The Failure Of Corporate Governance Mechanisms Accounting Essay

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The year 2002 saw the end of an era of skyrocketing stock prices and booming businesses. Things that had seemed to be too good to be true were just that. Companies that were previously thought of as unstoppable didn't have the earnings they claimed to have. [1] In this chapter, we examine the Enron saga in order to highlight the consequences that arise from the failure of corporate governance mechanisms. The reason for picking Enron is to explain why this case encouraged corporate governance reform worldwide, especially in the auditing process.

BACKGROUND

Enron was formed in July 1985 when Houston Natural Gas merged with Omaha-based Inter-North. The company was founded by entrepreneur, Kenneth Lay. As the energy markets, and in particular the electrical power markets were deregulated, Enron's business expanded into brokering and trading electricity and other energy commodities. In a period of 16 years the company transformed from a small entity, to the world's largest energy trading company (The Economist, 28 November 2002). Deregulation had a far reaching impact on all the energy providers. In this newly deregulated and innovative forum, Enron embraced a culture that rewarded "cleverness". Deregulation opened up the industry up to experimentation and the culture at Enron was one that pushed the employees to explore this new playing field to the utmost. [2] 

From the start of the 1990's until year-end 1998, Enron's stock rose by 311 percent, only modestly higher than the rate of growth in the Standard & Poor's 500. But then the stock soared. It increased by 56 percent in 1999 and a further 87 percent in 2000, compared to a 20 percent increase and a 10 percent decline for the index during the same years. By December 31, 2000, Enron's stock was priced at $83.13, and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market's high expectations about its future prospects. [3] 

Enron's success was phenomenal. It was rated as the most innovative large company in America in Fortune magazine's survey of the Most Admired Companies. It built up its glittering reputation and success before crashing down in such a monumental fashion. Ironically the company's commercial ended with the phrase, "Ask why, why, why?" Questions such as what happened, why did it collapse, why were there no backup plans, why did the world's leading energy company fail, bring us to the problems arising within the company before the filing for bankruptcy in 2001.

The word "Enron" has become synonymous with corruption on a colossal scale - a company where a handful of executives with unfettered power were able to pocket millions of dollars while carelessly eroding the life-savings of thousands of employees. The individual and collective greed of the executives had built within the company an atmosphere for arrogance. Arrogance and aggressiveness of the company management had pushed the law too far and this led to a heap of bad debts and ignominy.

THE FALL OF ENRON

Transparency is an essential ingredient for a sound system of corporate governance. The lack of transparency and the disclosure of the financial statements had given rise to various liabilities and losses which were not accounted. This was one of the main reasons for the collapse of the company. This whole affair took place with the help of Arthur Andersen LLP, who kept a floor of auditors assigned at Enron year-round. [4] 

Kenneth Lay along with Jeffrey Skilling changed the corporate culture at Enron. The company's reputation with the outside world flourished, but the internal culture, changed drastically. Skilling was responsible for the constitution of the Performance Review Committee (PRC) which was also known as the "360-degree review". It was the harshest employee ranking system. [5] This encouraged the employees to work longer and post earnings for the company which fostered fierce internal competition.

By the end of 1998 Enron had eight divisions. The revenue growth was tremendous from $2 billion to $7 billion within a span of four years. Thus the company was flying high with double digit growth (at least on paper) with every venture. The main reason for these figures was the mark to market accounting rule. Under these rules, companies who had outstanding energy related or any other derivative contracts (either assets or liabilities) on their balance sheets had to adjust them to fair market value, keeping into mind the unrealized gains or losses of the financial statement of that period. [6] The catch here was that commodities such as gas had no quoted prices to base valuations on, which left companies with the freedom to develop their own assumptions with regard to the base valuations.

Arthur Andersen LLP was widely considered the firm of choice for auditing businesses in the oil and gas industry, auditing 70 percent of Houston's oil and gas companies. [7] It was logical for Enron, one of the world's leading energy companies to choose Andersen to perform its financial statement audits. Thus Andersen was the professional gatekeeper [8] . They are reputational intermediaries who provide verification and certification services. The relationship began in 1985 when Andersen began auditing Enron, but soon became much closer. It performed the role of an external as well as an internal auditor. Enron frequently hired many of Andersen's auditors to the strategic positions of the CFO (Chief Financial Officer) and Chief Accountant. Because of these cosy relationships with Enron, Andersen's audit independence was called into question by SEC. This raised serious doubts about the quality of the audit process.

