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An Overview of Enron / Arthur Anderson Financial Scandal

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Introduction:

Enron was formed from a merger of two companies Houston Natural Gas Company and InterNorth Incorporated in 1985 (Segal, 2019). It has been named “America’s Most Innovative Company” by Fortune for six consecutive years between 1996 and 2001.

In 1992, Jeffery Skilling got SEC’s approval to switch from the traditional historical cost accounting method to the mark-to-market (MTM) accounting method. MTM is a measure of the fair value of accounts that can change over time, such as assets and liabilities (Segal, 2019). Enron has been using this method to inflate their income and profits. Andrew Fastow, CFO, had been using special purpose entities to hide their debts from creditors and investors. Enron was reporting gains on projected and expected income and on incurring losses it would transfer the asset to an off-the-books corporation, thus, making it go unreported.

On December 2, 2001, Enron declared bankruptcy. Its stock price plummeted from $90.75 to $0.26 in a matter of a few months. Investors lost about $78 Billion through the years.

Enron’s accounting firm Arthur Anderson was charged with concealing information from the SEC when their legal counsel David B. Duncan advised them to shred and destroy all documents related to Enron’s financials. They were found guilty in June 2002.

Andrew Fastow was sentenced to six years in prison and pleading guilty for fraud and money laundering (Cernusca, 2011).

Around 5,000 jobs and $1B in employee retirement fund was lost overnight when Enron filed for Chapter 11 bankruptcy (Flanagan, 2020).

Main Characters

  • Enron
  1. CEO: Jeffery Skilling
  2. Former CEO: Ken Lay
  3. CFO: Andrew Fastow
  • Arthur Anderson
  1. Partner: David B. Duncan

Ethical Issues

  1. Objectivity is must: To have the option to hold yourself and your work to the most elevated moral guidelines, you should remain objective. Now and then it gets excessively simple to rationalize or legitimize our activities when we realize our conduct is crawling toward abusing the Code of Professional Conduct.
  2. Ignorance is never a reason – Playing the obliviousness card doesn’t work. (‘In any case, I didn’t realize I was breaking the Code.’) It is your obligation to know, retain, and live by the Code of Conduct.
  3. Free pass is never gained by passing a buck– Asking another person to do what you know isn’t right or getting some distance from untrustworthy conduct doesn’t ensure you is as yet thought to be an infringement of the Code of Conduct. The ‘it wasn’t me’ pardon isn’t a reason for disregarding conduct you know isn’t right.
  4. Client infringement can never be disregarded – You’re simply working for your customer, so their thoughtless activities aren’t your concern, isn’t that so? … Doing so implies you are permitting them to intentionally damage inward controls. As it were, it’s difficult to act morally when you’re performing administrations for a customer who is endeavoring to cheat the administration, customers, investors, or speculators. Performing administrations for them makes you a backstabber in misrepresentation and no less dependable than if you did it without anyone else’s help.

Impact on the market and community

Large count of Enron employees in thousands lost 401(k) retirement plans that held company stock.

Public who had invested on Enron shares faced extreme loss as Enron stock was dropped to below $1 per share after the largest single day trading volume for any stock listed on the New York Stock Exchange.

The trust and hope were lost in the market on accounting firms especially on Arthur Andersen after getting to know that thousands of Enron documents such as physical documents, computer files, and emails which was a gigantic shock for public.

As per HG.org Legal Resources, “The legacy of Enron/Arthur Andersen live on in various changes to the profession. While prior to this case the accounting field had been supervised considerably by the Public Oversight Board (POB), after this case came to light SEC Chairman, Harvey L. Pitt, in 2002 made a series of inquiries about the system of self-regulation in the accounting profession without consulting the POB. This ultimately led to the POB voting to disband in May, 2002. As a result, the FASB emerged in the public spotlight as the leader of the system of self-regulation and has taken a significant role in the reform of accounting rules. In January, 2003, the FASB announced new accounting rules designed to force US companies to move billions of dollars from off-balance-sheet entities into the companies’ balance sheets. The SEC has enhanced its oversight of the profession, as well.”

Charges and Lawsuits

Overall, there were a total of 41 charges that were taken out against the Enron founder Kenneth Lay and the former CEO Jeffrey Skilling. Individually, Lay faced a total of six counts of fraud and conspiracy and four counts of bank fraud; while Skilling had 35 charges ahead of him. (Segal,2019)

Both gentlemen were accused of lying about the actual financial state of Enron before the company began to go under in December 2001. They began to lie about the information just when they realized there were hidden debts and highly inflated profits. In all these, both executives pleaded not guilty.

There was a total of forty-one counts leveled against both men. They are described below:

  • Count 1: – Conspiracy to commit securities and wire fraud leveled against Lay and Skilling. Skilling approved quarterly and annual misstated earnings and arranged fake conference calls with Wall Street analysts stating that Enron was doing well.
  • Count 2-6: Securities and Wire Fraud against Skilling

Skilling knowingly approved four fragile unstable financial structures to be backed by Enron stock. This stock was used to hedge inflated asset values and also used to keep millions of debts off the company’s books.

