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Enron was founded in 1985 by Kenneth lay as a natural gas company when the U.S. gas market was in the midst of deregulations. The company took advantage of this deregulation, by offering long term contracts with fixed prices to guarantee gas buyers stable prices for the duration of the contract since one of the side effects of these deregulations was exposing gas buyers to short term volatile gas prices. With this at hand the company grew to be the biggest seller of natural gas in North America by 1993 recording$ 316 million earnings before tax. Consequently Enron expanded worldwide gaining market share and extending their commodities in Europe, Asia, Africa and South America
As a result of diversification and growth, Enron's share price rose sharply until 1998 by more than 300%.By 2000 Enron share price was valued at $90, an increase from $ 0.8 in 1989.However due to its creative accounting practiced by its internal auditors, and not been exposed by external auditors for the reason of the significant compensation they were receiving from Enron, the company shares lost value extensively. The securities exchange commission (SEC) lodged an investigation into potential conflicts of interests between Enron, its directors and the special partnerships in 2000.Nevertheless, its major competitor (Dynergy) which had agreed to acquire it, the November 28 credit rating which downgraded Enron's debt as junk-bonds made Dynergy to pull out of the merger. Consequently on 2nd December 2000 Enron filed for bankruptcy
Why is accounting being blamed for the losses sustained by investors as a result of the collapse of the company? Is this criticism fair and do financial accounting and reporting practices need to be reformed?
Accounting is been blamed because there was financial misrepresentations. Enron used two main tactics to misrepresent financial statements. The first one was of creating ghost companies (special purpose companies (SPEs)) which they used to transfer money to and from and also banks would give loans to. The end result was a complex set of financial statements which disguised the loans as cash flows therefore making the financial statements look very healthy. According to Albrecht (2003), Many Enron SPEs transactions were timed (or illegally back-dated) just near end of quarters so that income could be booked just in time and in amounts needed, to meet investor expectations .He also goes ahead to explain that, these SPEs were not illegal because as at the time, the EITF 90-15 resolution created in 1990, only required 3% of capital/assets to be contributed by independent external sources. Thus this resolution was a license to create imaginary profits and hide losses as it was not a must to consolidate the financial statements even though the 97% of the capital came from the parent company. With this kind of a loophole Enron was able to fully exploit the chance and consequently the accounting is been blamed because of this. All in all the American standards of accounting allowed it at the time. Albrecht says that In the U.S., accounting standards were "rules-based" instead of "principles based. This Allowed companies and auditors to be extremely creative when not specifically prohibited by standards
The second tactic Enron used was procedure known as mark to market. This method allowed it to increase the value of present assets held by the company (e.g. long-term contracts for the sale of energy) by estimating future market prices. Since Enron had a significant control of the energy trading business, the prices which were marked to be marketed were largely subjective i.e. established by Enron itself in accordance with the profits it wanted to report. These manipulations did not increase the reported cash flow, since no money from the listing was actually coming in; instead they overestimated earnings by hiding losses and debts from SPEs. This practice was not illegal but Enron used it excessively as they were under pressure to beat earning estimates.
However it's not only this tactics that allowed accounting to be blamed but also its auditors. Andersen the auditing firm for Enron and one of the biggest in the world at the time is to blame also. According to Thomas (2002), Andersen had the job not only of Enron's external but also its internal audits. He claims that Andersen kept a staff on permanent assignment at Enron's offices and that Many of Enron's internal accountants, CFOs and controllers were former Andersen executives. Therefore because of these associations and the significant amount of fees Andersen was receiving from Enron its auditing independence was compromised.
The financial criticism is fair because as I have mentioned above the U.S., accounting standards at that time were "rules-based" instead of "principles based .This allowed the companies to practice creative accounting and there were many loopholes. For this reason the standards need to be changed. The introduction of financial accounting standards (FAS) 57 took care of the disclosure of SPEs. However the current discussion and implementation of IFRS (international financial reporting standards) will be a major boost to curb the accounting scandals in future. Thus the American GAAP should be extensively reviewed and once the IFRS is complete they should adopt them. All in all it is not going to be easy implementing them as different people have different ideas about particular items. Considering that these rules will be used by accountants from different countries and who abide by different personal principles will be a major tag of war before they are implemented.