Both the auditing and the accounting function at Enron were fraudulent and opaque. Enron's accounting was anything but transparent. The company recorded profits, for example, from a joint venture with Blockbuster Video that never materialized (The Economist, 7 February 2002). Enron manipulated the accounting numbers to inflate the earnings figure. They removed substantial amounts of debt from their accounts by setting up a number of off-balance sheet entities. Off-balance sheet entities are used to artificially inflate profits and make firms look more financially secure than they actually are. Enron would build an asset such as a power plant and immediately claim the projected profit on its books even though it had not generated any earnings from it yet. This was done with the help of Andersen, in order to hide the company's liability from the balance sheet.

In order to appease the credit rating agencies such as Moody's and Standard & Poor's, Enron made sure that the leverage ratios were within acceptable ranges. Andrew Stuart Fastow, the former CFO of Enron continuously lobbied around these agencies with the intention of influencing their decisions and raising Enron's credit rating. This entire process resulted in a cumulative profit reduction of $591 million and a rise in debt of $628 million for the financial statements from 1997 to 2000. [9] This triggered an investigation by the SEC into the auditing work of Andersen which resulted in a huge difference of profit figures and such inflation had allowed the company to increase its Earnings Per Share (EPS). EPS is equal to net income minus dividend on preferred stock, divided by average outstanding shares. The company had exaggerated its profits by manipulating Andersen. The goal here was short-termism, which refers to concentration on immediate profits at the expense of long-term results. The temptation is to cheat in order to get good results.

As mentioned earlier, Andersen had a very cosy relationship with Enron which resulted in conflicts of interest. Conflicts of interest are a frequent problem in the audit profession. Independent appointment of the company's auditors by the company's shareholders is frequently replaced by subjective appointment by company bosses, where the auditor is all too often beholden to the company's senior management. Further, there are conflicts of interest arising from interwoven functions of audit and consultancy. [10] These special cosy relationships between the company management and the auditors compromise independent judgement and cloud the auditing function. Enron's bankruptcy called into question with disclosure mechanisms practised USA. It raised serious doubts over the integrity of the independent audit process.

REFORMS

The Enron Corporation was one of the darlings of Wall Street. When it collapsed the US Congress responded very rapidly and enacted the Sarbanes-Oxley Act (SOX) on 30th July, 2002. The Enron meltdown shocked investors and creditors who believed that the company was "Too Big to Fail". In order to restore public confidence in the audit process they decided to strengthen and oversight the accounting profession. [11] 

The faulty accounting and business practices in Enron contributed to the formation of provisions for regulating auditor independence. Title II encompasses nine sections devoted entirely to auditor independence (Section 201 - 209). As Andersen was engaged in inappropriate relations with Enron, the focus of the act was to regulate this biased outlook of auditors towards the companies they audit. They established a wall of separation between the interests of the client and the auditors to avoid problems of conflicts of interest. These sections provide for scrutiny of the non-audit services being provided by the audit firms as well as the rotation of the audit partner for every five consecutive years. The third hand under the audit function i.e. audit committees, should take on the task of supervising the entire audit process to ensure the efficiency of the reports being produced, which lacked in Enron. The Act constituted the Public Companies Accounting Oversight Board (PCAOB), to monitor, supervise and oversee the audit process within listed companies in US. The Act has come up with independent audit standards and quality control checks, to improve the reliability of the audit reports. As outlined in Ramos (2004), the SOX made substantial changes to the financial reporting aspects of internal control. It created new accounting standards by making CEO's and CFO's personally liable and accountable for the accuracy of the financial statements. The external auditors were required to audit the companies' report on the effectiveness of internal control systems and give their opinions in the annual report.

The investigation by the SEC broke open the doors to one of the biggest auditing scandals of all time. It is the primary overseer and regulator of the US securities markets responsible for ensuring efficiency of markets and capital information and protecting investors against fraud. [12] The disaster at Enron prompted aggressive SEC enforcement responses by creating a Financial Fraud Task Force to focus on companies, their managers and auditors, where financial statements may reflect improper earnings or GAAP violations. [13] Along with enforcement scrutiny the possibility of criminal indictment was increased.