  • Count 12-13: Wire Fraud against Lay

Lay lied to Enron employees about the company’s financial health via video and teleconference. He mentioned that the third-quarter performance was looking great and that they were sure to hit their numbers. This was after he knew very well that Enron was about to announce a $1.2 billion loss in shareholder equity alone. He also knowingly held back information from analysts.

  • Count 14-20: Securities Fraud against Skilling

Skilling knowingly lied to the SEC in the quarterly and annual reports filed in 2000 and 2001. He lied that Enron’s revenues and earnings and this was because of the accounting schemes that were put in place.

  • Count 21- 26: Securities Fraud against Skilling

Skilling again lied about Enron’s revenues from the energy trading in California. He mentioned that the revenues from Enron trading in California were small; all the while lying to analysts in several calls and an analyst conference in 2000 and 2001

  • Counts 27- 30: Securities Fraud against Lay

Lay lied and misled a credit rating agency representative just a couple of days before the massive losses were announced. He also mentioned that Enron was not hiding anything even when the company’s financial health was disclosed.

  • Counts 31-36: False statements to auditors, against Skilling

Skilling apparently signed misleading letters to auditors at Arthur Anderson LLP about the truth of Enron’s financial statements in 2000 and 2001

  • Counts 38- 41: One count of Bank Fraud and three counts of False Statement to Banks against Lay.

Lay allegedly took loans adding up to $75 million from three banks and then went bank on his agreement with the lenders that he would not use the money to carry out Enron stocks

  • Counts 42- 51: Insider trading against Skilling

Skilling allegedly hid the health of the company and sold $62.6 million in stock whiles the shares were inflated by the company. One of the trades happened after he had resigned in September 2001.

Andrew Fastow was also found guilty on two counts of wire and securities fraud for aiding Enron’s corrupt deeds.

Arthur Andersen was found guilty by shredding company documents to hide them from the SEC. It was later overturned on appeal. Meanwhile, for aiding Enron’s business practices, Andrew Fastow pleaded guilty on two counts of wire fraud and securities fraud. (Segal, 2019)

New regulation after scandal

Due to the Enron scandal, the entire Wall Street community was devastated and there was strong consensus among all the financial institutes to have strong law in place that can stop such unethical behavior to occur in future. There was a need to have accurate financial reporting standards for any publicly traded companies. This topic was highly discussed among various economists and a variety of laws were suggested. After much contemplation, congress finally decided in 2002 to pass the bill signed by President George W Bush that was going to change how financial reporting for publicly held companies takes place. This law was nothing but Sarbanes-Oxley act. The Sarbanes-Oxley Act is a ‘mirror image of Enron: the company’s perceived corporate governance failings are matched virtually point for point in the principal provisions of the Act.’ (Deakin Simon, 2003). On top of the Sarbanes-Oxley Act, Variety of other measures were taken By Financial accounting standards board that would increase the oversight of financial operations in publicly held companies in order to raise ethical conduct. This led to a variety of measures such as firing and replacing underperforming managers, independent board of directors, overseeing company’s audits as well as verifying publicly disclosed quarterly reports and many more.

The Sarbanes-Oxley Act

The Sarbanes-Oxley Act was passed by congress in 2002. As per The Sarbanes-Oxley Act, the management of a public company shall report on the internal control of its annual financial reporting. Under SOX, a public company is responsible for having an internal control system and for reporting on its effectiveness. Also, management is required to disclose any internal control deficiencies and material weakness. (Henderson, 2019). Due to implementation of this law, many outside auditing organizations received thumbs up to check the accuracy of all accounting information for any publicly traded companies. This law created transparency in the financial institutes and resulted in increased trust in the stakeholder community.

Recommendation

Between the range of 1989 and 1995, Enron was named ‘America’s Most Innovative Company’ by Fortune magazine. In 2000, it was likewise the seventh most prominent organization in the United States by advertise capitalization. Despite that, the organization sought bankruptcy in 2001. Based on the theories that were illustrated, various authors thought of specific recommendations to improve corporate administration and prevent failure, for example, Enron from occurring in the future. For instance, Johnson (2002) refers to prerequisites that executives claim and keep on holding a lot of organization shares during and after their useful term, term limits, intermediary providing details regarding the reputation of directors at different companies where the person in question additionally serves on, as far as possible on the number of board posts a solitary individual can hold, parting the situation of CEO and administrator, requiring an autonomous executive when the board plays out any sort of self-assessment, exposure of individual executives’ decisions on significant issues likes, proper compensation, choice expensing, the arrangement of evaluators, merger choices, etc.

As indicated by SOA, the CEO and the CFO should likewise ensure yearly reports and may face criminal punishments in instances of reckless certifications. SOA additionally prohibits individual advances to executives and ejects motivating force-based compensation and stock deal benefits if accounts are overstated. It likewise requires senior financial officials to disclose their corporate code of ethics. Economic institute foundations should be urged to recognize financial instruction and financial data and ‘business’ finance advice. Any related financial guidance for business purposes should be transparent and reveal unmistakably any business nature where it is additionally being advanced as a financial training activity. The government should have the ongoing scandals filled in as an update that even a well-working business sector economy should continually endeavor to adjust individual and open governance responsibility. Very much structured and implemented legislation characterizes positive and negative motivations, to empower conduct that reasonable and productive activity of the commercial center (Mandaci, 2012).

