Question

The Enron scandal, revealed in October 2001, eventually led to the bankruptcy of the Enron Corporation, an American energy company and de facto dissolution of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. Enron shareholders filed a $40 billion lawsuit after the company's stock price, which achieved a high of US $90.75 per share in mid-2000, dropped to less than $1 by the end of November 2001.
The company had lost the majority of its customers and had ceased operating. Employees and shareholders received limited returns in lawsuits, despite losing billions in pensions and stock prices. The US Securities and exchange commission began an investigation. Many executives at Enron were indicted for a variety of charges and were later sentenced to prison. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history.
a. Explain, what causes the reasons for the collapse of Enron? What will be the significant impact on financial accounting standards, auditing rules, and institutional structures such as FASB and the Securities Exchange Commission?
b. What precautions/measures should be taken by the management to save Enron from bankruptcy?
Your answer should be around 400 words for each question.

Answer 1

a. Explain, what causes the reasons for the collapse of Enron? What will be the significant impact
on financial accounting standards, auditing rules, and institutional structures such as FASB and
the Securities Exchange Commission?

Ans. Enron scandal case is one of the biggest fraud in the history that took place due to corrupt practices of the company's management like Lay, Jeffrey Skilling, Andrew Fastow, and other executives such as Rebecca Mark. Besides company's management this fraud was possible due to company's auditor  Arthur Andersen LLP. This incident not only lead to bankruptcy of enron but also forced dissolution of Arthur Andersen LLP one of the big five accounting firm in the world. Some of the reasons behind downfall were that company was making investments which turned unfavourable and lead to huge debts on company. Management try to hide these debts by entering into complex transactions which could not be easily understood by investors. Jeffrey Skilling constantly focused on meeting Wall Street expectations, advocated the use of mark-to-market accounting (accounting based on market value, which was then inflated) and pressurised Enron executives to find new ways to hide its debt. Audit committee of company just meet few times in a year and members were having very less experience of accounting and finance. All of above factors were responsible for enron downfall.

Here Auditor who were responsible for reporting the misconduct became part of the scandal. They never reported what was going on in company, how management was manipulating financials of the company. Reason behind there non reporting was that enron was biggest client of that firm. Besides this billables were huge from enron. But this accounting firm did not perform its role properly due to pressure from top management of company. Out of various ways this fraud was committed as reported above, there was one more aspect to this fraud. That was the creation of shell companies who bought the stocks of poorly performing enron stocks.    

To sum up auditor's role and how they hid management's manipulation, we will talk about various factors. Like thay applied reckless standards in its audits because of a conflict of interest over the significant consulting fees. They did not fairly reported as per auditing and accounting standards. They did not review revenue  recognition, special entities, derivatives, and other accounting practices. Besides this  Andersen shred several tons of relevant documents and delete nearly 30,000 e-mails and computer files, causing accusations of a cover-up when news of U.S. Securities and Exchange Commission (SEC) investigations was heard.

The significant impact on financial accounting standards, auditing rules, and institutional structures such as FASB and the Securities Exchange Commission was that after this scandal new legislation was enacted, the Sarbanes–Oxley Act which increased penalties for destroying, altering, or fabricating records in federal investigations or for attempting to defraud shareholders.The act also increased the accountability of auditing firms to remain unbiased and independent of their clients. Basically changes due to this scandal that were made were to strengthen the internal controls of the company, so that scandal like this never occurs in future.

b. What precautions/measures should be taken by the management to save Enron from
bankruptcy?

Ans. Precautions / measures that should be taken by the management to save enron from bankruptcy were :

1. Management should never do window dressing of there accounts: This was the first and foremost reason behind enron scandal. Management in order to show that there company was performing excellent started window dressing there accounts. Due to which investors believed and invested lot of there wealth in company. Although company’s assets base were eroding continuously. Resulting in bringing the company shares from $ 90.75 to $ 1 within span of one and half year. So, management needs to take care of the accounts very carefully. Implementing the accounting policies very judiciously on conservative approach.

2. Management would never encouraged auditor to issue false audit reports on there financials: This is one of the other main reason behind enron scandal. If auditor would have played his part honestly, history’s biggest scandal would have never occurred. Management should always hire independent auditors and give them free hand to report any faulty practices that are going in business currently. Management should never indulge with auditor and never bribe him to report in there favour. Auditor should be given complete independence in performing his audit procedures, so that his report give a true and fair view of company’s financials.

3. Management should have implemented strong internal controls that should have ensured in the first place that this scandal would have never taken part: Internal controls are the prime factor in any company that ensures that business is running smoothly and management is knowing every thing that is going in the company. Which in turn ensures that investors and other stakeholders are getting true picture of financial position of company from time to time. Government has also enrolled Sarbanes oxley act just to ensure the effectiveness of internal controls of company. So, management needs to implement and operate effective internal controls throughout the company.

4. Standard reporting procedures: Besides another precaution that management should have followed include standard reporting requirements and should not have entered in complex transactions to hide actual financials. This means management should ensure that there are no transactions in financial statement that are posted to hide real picture of financials of the company. Like subsidiaries should not be formed to conduct bogus transaction whose role is just to hide the actual financial picture of the company.

These could be the various precautions/measures that should have been taken by the management to save Enron from bankruptcy.