In June, 2002 the New York Stock Exchange (NYSE) issued a report on corporate accountability, which stated that the role and authority of independent directors should be increased. Audit committees should consist of these independent directors who would have the sole authority to hire and fire auditors. [14] Thus the company management should not interfere with the activities of the audit committees. The NYSE, National Association of Securities Dealers Automated Quotations (NASDAQ) and SEC have proposed new rules for stricter corporate governance and disclosure practices, stressing on the need to have independent board committees.

CONCLUSION

The aftermath of Enron was terrifying as it affected innocent employees who lost their jobs. Due to the reckless acts of a few executives, the jobs of about 4500 individuals were put in jeopardy. The Enron saga was a collective failure on the part of the auditors (gatekeepers). In this chapter, we discussed the background, the fall and the reforms pertaining to independence brought about in USA after the collapse of Enron. The background throws light on the success story of Enron from the year 1985 to 2000. The stock prices and other financial statements provide insights on the growth of the company within a span of 15 years. At the end, we discuss how the glittering success and reputation of the company was put to stake by the activities of a few executives.

This case is a clear cut example of the failure of corporate governance. Greed, arrogance and over-confidence led to the downfall of the company. The unethical behaviour and the changed corporate culture on the part of the company management and the auditors resulted in fraudulent and creative accounting brought on by a lack of transparency. This allowed Arthur Andersen LLP to inflate the Earnings Per Share of the company aided by the company's rotten leadership which encouraged the lack of necessary checks by the audit committee. In order to ensure cases like Enron do not happen again various corporate governance mechanisms should be constituted to avoid unethical activities and concentration of power in the hands of few individuals. The upshot of the Enron case was the establishment of the PCAOB by the Sarbanes-Oxley Act in order to oversight the process through a system of internal and supervisory checks.

CHAPTER 4: UK CASE STUDY

In February 1995, Britain's oldest merchant bank of two hundred years, Barings bank came to a dramatic and fatal halt. [15] The actions of one trader, Nick Leeson who was stationed at Singapore destroyed the company. The losses accounted to more than $1 billion by unauthorized trading of future contracts. Future contracts are a type of financial derivatives where the price of the commodity is pre-determined. This chapter will examine the main highlights of the case and throw light on the reforms introduced in UK after the collapse of the bank.

BRIEF HISTORY OF THE BANK

Before the fall, Barings Plc had been the blue-blooded patriarch of English investment institutions, boasting a clientele of wealthy, the titled and the royal, and with a proud history of once firmly entwined with the fortunes of the British Empire. [16] Barings bank was established in the year 1762. It progressed rapidly during the Napoleonic wars from 1798 to 1814. It won the title of the sixth greatest European power at the Congress of Vienna in 1815. During the 1830's and 1840's Barings gained the reputation of being the most influential financial house in the US. This success was short lived as there was a financial crisis in the year 1890. The main reason for this crisis was over-exposed bad loans provided to Argentina in the year 1824 which led to debt in 1888. The company reported losses and liabilities worth 21 million pounds sterling. The impact of the crisis hit so hard that the company withdrew all its transactions from the North American continent. Luckily the company was rescued by the British government and the Bank of England. After the crisis the company initiated repair work and built up a reputation based on corporate finance, strong investment management and trading these to the wealthy and best clients in London, including the Royal Family. This pushed them back into the American finance scene in the year 1980's. The growth of emerging markets led the bank to expand its business in Asian countries like Tokyo and Singapore. [17] The expansion of the company into the Asian market satisfied the board of directors and they began to develop ways in which profits could be earned in short time. In order to further this plan they established Barings Future (Singapore) Pte Ltd (BFS) on 17th September, 1986. After the constitution of the BFS, the company asked for and were granted the membership of the Singapore International Monetary Exchange Ltd (SIMEX). Nick Leeson was put in charge of the offices at Singapore, whose activities led to the collapse of the oldest British bank.

