the indirect knowledge of a number of executive including Andrew Fastow, Jeffrey Skilling and Lay. As an ongoing practice, Jeffrey Skilling clearly focused on beating the expectations of Wall Street and thus pushed for the application of market-to-market accounting in addition to mounting pressure on Enron executives to come up with fresh techniques of concealing its debt. To achieve this, these executives together with Andrew Fastow, produced bewildering deals, complex financing structures and off-balance sheet mediums that can only be understood by a few individuals to date. The blend of these deals and issues subsequently yielded the bankruptcy of Enron Corporation.

Special Purpose Entities

These entities included companies and limited partnerships that were created to fulfill a particular or temporary purpose, say to manage or fund risks linked to certain assets. Enron only supplied limited use of these entities, though they were financed through debt or independent equity investors, but created through a sponsor. Enron had used 100s of such shell entities to conceal its debt e.g. through circumventing accounting conventions. This enabled Enron to overstate its equity, overstate its earnings and understate its liabilities in the balance sheet (Salter, 2008). The shell companies and limited partnerships that were created to fulfill a particular or temporary purpose by Enron included: JEDI and Chewco, Whitewing, LJM and Raptors, etc.

Revenue Recognition

Energy merchants including Enron earned their gains by developing natural gas, storage, pipelines, processing facilities, electric power plants whilst offering diverse services that included risk management and wholesale trading (Dharan & Bufkins, 2004).  These merchants were mandated to report cost of products’ as the cost of sold goods and the selling price as the revenues, while taking the peril of selling and buying products. On the contrary, an agent offers a service to a customer without taking similar risk as that of merchants for buying as well as selling. When service providers are classified as agents, they are in a position to report brokerage and trading fees as revenue, but not for the whole transaction value.

Taking advantage of the apparent loophole, Enron opted to report the whole value of every trade belonging to it as revenue (merchant model), as opposed to agent model where only brokerage and trading fee could be reported as revenue. The Enron’s “merchant model” technique was thought to be more aggressive in the interpretation of accounting as opposed to the agent model (Healy & Palepu, 2003). The Enron’s approach inflated its revenues from trading. These highly inflated revenues created an impression of high growth, spectacular business performance and innovation than the concealing of debt. Enron had recorded a 750% growth in its revenues, rising from $13.3b- $100.8b from 1996 to 2000 respectively (Dharan & Bufkins, 2004)

Market-to-Market Accounting

Enron’s accounting used to be unambiguous in its primary natural gas business as noted by the company’s listing of actual costs incurred in supplying the gas plus actual revenues obtained from selling the gas.  However this changed when Skilling joined Enron and demanded a marker-to-market accounting approach be adopted in the trading business; claiming that this would reflect a true economic value. Enron went ahead to apply the same in its long-term contracts that were very complex. This approach required that the net future cash-flows be discounted to present value once a long-term contract was signed, despite the fact their related costs and viability were difficult to determine. This implied that investors continued to receive misleading or false reports owing to these discrepancies, since income from projects continued to augment financial earnings which could not be added in future.

Poor Corporate Governance

Enron had a complex network of intermediaries and corporate governance. Despite this fact, it continued to conceal its actual performance through a chain of financing and accounting maneuvers, hype its stock value to unsustainable levels, and attract huge capital funding for its questionable business model.

Executive Compensation

Enron’s performance and compensation management system encouraged employees to look for instant and high-volume deals, which disregarded the quality of profits or cash higher companies and limited partnerships that were created to fulfill a particular or temporary purpose, flows, so as to attain a higher rating in the company’s performance review.

Risk Management

Enron’s use of questionable and aggressive use of special purpose entities and derivative can be blamed for its bankruptcy. It hedged its risks with shell entities that it owned thus retaining each and every risk inherent to the transactions involved. The board of directors for Enron also knew of the risky accounting practices that were being applied in company’s financial reporting, but never took any step to minimize this risk (Fusaro & Ross, 2002).

Financial Audit

Arthur Anderson was Enron’s auditor. He applied reckless standards in his audits plus a conflict of interest as he received substantial consulting fees from Enron.

Principles and Rules Being Enforced To Prevent Occurrence Such As Enron Scandal

Following the occurrence of Enron scandal, a number of accounting principles were introduced, fresh legislation and regulations were are enacted so as to enhance and expand financial reporting reliability. These include:

Sarbanes-Oxley Act

This Act almost reflects the circumstances of Enron. The Act expands the repercussions for fabricating, altering or destroying records in an attempt to defraud shareholders or in any federal investigations. The Act seeks to enhance the accountability of each and every auditing firm to remain independent of their respective clients and to remain objective.

S. Securities and Exchange Commission (SEC)

This is an independent agency of the U.S. government responsible for regulation of securities industry and the enforcement of federal security laws. SEC prevents various corporate abuses that relate to corporate reporting, the sale and offering of securities. SEC has the mandate to regulate and license stock exchanges, companies trading their securities in those stock exchanges, dealers and brokers who conduct the trading (U.S. Securities and Exchange Commission, 2009).

The Credit Rating Agency Reform Act Of 2006

This is a federal legislation that is intended to improve and promote quality ratings so as to protect the interest of investors and that of the public by fostering competition, transparency and accountability within the credit rating industry.

Revenue Recognition Principle

This is an accounting rule that states a reporting entity must only recognize revenues or sales within the accounting period during which they arise, plus measure them on the particular date in which they arise, if and only if, it can establish both their measurement and occurrence with sufficient reliability (Financial Accounting Standards Board, 2008).

References

Dharan, B.G. & Bufkins, W.R. (2004). Enron: Corporate Fiascos and Their Implications. New York: Foundation Press.

Financial Accounting Standards Board (2008). Statement of Financial Accounting Standards No. 66, Paragraph 65. Retrieved March 23, 2009 From . http://fasb.org/pdf/aop_FAS66.pdf

Fusaro, P.C. & Ross, M.M. (2002). What Went Wrong at Enron: Everyone’s Guide to the Largest Bankruptcy in U.S. History. New York: John Wiley & Sons.

Healy, P.M. & Palepu, K.G. (2003). The fall of Enron. Journal of Economic perspectives, 17 (2): 10.

McLean, B. & Elkind, P. (2004).The Smartest Guys in the Room. New York: Portfolio Trade.

Salter, M.S. (2008). Innovation Corrupted: The Origins and Legacy of Enron’s Collapse. Massachusetts: Harvard University Press.

U.S. Securities and Exchange Commission (2009). How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation (Securities and Exchange Commission). Retrieved November 13, 2009 from http://www.sec.gov/about/whatwedo.shtml#org