Impact of the Enron Scandal on Accounting Standards

Abstract

Every firm and its managers are expected to maximize investor returns while complying with regulatory standards, avoiding principal-agent conflicts of interest, and enhancing the reputational capital of their firms. However, in practices, being ethically is not just about giving large sum of charity’s money but recognizing and acting on potential ethical issues before they become legal problems are more important aspects to taking care of. Enron collapsed as the result of unethical management practices such as the equivocation of taxes and fraudulent accounting practices. The Enron scandal is the most significant corporate collapse in the United States since the failure of many savings and loan banks during the 1980s. This scandal demonstrates the need for a close look at the ethical quality of the culture of business generally and of business corporations in the United States. Organization need to infuse ethics and integrity throughout their corporate cultures as well as into their definition of success. Unethical and illegal business practices at Enron led to the creation of Serbanes – Oxley Act of 2002. This report will discuss and find out illegal and unethical activities, impacts on stakeholders and lessons from the Enron case.

The Enron Scandal and Ethical Issues

Enron Corporation is an energy trading, natural gas, and electric utilities company located in Houston, Texas that had around 21,000 employees by mid-2001, before it went bankrupt. Its revenue in the year 2000 was more than $100 billion and named as “America’s most innovative companies for six consecutive years by Fortune. Enron was a company that was able to profit by providing the delivery of gas to utility companies and businesses at the fair value market price. Enron was listed as the seventh largest company in the United States and had the domination in the trading of communications, power, and weather securities (Corporate Narc, nd).

At first sight, Enron looks like an excellent corporate citizen, with all the corporate social responsibility (CSR) and business ethics tools in community (Sims & Brinkmann, 2003). However, the scandal of Enron has been the largest corporate scandal in history, and has become emblematic of institutionalized and well-planned corporate fraud; the Enron scandal involves both illegal and unethical activities.

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According to Carroll and Buchholtz (2008), the CFO Jeffrey Skilling and the CEO Ken Lay played major roles in the Enron scandal. Both of them committed securities fraud and conspiracy to inflate profit. In disguise debts of Enron, Lay and Skilling used off-the-books partnerships, after that “they lied to investors and employees about the company’s disastrous financial situation while selling their own company’s shares” (Carroll & Buchholtz, 2008, p. 256). Enron’s top level management has violated several accounting laws, SPE laws, and bent the accounting rules to satisfy their own desires of profit in the short term but ignoring long term repercussions for investors, stockholders, employees and the business itself. The close relationships that were formed among top leading executives and the board of directors grew arrogant, thinking they were invincible and causing them to act in an unethical manner. Enron allowed Andrew Fastow, the Chief Financial Officer to control two SPE’s (special purpose entities) that were knowingly connected to Enron, and gave him an opportunity to abuse his power.

Enron also parked some of its debt on the balance sheet of its SPVs and kept it hidden from analysts and investors. When the extent of its debt burden came to light, Enron’s credit rating fell and lenders demanded immediate payment in the sum of hundreds of millions of dollars in debt (Sims & Brinkmann, 2003). It means that Enron’s decision makers saw the shuffling of debt rather as a timing issue and not as an ethical one. They maintained that the company was financially stable and that many of their emerging problems really were not too serious, even though they knew the truth and were making financial decisions to protect their personal gains.

No discussion of the Enron scandal would be complete without a discussion of the involvement of Enron’s accountants, the firm Arthur Andersen. Arthur Andersen was one of many causes of the Enron collapse when they were the conflict of interest between the two roles played for Enron, as auditor but also as consultant. Andrew Fastow, the Chief Financial Officer of Enron pushed many deals across where he had a vested interested on both sides of the deal. By creating and knowingly participating in these deals, he put his financial greed above the responsibility to his position for the company. According to Paul and Palepu (2003) in 2000, Arthur Andersen earned $25 million in audit fees and $27 million in consulting fees, this amount accounted for roughly 27% of the audit fees of public clients for Arthur Andersen’s Houston office. The auditors’ methods were questioned as either being completed solely to receive its annual fees or for their lack of expertise in properly reviewing Enron’s revenue recognition, special entities, derivatives, and other accounting practices. Due to these relationships that Enron had with Arthur Andersen, it was just too easy for both Enron and the accounting firm to work together in covering up financial losses and debt. Andersen was also responsible for some of Enron’s internal bookkeeping, with some of Andersen’s employees eventually leaving to work for Enron. The result of the accounting scandal was that many of the losses that Enron encountered were not reported in its financial statements. In November, 2001, Enron revises financial statements for the previous five years to account for $586 million in losses (Corporate Narc, nd).

