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From the 1990’s until the unfortunate scandal in 2001, the Enron Corporation was a household name in the global business community. The company was well-known for her innovations, state-of-the-art technology and daring spirit in business. The unenvisaged fall of Enron in 2001 had a devastating effect on the business world as well as on their employees. Apparently, the impressive success of Enron was a mirage and got entangled in a financial mess that was considerably of its own creation. Enron’s growth and success was based on doctored profit declarations, unethical accounting practices and fraud. The scandal marked the dawn of an era of revolutionary turnaround in corporate governance globally. It led to the birth of law reformations to prevent, or at least alleviate, future corporate failures – Sarbanes-Oxley Act 2002.
Enron’s problem was further compounded by substantial fluctuations in revenue from the business. As a result, Enron utilized strategies aimed at increasing her financial and operation performance so as to sustain the company’s investment-grade credit rating which earns her access to low-cost financing and encourage investment. Notable amongst the strategies employed by Enron were: Prepayment, syndicating assets and hedging contacts with its Special Purpose Entity (SPE).
Enron failed to comply with the United States’ Generally Accepted Accounting Principles (GAAP) in booking prepayments. According to GAAP, prepayments must be recorded as debt and cash flow from financial activity. However, in order to enhance her credit ratings and increase her share price, Enron booked prepayment as a trading liability and cash flow from operational activities. This manipulation has immense influence on the outlook of Enron’s performance.
Three criteria must be met for SPEs to be legally excluded from a company’s financial statement: a minimum of 3% of its equity must be from an external investor, the entity must be under the control of an independent party and the company must not be liable for any liability. Enron bypassed these criteria and employed the SPEs in concealing the company’s debt since high debt profile would reduce the investment grade and consequently cause banks to recall money. The SPE under the leadership of Enron’s Chief Financial Officer, Fastow, used Enron’s stock as collateral to take a massive amount of loan which was used to clear the company’s overvalued contracts. By so doing, Enron converted loans and assets with debt obligations into income using the SPE. Failure to report the incurred debts in Enron’s financial report deceived shareholders into believing that debt was not increasing and revenue was increasing.
Directors are expected to take full responsibility for governing and coordinating company’s affairs in a manner that best protects the interests of the company and its shareholders. This was not the case with the Enron’s directors, as they failed in their fiduciary duties. The Board of Directors is not only aware but also failed to go against the Company’s debatable strategies, unscrupulous policies and deceitful transactions. Some of the shortcomings on the part of the directors which contributed to Enron’s fall include: accepting high risk accounting practices, failure to prevent conflicts of interest, inadequate oversight of key business transactions and executives’ compensation and Enron’s Board of Directors’ economic bond with the external auditors.
Enron’s unethical and dishonest cooperate culture was more than enough to dishearten the company’s whistle-blowers. Even when some whistle-blowers summon courage to come forward, no action was taken to follow it up because the “whistle was blown’’ to the wrong people. The CEO and the CFO, who were supposed to take action, were directly involved in the wrongdoings being reported.
The Role of the Internal Auditor
A very crucial mechanism in internal corporate governance is the internal audit. The outsourcing of internal auditors from Arthur Andersen had an immense contribution to the fall of Enron, because it gave room for devious transactions and increased the chances for wrongdoings to go unnoticed . In addition, outsourced auditors may have hindered the effectiveness of the audit department as their reports were premised on a limited knowledge of the business.
The Role of the External Auditor
Enron’s external auditor, Arthur Andersen, played a vital role in the disaster that befell Enron. An external auditor is expected to ensure that audited financial reporting is honestly presented by management. In discharging this duty, external auditors are required to be unbiased and free from any financial interest in the audit client. Unfortunately, this was not the situation of Arthur Andersen in Enron’s case, as the auditor failed to disclose information about the company’s financial crises. Investigations revealed that the unethical action by the audit firm was probably as a result of a clash of interests due to the fact that the audit firm also renders non-audit services to Enron for a large sum.
Enron was portrayed as a steady company with good revenue but that was far from the reality. A chunk of the company’s profit claims were illusions. Enron filed for bankruptcy in late 2001 when the true financial standing of the company was uncovered and was found to be heavily indebted. The root of the Enron’s trouble is the need to access considerable lines of credit as a way of giving assurance that the company possessed adequate funds at the end of each day to clear signed contracts transacted on the company’s online platform.
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