Conclusion

The most reliable accounting firms can fall as a result of mismanagement in interest of a legitimate concern for clients. The Extended rule and oversight have been proposed a bill to help prevent corporate humiliations of Enron’s magnitude. The extra examination moreover protects associations and open accounting firms from submitting the sorts of mistakes that could finally add to their downfall. The essential party that could have conveniently prevented a noteworthy number of the accounting encroachment was its auditing firm. Managers at Arthur Andersen and Enron didn’t set out to decidedly influence the accounting business or any industry. They set out to get as a great deal of cash stream for themselves as quick as could be expected under the circumstances. They were glad to do whatever it took to acquire that money. These careless acts and unquenchability drove the two associations to a potential devastation in bankruptcy. Regardless, the accounting industry reacted by introducing changes that would, as time goes on, create itself and the economy in which it exists. We are probably watching the last laws, declarations, and statements that are a quick outcome of these actions. Regardless, the movements that have happened leave the accounting industry and the economy more grounded. Will the business ever be perfect? Presumably not, anyway accountants and the world must continue attempting to make it as handy as it tends to be. Just by this continued attempting can the industry be adequate to work effectively and even thrive. The Enron trades discussed now only a testing of defective trades that Enron completed which were inspected, if not pre-approved, by Andersen. They outline how much Enron, with Andersen’s assistance, went to mishandle the standards of GAAP, while dismissing their motivation. Ensuring scrutinizing the Examiner’s reports, one can simply construe that Enron couldn’t have done a significant carry out of the misleading in its financial statements without the dynamic assistance of its independent auditors. Despite the way that there is verification that Enron found aid, if not support, from various specialists, for instance, lawyers and investment bankers, the now antiquated Arthur Andersen LLP. One can simply speculate on whether a principles-based accounting and itemizing system would have prevented the abuse at Enron, or Andersen’s activity in supporting them. One of the basic inspirations to consider history is to perceive how one set of events convinced later events. There can be no vulnerability that the failure of Enron, and the implication of Andersen in that failure, have had an obvious impact on the organization and rule of unreservedly held associations in the U.S., on the audit system and the rule of firms that audit those associations, on the structure inside which assessing and accounting standards are proclaimed in the U.S., and on the FASB’s general method to manage encompassing accounting standards. The likelihood of occasion of monstrous accounting and audit failures, for instance, those at Enron and Andersen, should be on a very basic level reduced later on in light of the regulatory response to those failures.

References

  1. CERNUȘCA, L. (2011). Ethics in Accounting: The Consequences of the Enron Scandal. Agricultural Management / Lucrari Stiintifice Seria I, Management Agricol, 13(3), 35–42.
  2. Frayter, K. (2008, September). Enron investors to split billions from lawsuit. Retrieved from http://www.cnn.com/2008/US/09/09/enron.settlement/
  3. Houston, (2006, January 18). Breakdown of the charges against Enron’s top officers. https://www.nytimes.com/2006/01/18/business/worldbusiness/breakdown-of-the-charges-against-enrons-top-officers.htm
  4. Segal, T. (2019, May 29). Enron Scandal: The Fall of a Wall Street Darling. Retrieved from https://www.investopedia.com/updates/enron-scandal-summary/
  5. Deakin Simon, S. J. (2003). Learning from Enron. ESRC Centre for Business Research, University of Cambridge paper 274, 1.
  6. Henderson, E. (2019). Users’ Perceptions of Usefulness and Relevance of Financial Statement Note Disclosures and Information Overload. International Journal of Business, Accounting, & Finance, 41-56.
  7. Hartgraves, A. (2004). Andersen’s Role in Enron’s Failure. Retrieved 5 April 2020, from https://www.researchgate.net/publication/313607848_Andersen’s_Role_in_Enron’s_Failure
  8. Hg.Org. (2019). The Fallout of Arthur Andersen and Enron on the Legal Landscape of American Accounting. Retrieved from https://www.hg.org/legal-articles/the-fallout-of-arthur-andersen-and-enron-on-the-legal-landscape-of-american-accounting-31277
  9. Johnson, K., 2002. Rebuilding corporate boards and refocusing shareholders for the post-Enron era. St. John’s Law Review, Fall, Vol. 76, Iss. 4, pp.787–800. New York: St. John’s Law Review Association.
  10. Mandaci, P. E., & Kahyaoglu, S. B. (2012). The Role of Internal Auditing and Corporate Governance in Enterprise Risk Management: Empirical Evidence on Non-Financial Firms Listed in Istanbul Stock Exchange. World of Accounting Science, 14(1), 43–66.
  11. Flanagan, P. (2020). Andrew Fastow, Who Helped Bring Down Enron, Saw Himself as ‘Hero’. Retrieved from: https://www.bloomberg.com/news/articles/2020-01-09/fastow-who-helped-bring-down-enron-saw-himself-as-hero

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