After a series of scandals involving irregular accounting procedures bordering on fraud involving Enron and its accounting firm Arthur Andersen, it stood at the verge of undergoing the largest bankruptcy in history by mid-November 2001. As Enron was considered a blue chip stock, this was an unprecedented and disastrous event in the financial world. Enron’s plunge occurred after it was revealed that many of its profits and revenue were the result of deals with special purpose entities (Corporate Narc, nd).

Enron’s leaders also ignored, then denied serious problems with their business transactions and were more concerned about their personal financial rewards than those of the company. When the company’s stock price began to drop as the problems were becoming public, the company was transitioning from one investment program to another.

Impacts on Stakeholders

Every business has a moral obligation to serve its stakeholders, whether they are business partners, customers, stockholders, or employees. Enron’s bankruptcy has injured several parties including banks, stockholders, former employees, customers, suppliers, communities, and also the United States.

Impacts on Employees

The first thing, and most important thing the Enron scandal had an effect was the job situation. Carroll and Buchholtz (2008) argued that “when Enron went bankrupt and then the Arthur Andersen accounting firm went out of business in 2002, employees were displaced and significantly affected” (p. 47). Enron’s financial implosion has cost thousands of employees their jobs, left thousands of people still employed by the bankrupt trader and “left 5,600 employees jobless and facing retirements with no nest eggs” (Carroll & Buchholtz, 2008, p. 256). Many employees had their entire pensions vested in Enron stock, Kenneth Lay advised employees keep their Enron stock when the firm was crashing, and he was selling his own. While the employees were unable to sell their stock, Lay and other executives were quickly selling off many of their shares. The lives and savings of thousands employees were destroyed. They also were deprived of the freedom to diversify their retirement portfolios; and they had to stand by helplessly while their retirement savings evaporated at the same time that top managers cashed in on their lucrative stock options.

Impacts on Investors and Stockholders

As the result of Enron scandal, individual and institutional investors lost millions of dollars because they were misinformed about the firm’s financial performance reality through questionable accounting practices, and all of the shareholders lost the money that they had invested in the corporation after it went bankrupt. Shareholders lost nearly $11 billion when Enron’s stock price, which hit a high of US$90 per share in mid-2000, plummeted to less than $1 by the end of November 2001 (Answers.com, 2010). Investors those who were hurt can never be made totally whole once again after the terrible experiences of Enron.

Impacts on the United States and Communities

Political parties, such as the Bush administration, who accepted contributions from Enron, were finding themselves in positions where returning the funds to Enron or donating them to a charitable. Enron also affected the United States in several important ways. If anything positive can be said about the Enron scandal, it is that the scandal itself heightened awareness of the importance of integrity in Accounting and business in general, and led to the creation of new safeguards to make sure that something like this would not happen again, or at least not to the full extent of the Enron damage.

Enron cynically and knowingly created the phony California electricity crisis of 2000 and 2001. Between 30 percent and 50 percent of California’s energy industry was shut down by Enron a great deal of the time, and up to 76 percent at one point, as the company drove the price of electricity higher by nine times (Corporate Narc, nd).

Impacts on Other Stakeholders

The Enron scandal also harmed other stakeholders. For example, Enron top managers pressured Arthur Andersen to certify maximum-risk; questionable accounting practices in part to retain their consulting business and, by acceding to this pressure, Arthur Andersen won huge contracts in the short run however ultimately lost their professional credibility and client base. Some investment banks such as Citigroup, J.P. Morgan, and Merrill Lynch made over $200 million in fees from deals that helped Enron and other energy firms boost cash flow and hide debt, and, by failing to exercise their own adequate due diligence, they multiplied the harm done to other stakeholders. Citigroup and JP Morgan Chase in particular appeared to have significant amounts to lose with Enron’s fall.