If capital markets are efficient, does it make any difference as to what accounting policies are adopted by a company as long as they are adequately disclosed?
In the major stock markets, prices are set by forces of supply and demand. There are also hundreds of analysts and thousands of traders each getting fresh information about companies through electronic and paper media. The moment an unexpected, positive or negative piece of information leaks out investors will act and prices will either rise or fall rapidly. This information should neither be biased nor irrelevant and therefore the price change will reflect the information that was released. This is what is termed as efficient capital market. All in all it is defined as the degree to which the present asset price accurately reflects current information in the market place (financial dictionary 2004).
Capital market cannot work efficiently if the information from the companies is not reliable. Thus companies need to disclose all relevant and reliable information from their financial statements. The financial statements tend to give all kinds of signals to the market but it also depends with the interpretation. Most investors look at the dividends policies and the profit the company is making .With this kind of information they are able to make decisions as to whether to invests in a company or not. However some companies use creative accounting to cheat on the information if they are doing badly so that they can give a positive sign. All this depends on the accounting policies that the company has adopted and whether it is using it appropriately.
In our case Enron did don't adequately disclose the information to the investors. Due to the reason of their complex business model they were able to manipulate the financial information by claiming that the all the information was in the notes while the notes language was very complex. Enron also had adopted the ruled based principles which according to Basset and Storrie (2003), the rules-based system that guides U.S.GAAP make people to look, not at whether the information presented to the Market has a true and fair characterization of the condition of the company, but at whether it complied with the rules. This tends to make people be concerned less about accounting principles.
Enron used four main ways to hide and manipulate their financial information and presentations.
Wash and Roundtrip Trades: These are transactions in which there is no real counterparty. Enron appears to have essentially been "trading with itself" in a number of cases, seemingly to inflate its revenues and possibly its asset values without generating any tangible economic benefits.
â€¢ Mark-to-Market Accounting: Enron improperly applied this principle which is accepted by accounting standards in marking certain transactions to their current market values to create false accounting results. This information when used in the capital markets prompted the investors to invest heavily knowing the company is doing well when actually it was not.
â€¢ Revenue Recognition: Enron apparently booked trading revenues on many energy transactions when the deals were first entered to, instead of waiting for the actual economic profits to be earned over the life of the transaction.
â€¢ Special Purpose Entities: Enron used certain SPE inappropriately to facilitate improper wash trades and mark-to-market accounting. As a result it hide its total indebtedness and inflated certain asset values.
With this kind of complex accounting Enron was able to hide a lot of information and thus the investors made their decisions blindly. Creative accounting which was practiced by Enron could not be realized because even in a semi strong form of efficient market hypothesis (EMH) it is not easily noted unless it is wholesale and by this time it will have presented a very big fraud and lies. In a semi strong EMH the share price fully represent the publicly relevant information available. This does not only include past price movements but also earnings and dividend announcements, rights issues, technological advancements, resignations of directors etc.
With all this going on we have to ask ourselves what it the purpose of the financial statements if they cannot be trusted when released from the companies. Well for now since it's the only measure that we have to measure the performance of the company we need to improve the rules that guide this reporting. If strict rules and loophole are discover and counter measure applied then I think the financial statements will have an increase value of to investors.
To what extent did Enron use off-balanced sheet financing in its operations? Were these transactions appropriately treated and adequately disclosed in the financial statements of the company? What consequences did the accounting treatment of these transactions have for Enron and its investors?
Off balance sheet financing is any form of funding that avoids placing owners' equity, liabilities or assets on a firm's balance sheet (glossary encyclopedia 2009). This is generally accomplished by putting those items on some other entity's balance sheet. This is mostly used by companies who want to hide their debt because it allows a company to appear more creditworthy but at the same time misrepresents the firm's financial structure to creditors, shareholders, and the public.
Enron used SPEs to do it off balance sheet financing because the US GAAP allowed SPEs to qualify for non-consolidation if they had an outside equity of at least 3% of the SPE's total assets .This advantage made it possible for Enron not to report the assets and liabilities from these SPE's in the balance-sheet, but rather buried them somewhere in the notes with language that was not so clear. The reason for this was because it was acquiring a substantial amount of cash by using them to get loans and for those that reported losses, there was no need of associating them with Enron since it was a bad image.
