Question

Find information regarding the Enron bankruptcy. and how exactly they filed for bankruptcy Discuss what went wrong with it's governance and why regulators/auditors could not see what was happening with the firm. Please list sources and references, thank you!

Answer 1

Enron scandal

1) An overview: Enron scandal, series of events that resulted in the bankruptcy of the U.S. energy, commodities, and services company Enron Corporation and the dissolution of Arthur Andersen LLP, which had been one of the largest auditing and accounting companies in the world. The collapse of Enron, which held more than $60 billion in assets, involved one of the biggest bankruptcy filings in the history of the United States, and it generated much debate as well as legislation designed to improve accounting standards and practices, with long-lasting repercussions in the financial world.

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, Texas, and the dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. In addition to being the largest bankruptcy reorganization in American history at that time, Enron undoubtedly is the biggest audit failure. It is ever the most famous company in the world, but it also is one of companies which fell down too fast. In this paper, it analysis the reason for this event in detail including the management, conflict of interest and accounting fraud. Meanwhile, it makes analysis the moral responsibility From Individuals’ Angle and Corporation’s Angle.

2) Inherent risk: Enron’s accounting for stock was inadequately disclosed causing conflict of interest through understating the liability and overstating Owner’s Equity to satisfy stakeholders (Benson and Hartgraves, 2002). Arthur Andersen may have labelled their detection risk as ‘low’ to ensure trust in the inherent and control risk. According to Lev (2002), Enron’s internal procedures indicate that due to their high amount of intangible assets, the inherent risk would be greater as the economic value added to the firm would have diminished faster than their physical assets.

Specially in complex financial instruments and structured financial transactions and be comfortable that there is an effective system of internal control in place covering operations, financial reporting and compliance objectives.

3) Key accounting policies of Enron: (using “mark to market” and SPE as tools)

1. Mark to market :

As a public company, Enron was subject to external sources of governance including market pressures, oversight by government regulators, and oversight by private entities including auditors, equity analysts, and credit rating agencies. In this section we recap the key external governance mechanisms, with emphasis on the role of external auditors. This method requires that once a long-term contract was signed, the amount of which the asset theoretically will sell on the future market is reported on the current financial statement. In order to keep appeasing the investors to create a consistent profiting situation in the company, Enron traders were pressured to forecast high future cash flows and low discount rate on the long-term contract with Enron. The difference between the calculated net present value and the originally paid value was regarded as the profit of Enron. In fact, the net present value reported by Enron might not happen during the future years of the long-term contract. There is no doubt that the projection of the long-term income is overly optimistic and inflated.

2. SPE - Special Purpose Entity

Accounting rule allow a company to exclude a SPE from its own financial statements if an independent party has control of the SPE, and if this independent party owns at least 3 percent of the SPE. Enron need to find a way to hide the debt since high debt levels would lower the investment grade and trigger banks to recall money. Using the Enron’s stock as collateral, the SPE, which was headed by the CFO, Fastow, borrowed large sums of money. And this money was used to balance Enron’s overvalued contracts. Thus, the SPE enable the Enron to convert loans and assets burdened with debt obligations into income.

In addition, the taking over by the SPE made Enron transferred more stock to SPE. However, the debt and assets purchased by the SPE, which was actually burdened with large amount of debts, were not reported on Enron’s financial report. The shareholders were then misled that debt was not increasing and the revenue was even increasing.

4) Fall-out of Enron: In May 2001, Enron’s executive Clifford Baxter left the company, apparently in uncontroversial circumstances. It was rumored that Baxter, who later committed suicide, had clashed with Jeff Skilling (Enron’s CEO), over the righteousness of Enron’s partnership transactions.

On 14th August 2001, Jeff Skilling resigned as Chief Executive, citing personal reasons and Kenneth Lay became Chief Executive Officer. Skilling’s departure was prompted by concerns over Enron's bungled accounting and bad management.

In mid August 2001, Sherron Watkins, Enron’s Corporate Development Executive, who was later referred to as the “whistleblower” in the Enron scandal, wrote a letter to Kenneth Lay warning him of accounting irregularities that could pose a threat to the company. This development shocked investors who suddenly panicked. The lack of transparency sent a selling wave in the market. Investors sold millions of shares, knocking almost $ 4 off the price to less than $40 over the course of the third week of August 2001.

In spite of the drop in price, management still insisted all was well. Despite the air of impending doom, Kenneth Lay found two banks willing to extend credit. But the worst of revelations were to come yet.

On 8th November 2001, the company took the highly unusual move of restating its profits for the past four years. Enron effectively admitted that it had inflated its profits by concealing debts in its complicated partnership arrangements (Special Purpose Entities).

