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Enron was founded in 1985 by Kenneth Lay through a merge of Houston Natural Gas and Internorth. It owns 37,000 miles of pipelines for the use of natural gas transportation between producers and utilities. During the early 1980s, most of the contracts between gas producer and pipelines were "take-or-pay" contracts. Few years later, Enron profited from the changes in regulation of natural gas market that led to increased use of spot market transaction. In 1988, Jeff Skilling suggested a gas trading business by creating a natural "gas bank" which turns out as a huge success. In 1992, the gas trading business became a major contributor to Enron's net income. However, they starting to use off-balance sheet financing vehicles to finance these transactions. In the mid 1990s, Enron extended its business to electric power, coal, steel, paper and pulp, water and broadband cable capacity. Enron first developed the electric power market. They use "peaking plants" to meet power in need during peak periods and had some successes in this market. In the late 1990s, Enron began using "asset light" strategy where they only hold "heavy" assets for the use of generating information. This strategy is so effective until its gas financial trading represented 20 times its pipeline capacity by late 2000. Enron also expanded their business outside the U.S border. Their subsidiary was funded to construct and manage energy assets outside the U.S. which represented huge investments in the countries' economies. Though having core competence in managing pipelines, Enron still face many other risks in international diversification such as political risks.
The Enron's complex business model contributed to the fall of Enron as it had created opportunities for Enron to take full advantages of accounting limitations in managing its financial report.
First, the trading business in natural gas involved long-term contracts. In original, the accounting had been straight forward by listing the actual cost of supplying the gas and actual revenues received. However, Enron started to adopt mark-to-market accounting, when a long-term contract was signed; the present value of the stream of future inflows was recognized as revenue while the present value of the expected cost of fulfilling the contract was recognized as expenses. Thus, the market value of unrealized gains and losses under the contract were needed to be reported as annual earnings or losses when they arose later. This had created problems in the financial report as Enron estimated the present value of the future inflows even when there were serious questions about the viability of these contracts and their associated costs.
Second issue was the exercise of special purpose entities by Enron to isolate the firm from financial risks. Special purpose entities are the shell firms created by sponsors but funded by independent equity investors and debt financing. According to generally accepted accounting standards, special purpose entity only have to be consolidated with the firm's business when independent third party have substantive equity stake in the special purpose entity which are at least 3 percent of the special purpose entity's total debt and equity.
This had turned Enron's balance sheet to be unreliable when Enron was avoiding showing some equivalent debts on balance sheet by exercising special purpose entities. Other than that, the expansion of Enron's new business which were not performing as well as expected led to Enron's accounting problems.
However, all these problems were undetected for long period due to several parties failed to recognize the problems which including Enron's top management, audit committee, external auditors, fund managers and sell-side analyst.
Enron's top management heavily used stock option to create expectation of rapid growth and its effort to puff up reported earnings to meet Wall Street's expectation caused the problems concealed. Audit committee did not observed the problems occurred in the firms as they did not seriously concerned about the evolution of Enron's business and heavily relied on the information provided by management, internal auditors as well as external auditors.
Arthur Anderson, the external auditor of Enron was sued for using lax standards in their audits. There is a questionable conflict of interest over the huge amount of consulting fees paid by Enron to them. In addition, Arthur Anderson also failed to voice up sound business judgement regarding the transactions performed by Enron. The transactions were clearly designed for financial reporting rather than business purpose.
At the height of their popularity, large institutional investor owned 60 percent of Enron's stock. It drops to 10 percent after the company announced its negative accounting issues in December 2001. There are some reasons that led fund managers in so slow in noticing the problems in Enron. First, they were misled by the misstated financial statement or by sell-side analysts. Besides, their incentives to seek out high-quality information were also poor.
Sell-side analysts were slow in recognizing the problems that occurred in Enron yet recommended Enron's shares to public even 2 months before Enron's bankruptcy. One of the common practice in the industry was sell-side analyst tend to receive financial incentives in recommending Enron to their clients in order to support their firms' investment banking deals with Enron. Besides that, sell-side analysts relied heavily on internal information that provided by management which caused analyst did not provide reliable analysis due to management tend to not provide to analysts with critical and negative information.
Mechanical, inflexible accounting standards since years ago caused a company's financial report did not clearly reflect the financial risk. The arguments within Financial Accounting Standard Board (FASB) make things even worst when they did not come out with a satisfy standards.
Lots of potential ways to prevent future Enron situations arise due to the Enron case. Independent managing of audit firms, such as stops consulting business or cancels some types of audit clients' consultation was suggested by Securities and Exchange Commission. Some have proposed to restrict the rules of changes in stock options. Besides, there are firms inviting outsider as their board members and hire more professional financial officer, as well as ensure more meetings and discussions among audit members and committees.
Other than those potential ways, there are few more fundamental ways may help to solve fraudulent of financial reporting, such as changes from Audit Committees to Transparency Committees. Audit committees are basically tosz assure that firms are following the general accepted accounting principles, where the roles of transparency committees are ensuring that investors get adequate information from firms and evaluate the effectiveness of company's policies and decisions to assist either internal or external parties understand the firms' current situation, performance and future risks. Second, is to rethink the Auditor's Business Model. Successful auditor's business model comprises of good audit firm and profession auditors. A well managed audit firms hire more experts. Top management gives right incentives to the right person at the right time. Failures are analyzed by experts. While auditors maximize their value of audits through providing a true full set of firms' performance and risks to the investors, as well as minimizing the costs and legal risks of performing tasks. Finally, is to by creating an alternative environment for Institutional Investors. Capital market intermediaries such as analysts and investment banker supply unrealistic performance expectation and create unsustainable changes in stock market price, incentives for overly aggressive, fraudulent accounting, and for mismanaged firms. It is a must for investors to separate auditors from consultants, or sell-side analysts from investment bankers, other than have a deeper reconsideration of the goals, incentives and interactions among the capital market intermediaries.