All in all Enron continued using this SPEs to borrow money .i.e. Enron would use its stock to guarantee bank loans that were taken by SPEs since its stock had very good price. Besides this Enron allowed one of its officers (Fastow) to play a major role in the dealings of these SPEs and made a lot of money. Enron having transferred all its stocks to SPEs it needed to maintain the credit capacity of these SPEs and what better way to do it than increase the value of the stocks. By this increase Enron would provide enough value to cover all liabilities and still result in substantial returns to the chief executives and other investors. Wilson and Campbell (2003) say that, the strategy of using Enron's own stock to hedge its investment losses was so successful with SPEs that Enron continued this same strategy for all its investments that were likely to have significant declines in value. Actually as it was later revealed that Enron had 900 SPEs in which they conducted this strategy with.
The huge amounts of money, media coverage and reputable name gave Enron a reason to continue with this scam. The losses from this SPEs were not reported and those that were reported were put into very confusing language to hide them in the financial statements. This lack of disclosure was against the GAAP and therefore the investors were not been provided with the right information. This continuance use of borrowing using SPEs gave Enron a lot of pressure in keeping its stock prices up. Enron needed to keep its credit rating high so that it can continue to hide some of its big debts in the shell companies that it had created. Things took a new turn in 2000 as a result of the bubble dotcom. There is nothing Enron could do since it was happening to all companies whose shares had a good growth over the last decade. With this Enron's share started falling and the fraudulent transactions started revealing themselves. Some of its SPEs were wound up since they had massive debt and Enron could not handle them.
When this information came to light, investors started loosing confidence as the stock prices were going down fast .The audit firm recognized this and advised Enron to restate earning going back several years. For this reason the losses had to be revealed and SPE transactions included in the financial statements. The losses run up to 40 billion dollars worth from fraud only. These restatements and revaluations would not in themselves have bankrupted Enron .However, the events of 2001 shook market confidence for Enron, which had already been undermined by Skilling's unexplained resignation as CEO in August of that year. Consequently Enron credit rating went down. As the credit status declined (eventually falling below investment grade level),debts automatically fell due and liabilities accumulated under the terms of its loan agreements. Following this was a run to selling the Enron shares by share holders to avoid making big losses. Eventually the company was declared bankrupt making investors to incur huge losses and employees loosing their jobs.
If the treatment of off-balance sheet financing was not appropriate, what does this say about the financial reporting and accounting practices in the company and required by accounting regulators?
Enron engaged in various transactions that were spontaneous to pull off, off-balance-sheet treatment. Many of those transactions were well thought-out using SPEs. US GAAP only allowed off balance sheet financing only if, an SPE independent third-party investors made a substantive capital investment; generally at least 3% of the SPE's assets, and the third-party investment were genuinely at risk, among other things. If the third-parties were not truly independent, or their investments were not truly at risk, those transactions using the SPEs were improper for off-balance sheet treatment. However, Enron had other ideas. It fraudulently practiced off balance sheet financing by guaranteeing the SPEs in the loans they were taking and further more one of their executive was involved in the business dealings of this SPEs consequently violating the conditions. Thus it was dishonest in its financial statements presentation by not consolidating the SPEs. Though the US GAAP had a loophole at that particular time which Enron found it and excessively utilized it, it was dishonest to its investors and in its accounting by lacking to disclose all the information.
All in all Enron cannot be blamed wholly for this mess because in it right sense it was just following the US GAAP but rather just over utilized the loophole they found. Such loopholes should not be found in accounting standards as they can lead to very big problems in accounting. The FASB should be able to discover such things and set higher rules and regulations for them. According to Benston et al (2003) after the Asian financial crisis of 1997-98, Americans held out their systems of corporate governance and financial disclosure as models to be emulated by the rest of the world. However, the funny thing is that, barely 2 years later came one of the biggest corporate scandal "ENRON". This goes way forward to prove that the US GAAP at that particular time was very popular and people were confidence with them. The only problem is that the accounting standards setters relaxed instead of learning from what had happened in Asia. Eventually the US was hit by a scandal of its own leaving a question mark of their accounting standards. Investors started loosing confidence in the accountants and auditors and it was very difficult to convince them to invest in some positive investments. The lack of flexibility in changing the accounting rules and regulations in accordance to the changing world of economy is what perhaps made the loopholes like that Enron used, to emerge. Everyday people are getting clever at what they do and looking for better ways to benefit themselves and it is the responsibility of the accounting standards setter to make sure that they stay ahead of the game to avoid many people who rely on them e.g. investors, governments, customers, general public etc from been defrauded by cheeky people in the business world. By doing this, it is bound to minimize such scandals in future. The only question is are these standards setters up to the task or are they just too rigid and relaxed to reform?