On 9th November 2001, the humiliation of Enron appeared complete as it entered negotiations to be taken over by its much smaller rival, Dynegy. The following graph shows how Enron’s restated accounts. Enron filed for bankruptcy in December 2001 and filed a suit against Dynegy for pulling out of the proposed merger. Enron’s share price collapsed from around $ 95 to below $ 1. Enron’s employees lost their savings as well as their jobs. Mr. Kenneth Lay, the once renowned visionary chairman of the firm, resigned in January 2002.

It appears now that the phenomenal success of Enron was a daydream and it seems to have sunk into a financial predicament that is largely of its own creation. In just sixteen years, Enron grew into one of America's largest companies, however, its success was based on artificially inflated profits, questionable accounting practices and fraud. Several of the company’s businesses were losing operations; a fact that was concealed from investors using off balance sheet vehicles or structured finance vehicles.

Arthur Andersen ( Enron’s Auditor) : one of the world's five leading accounting firms, was Enron’s auditing firm. This means that Andersen’s job was to check that the company’s accounts were a fair reflection of what was really going on. As such, Andersen should have been the first line of defense in the case of any fraud or deception.

Arguments about conflict of interest had been thrown at Andersen since they acted as both auditors and consultants to Enron. The company earned large fees from its audit work for Enron and from related work as consultants to the same company. When the scandal broke, the US government began to investigate the company’s affairs, Andersen’s Chief Auditor for Enron, David Duncan, ordered the shredding of thousands of documents that might prove compromising. That was after the Securities and Exchange Commission (SEC) had ordered an investigation into the speculative actions of Enron. Duncan said he was acting on an e-mail from Nancy Temple, a lawyer at Andersen, but Temple denied giving such advice.

While Andersen fired Duncan, its Chief Executive Officer, Joseph Berardino, insisted that the firm did not act improperly and could not have detected the fraud. Berardino conceded that an error of judgment was made in shredding documents, but he still protested Andersen’s innocence.

5) Purpose of Audit: The objective of an audit is to form an independent opinion on the financial statements of the audited entity. The opinion includes whether the financial statements show a true and fair view, and have been properly prepared in accordance with accounting standards. A misconception is that auditors are required to identify all misstatements. However, they are responsible for identifying material misstatements, not all misstatements.

The demonstration of Enron and Arthur Andersen’s involvement in influencing financial statements has resulted in one of the biggest corporate collapses in US history. Both firms encountered conflict of interest through familiarity threats and they have breached their standard of care in presenting untruthful and unfair financial statements, which were not in accordance with ACA and ASB requirements.

6) Reason for scam: The lack of truthfulness by management about the health of the company, according to Kirk Hanson, the executive director of the Markkula Center for Applied Ethics. The senior executives believed Enron had to be the best at everything it did and that they had to protect their reputations and their compensation as the most successful executives in the U.S.

Other Reasons- Conflict of interest, Segregation of duties, Inadequate financial disclosures, Inadequate auditor opinion.

As corporate acts originate in the choices and actions of human individuals, it is these individuals who must be seen as the primary bearers of moral duties and moral responsibility.

The then chairman of the board, Kenneth Lay, and CEO, Jeffrey Skilling, to allowed the then CFO, Andrew Fastow, to build private cooperate institution secretly and then transfered the property illegally. The CFO, Andrew Fastow, violated his professional ethics and took the crime of malfeasance. When the superior, the chairman of the board of Kenneth Lay and CEO Jeffrey Skilling, ordered conspiratorial employees to carry out an act that both of them knowing is wrong, these employees are also morally responsible for the act.

The courts will determine the facts but regardless of the legal outcome, Enron senior management gets a failing grade on truth and disclosure. The purpose of ethics is to enable recognition of how a particular situation will be perceived. At a certain level, it hardly matters what the courts decide. Enron is bankrupt—which is what happened to the company and its officers before a single day in court. But no company engaging in similar practices can derive encouragement for any suits that might be terminated in Enron’s favor. The damage to company reputation through a negative perception of corporate ethics has already been done. Arthur Andersen violated its industry specifications as a famous certified public accountant.

7) Sarbanes Oxley Act : The Sarbanes-Oxley Act of 2002 cracks down on corporate fraud. It created the Public Company Accounting Oversight Board to oversee the accounting industry.It banned company loans to executives and gave job protection to whistleblowers.The Act strengthens the independence and financial literacy of corporate boards. It holds CEOs personally responsible for errors in accounting audits.

The Act is named after its sponsors, Senator Paul Sarbanes, D-Md., and Congressman Michael Oxley, R-Ohio. It's also called Sarbox or SOX. It became law on July 30, 2002. The Securities and Exchange Commission enforces it.