THE COLLAPSE OF BARINGS BANK

The movie Rogue Trader based on the book 'Rogue Trader: How I brought down Barings Bank and shook the Financial World' written by Nick Leeson, showcases an interesting insight on the way in which derivative trading takes place. This unauthorized derivative trading in Singapore on the SIMEX exchange washed off the bank. Derivatives are financial instruments whose value is derived from another 'underlying' instrument. For example, a stock option is a derivative because it derives its value from that of a stock i.e. it is an interest rate swap as it derives its value from one or more interest rate indices. Generally derivatives consist of two major categories they are Over the Counter (OTC) and futures. The former one are privately negotiated and the latter are standardized exchange traded one's. The collapse of Barings was brought about by futures derivatives trading.

On July 1, 1992, BFS started trading on the SIMEX where Mr. Nick Leeson was put in charge of operations for BFS, coupled with the responsibilities of trading, accounting and settlements activities. [18] Nicholas William Leeson, a 28 year old who did not even graduate from college was appointed by Barings as a chief trader for BFS in Singapore. This opportunity changed his lifestyle completely. With relatively little experience, he failed to understand the way in which the business was managed and so traded out of the losses using the money from the bank's clients. [19] After being appointed as the General Manager and the Head Trader at BFS, Nick Leeson started making huge profits for the bank on the Far East money markets but investing in these markets was a risky business. He set up an 'errors and omissions' account, number 88888, on July3, 1992 just two days after BFS was granted the membership by SIMEX, in order to accommodate all differences in trading balances. During the first few months of this account, a large number of transactions were booked which clearly indicates that this account was never meant to act as an error account. The losses incurred by him were transferred into this special account which covered up all his activities. In order to continue his trading in Singapore, he requested the bank to grant him more and more funds which proved to be a disaster and resulted in the collapse of the bank.

A large French client of the bank wanted to purchase options contracts on the yen for a relatively low price, and in order to keep the client, Nick Leeson confirmed the deal. This resulted in a massive loss to the bank which as usual was transferred to the error account. The client left Barings, which left Leeson in a very difficult position and he decided to cover the losses by trading on the bank's account as before, but this time it did not work. Unauthorized trading continued at Barings especially on Nikkei 25 stock index with the help of the secret error and omission account. The Kobe earthquake in Japan added to the misery of Nick Leeson, he made losses after losses against the yen and ran up a debt in yen options amounting to 400 million dollars. Due to the lack of scrutiny on the part of the bank, the losses increased to 830 million pounds by February 1995. [20] 

The executive management team at Barings Bank was called into question by the official regulatory bodies regarding the bank's controls and monitoring procedures. Although Nick Leeson behaved in an unethical manner by trading without any authorization from the bank and on the bank's account, the bank was also much to be blamed as it lacked the internal control mechanisms to constrain Leeson's activities. The bank knew that Leeson was covering the losses with the help of the error account; it showcases a clear failure on the part of the audit function. Nick Leeson was responsible for managing the trading as well as the accounts which led to the demise of the bank. Lack of supervision and control, lack of segregation of powers, lack of knowledge of derivative trading in Singapore by the senior management at Barings Plc also resulted in the fall of the bank. In this case auditor independence was non-existent, as there was a failure on the part of the auditors to conduct the necessary investigations and checks about the audit. They failed to pass on information to the shareholders and investors about the existence of the error account and how losses were transmitted to it with the help of the client's money.

REFORMS

The Maxwell affair triggered corporate governance and led to a huge discussion by policy makers in UK about the subject and how such abuse of power could be curbed. The Cadbury Report was produced in 1992 by The Committee on the Financial Aspects of Corporate Governance. The report dealt with three areas namely: board of directors; auditing and shareholders. Although this report covered auditing and accounting functions, it was clearly neglected by Barings Bank. The collapse of British Gas, led to The Greenbury Report 1995 which focused mainly on executive remuneration. The aim of this report was not to reduce salaries but to establish a balance between remuneration and individual performance of executive directors. The next reform in UK was the Hampel Report 1998 which led to the establishment of the Combined Code, the currently applicable code of best corporate governance practice for UK listed companies. It was a successor to the previous two reports and included a combination on the financial aspects of corporate governance.

Reforms were in place in UK during the collapse of Barings Plc but the lack of internal control and risk management were not covered up by the previous reports. The collapse led to the formation of the Turnbull committee which dealt exclusively with internal control systems. The Turnbull Report 1999 responded to the provisions of the Combined Code and made clear recommendations on the internal control aspects of corporate governance. The aim was to provide guidance on developing and maintaining the internal control systems. Earlier cases of Maxwell, British Gas and Barings Bank involved weaknesses in internal control systems so to tighten regulations UK came up with the Turnbull Report 1999.