Punishment

Thousands of aggrieved employees, investors, and other stakeholders were waiting to find out what punishment will be meted out to those who covered up Enron’s true financial position so successfully for so long. Three individuals that participated in the various frauds that were committed by Enron included the former president and CEO of Enron, Jeffrey Skilling; former chief financial officer in charge of LJM, Andrew Fastow; founder, former chairman, and CEO, Kenneth Lay. At first, in 2002, Enron’s former chief financial officer, Andrew Fastow, and three other current and former Enron executives exercise their Fifth Amendment right not to testify at a congressional hearing. He was charged with securities fraud, wire fraud, mail fraud, money laundering, and conspiracy. It is alleged that Fastow and others devised a scheme to defraud Enron and its shareholders (Cbsnews.com, 2006). Fastow, his wife Lea Fastow and nine other former executives faced 31 more charges and 98 counts of fraud and they were also indicted on a host of fraud, insider trading, and other counts (Associated Press, 2006). Andrew Fastow pleaded guilty to two counts of conspiracy. The plea called for a 10-year sentence and his aid in targeting former top Enron executives Kenneth Lay and Jeffrey Skilling. Lea Fastow pleaded guilty to filing false tax forms. Finally, in March 2006, Fastow had already pleaded guilty and faced up to 10 years in prison on two counts of conspiracy.

Lay and Skilling went on trial for their part in the Enron scandal in January 2006 in Houston. Skilling faced 31 counts ranging from fraud to lying to auditors for allegedly lying about Enron’s financial state. Lay faced seven counts of fraud and conspiracy for allegedly perpetuating the scheme. After six days of deliberations, on May 25, 2006 a verdict was reached in the Houston trial of former Enron chiefs Kenneth Lay and Jeffrey Skilling. Skilling was convicted of 19 of 28 counts of securities fraud and wire fraud and acquitted on the remaining nine, including charges of insider trading, making him the highest ranking former executive charged in the collapse of Enron. He was sentenced to 24 years and 4 months in prison for his role in one of the biggest corporate scandals in U.S. history (Cbsnews.com, 2006). Lay was convicted of all six counts against him, including conspiracy to commit securities and wire fraud and he faced a total sentence of up to 45 years in prison. However, before sentencing was scheduled, Lay died on July 5, 2006 due to a heart attack (Answers.com, 2010).

Lessons from the Enron Case

In the new economic, the Enron scandal has been being the morality lesson. The case will teach executives and the American public the most important ethics lessons. The first lesson it that both individuals and organizations or firms should only earn money by providing goods or services that have real value in the new economic. Moreover, executives who are paid too much can think they are above the rules and can be tempted to cut ethical corners to retain their wealth and perquisites. Every firms need to demonstrate that they have eliminated all off-books accounts which distort the public’s understanding of the financial health of the organization and they should to pledge that they will not suspend the company’s code of conduct, or at least report to the public when they do. In order for companies to prevent an Enron-like scandal, there needs to be supervision over managers and executives as they exercise their own business judgments about what is in the best interest for an organization.

Kirk Hanson (2002), executive director of the Markkula Center for Applied Ethics, explained that the Enron scandal “demonstrates the need for significant reforms in accounting and corporate governance in the United States, as well as for a close look at the ethical quality of the culture of business generally and of business corporations in the United States”. Due to the accounting frauds that occurred in the Enron scandal, several accounting firms should reorganize their employees towards remaining loyal to the ethical standards demanded by the SEC. In order for companies to prevent an Enron-like scandal, there needs to be supervision over managers and executives as they exercise their own business judgments about what is in the best interest for an organization. On the other hand, when accounting firms have been moving to sever in both auditing and consulting services for their consulting businesses, the SEC should probably adopt additional disclosure requirements. Government regulations and rules need to be updated for the new economy, not relaxed and eliminated.

Conclusion

Looking at the Enron scandal from the retrospective viewpoint of history, essentially most of the problems faced by Enron derive from the immoral and unethical actions taken on by the board of directors in their attempt to achieve personal profits. The Enron scandal changed the lives of everyone in America and perhaps just as importantly, it forced everyone to look at themselves and fully realize the consequences of reckless greed and the breakage of laws on a whim. Most of individuals and organizations had been receiving proper punishment and lessons for their relevance.