However we cannot entirely say that they have not changed or are not willing to change but, it is the pace at which they regulate the standards am concerned with. According to business week (2002) the Financial Accounting Standards Board, was too slow to respond to changes of new rules of the economy. It goes ahead to explain that the FASB had been considering rules on special-purpose entities for more than 20 years. This is a long time to consider flexibility especially in the accounting industry. If left out for such a long time there will emerge a person who will discover a loophole and manipulate it as this what happened to the case of Enron. This should be prevented at all cost as it destroys the name of the accounting profession. Since the FASB is a board with high integrity persons, I would recommend that they move fast and in contrast to the way the world is changing rather than waiting for scandals to happen then they pick up from there. The recent move of harmonizing the accounting standards all over the globe is step to the right way as this will enable a more flexible system and minimize accounting frauds.
Are principle based types of accounting standards more effective in dealing with accounting abuses than the more rule based standards of the US?
The recent accounting scandals in the global economy have led us to ask a question on whether the rule base system of accounting is a good accounting system. This is because most of these scandals have aroused from the US which practices this system. Following the Enron fiasco, many commentators like wallison (2007) argue that the rules-based accounting system in the United States has provided a road map for abuse and I have to agree with it.
Following the US fiasco I will have to agree that principle based are better. This is because Rules-based systems encourage creativity by allowing accountants to stretch the limits of what is tolerable under law, even though this may not be ethically or morally acceptable. Rules-based systems only ensure what is required technically is achieved and ignore the substance of a rule. However, on the other hand, principles-base approach requires companies to report and auditors to audit the substance of the transaction, allowing managers and auditors to exercise professional judgments to ensure the accounting treatment is fair and reasonable. This allows better decision-making and a more honest and open description of the status of a business. All in all there are more reasons as to why principles based are better in combating accounting abuses. Some of them are as follows
Principal based systems contain broad guideline that allows them to be applied in many situations. this make them avoid the pitfalls associated with specific requirements in contracts which often lead to accountant only been concerned with following rules rather that focusing on what is right. This principle based is vital to be applied as different things can be viewed from different angles and becomes very easy to detect an error or a fraud. unlike the ruled based which is very hard to detect an error, this principle based makes it easy for senior management and the auditors to detect juniors and other staff if they are defrauding the company and if the correct practice is been followed. Thus a detailed description of what an accountant or any other member who follows and does accounting is bound to bring difficulty in doing their work and this is dangerous.
Principles based accounting standards also allow accountants to apply professional judgment in assessing the substance of a transaction. They simply do not have to follow the rules as compared to the rule based standards but rather follow their own judgments according to accounting principles. With this kind of behavior it is bound to increase the level of professionalism among accountants and be more credible in their work.
With the way the world economy is moving the rule based standard of accounting is bound to be in a lot of difficulty. This is because its flexibility level is very low. On the other hand principle based is well equipped to handle the emerging transactions which are becoming more and more evident in today's global economy. Its broad application in a variety of transactions as well as allowing accountant to practice their judgment gives it a positive recommendation of the way to the future.
Enron is liable for defrauding its investors and we cannot entirely blame it .accounting is another aspect that should be blamed for what happened in Enron since the accountants followed the rules and at that particular time they ware right. They just utilized a loophole in the accounting standards to maximize their profits. All in all it was wrong and accounting bodies should learn from this. Thus they should come up with standards that are less venerable to loopholes and counter measures of tacking problems. I have recommended for them to follow principle based standards since they are less venerable and more transparent in creating the international financial reporting standards .this will harmonize the world wide GAAP and corporate scandals arising from misuse of accounting will be reduced.