The fall of Enron had shocked and spun the world economy in 2002. It brought back to focus corporate governance issues and raised serious doubts over monitoring procedures undertaken by companies. The UK came up with the Higgs Report, Tyson Report and the Smith Report in 2003. The above reports mainly targeted on the role and effectiveness of non-executives directors and the relationships between the external auditor and the companies they audit. The Smith Report 2003 recommended improvements and represented ways in which production of accounts would be reliable and honest. In October 2008, the Financial Reporting Council (FRC), published and updated the Smith Report with regard to revised guidance on audit committees. The main element of this guidance was to take account of the risks associated with the external auditor. This meant more disclosure of information to the shareholders, investors and stakeholders about the audit selection within the company.

CONCLUSION

This chapter highlighted the manner in which the actions of one particular trader (Nick Leeson) abruptly shook Britain's oldest merchant bank: Barings. This case exposed the operational weaknesses of the senior management and the outcome of blindly relying on one individual. The dual position given to Nick Leeson was one of the main factors responsible for corporate failure in Barings. Thus separation of ownership and control would help reduce agency problems. The transactions under the error account were not monitored by the auditors of the firm, which led to massive losses as the client's money was used to carry out trading.

The chapter also focuses on the development of various policy documents and codes of practice for corporate governance in the UK. More importantly the Smith Report highlights the audit function, paying special attention to the role of audit committees within the company. The research paper suggests that they should keep an eye on the work of the external auditors to ensure independence in the auditing of financial statements. Mitchell and Sikka (2005) have stated that companies are failing to discharge a genuine accountability to society, they put profits before people and the company executives believe that they are accountable to no one. Like the company executives, the auditors are not far behind; they produce reports which have so many loopholes. Good corporate governance goes beyond just complying with the codes of practice. We can have various systems, checks and balances, regulations but human nature cannot be altered. The main difference between corporate governance systems in US and UK is that the former has a rule-based approach, whereas the latter as a principle-based approach.

CHAPTER 5: INDIAN CASE STUDY

This chapter would examine the corporate governance issues at the India based IT services company, Satyam Computer Services Limited (Satyam). Although the name 'Satyam' denotes being honest and true, the company were far behind this motto. The role of the auditors (Pricewaterhouse Coopers) raises serious questions on auditor independence and the quality of audit being provided. The Satyam scandal resembles Enron in various aspects such as concentration of power in the hands of a few and failure of the audit function.

BACKGROUND

Satyam Computer Service Limited (Satyam) currently known as Mahindra Satyam is a global information technology (IT) services provider, offering a range of services, including systems design, software development, system integration and application maintenance, [21] and is listed on the NYSE and Euronext. Satyam was founded in 1987 by Ramalinga B. Raju. The company employed over 53000 IT professionals across the globe to serve over 654 companies, 185 of which are Fortune 500 corporations, [22] and was one of the four big IT companies in India. The name of the company (Satyam) inspired trust but the 21st century generated a new breed of businessmen anxious to manipulate and take advantage. Satyam has several subsidiaries and group companies, Maytas Infrastructure was one of them which was founded in 1988 venturing into construction services and infrastructure development. It came under the scanner due to its association with Ramalinga Raju who resigned on 7th January, 2009 and confessed that he had manipulated the accounts by $1.47 billion. [23] 

THE SCANDAL

Satyam's dilemma began when one of its biggest clients, World Bank, pronounced that two employees of the former company hacked into their systems in order to access confidential and sensitive information. Due to this massive breach of conduct the World Bank decided not to renew their fiver year contract with Satyam and cut off all ties with the company. [24] The allegations were denied by Satyam. Right after this incident, Ramalinga Raju (Chairman) of Satyam decided to influx $1.6 billion into the acquisition of Maytas Infrastructure and Maytas Properties, which was withdrawn due to the pressure and revolt by the shareholders and investors in the company. The outcome of this decision affected the American Depository Receipt (ADR) which fell by 50% and the company suffered serious losses. To add to all this Upaid Systems a former client of Satyam won a pending litigation with a claim of $1 billion. The final blow was when Ramalinga Raju made a confession about repeatedly fudging the accounting books and overstating the profits and assets.

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