The Failures Of Recognizing Enron S Problem Accounting Essay

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Stock option award is one of the problems that cause Enron failed. In Enron, management parties were more emphasize on the way to motivate themselves for making decisions by using stock option because they will get extra financial benefits directly besides their salary if the Enron's stock rose. Besides that, management parties can get the same benefits or interest with shareholders. This will bring disadvantage toward shareholders and creditors who provide capitals or invest in Enron if compared to management parties who are not providing any capitals into Enron but also can enjoy the benefits with them. According to Hall and Knox, 2002, Enron had experienced the increase in short-term stock performance with stock option awards as a motivator to managers but do not create any value in the medium or long term.

Role of audit committee

Enron's audit committee members consist of a lot of expertise and qualified people such as professors or presidents from some universities, and also expert parties from other countries. They covered a huge number of important issues such as report on disclosures relating to litigation risks and contingencies and so on by using 85 minutes. Somehow, Enron have those expert and experienced professions as it audit committee members, none of them have second-guess and confidence to the auditors on some of the technical questions which are related to the special purpose entities and no doubt on the validity of representations of top management. According to Powers, Troubh and Winokur, 2002,it was mentioned that Enron's audit committee was no doubt about certain potential conflicts which related to party transactions and no full disclosure of those transactions are required.

Role of external auditors

Arthur Andersen, who is the Enron's auditor, has been charged in applying the lax standards in their audits because of the interest over the significant consulting fees generated by Enron. It has been said that the audit fees of Enron is roughly 27 percent higher than the audit fees of Arthur Andersen's Houston office public clients. Andersen also tried to cover up any improprieties in Enron's audit by shredding all the supporting documents. Audit firms are facing the pressure for the two major changes in the 1970s. First, audit firms are allowed to advertise and compete with each others when the Federal Trade Commission is concerned with the oligopoly by the large audit firms during the mid-1970s. Second, the company with questionable accounting information is no longer to be shown in order to make the investment as they can rely on the stock price itself. These changes have increased the litigation risks of auditors. The cost of audits can be reduced by practicing the mechanical accounting and auditing standards and developed standard operating procedures to reduce the variability in audits. Besides that, it will also provide a defense in the case of litigation. The impact of the failures of Enron's auditor to present the pure audited report is the regulators and general public perceive that auditors are beholden to their clients.

Role of fund managers

In the late of 2000 and beginning of 2001, 60 percent of Enron's stock owned by large institutional investors such as Barclay's Global investors, California Public Employees Retirement Fund, Morgan Stanley Investment Management and so on. Good situation of Enron does not last longer, in the end of 2000, Enron's performance been questioned by "The Energetic Messiah", 2000 and James Chanos who is a fund manager of Enron also realized that there are some problems from disclosures about party transactions. After that, Chanos sold out all the stock in November 2000. Three months later, he revealed the problems happened in Enron at Fortune. From October to December of 2001, the institutional ownership of Enron dropped from 60 percent above until 10 percent within one month because of the announcement of Enron's accounting problems.

There are some reasons that can explain on the factors which will lead to fund managers not alert to recognize the problems at Enron. First, the fund managers were misdirected by the aggressive accounting or sell-side analysts of Enron, due to unrealistic expectations of future performances. Another reason explained that the fund managers failed to recognize on Enron's risks because they are on demanded with the high-quality, long term company analysis. For example, Enron do not focus to fundamental analysis because index funds were important owners of Enron stock. On the other hand, non-index fund managers rewarded based on their relative performance. For example, if the manager holding less fund of Enron, the stock fall in the next quarter, the fund show superior relative portfolio performance and attract new capital. If the fund managers are continue to perform well on the next quarters, then he or she will underperform the benchmark and new capital will flow to other funds. Some of those risk-averse managers, who keep avoiding others to blame his or her performance, they will simply follow the crowd because of the stock crashes happen, no one will blame them since other funds also done a same mistake. In current stock downturns period of Enron, most of the fund managers will simply follow the crowds, and put more attention in identifying when the crowd will buy or sell, almost ignore about their own fundamental analysis.

Role of sell-side analysts

The falling of Enron is also because of the failure of sell-side analysts to provide an earlier warning of the problems faced by Enron. Lehman Brothers, UBS Warnburg and Merill Lynch which were known as the reputable institution have issued "strong buy" or "buy" recommendations for Enron. The explanation for why the analyst failed to provide an earlier warning of the problems of Enron is many analysts had financial incentives to recommend Enron to their clients in order to support their firms' investment banking deals with Enron. Many financial analysts will received bonuses if they support investment banking as investment banking had reported an earning of more than $125 million in underwriting fees from Enron from the period of 1998 to 2000. The analyst's one-year-ahead forecasts of Enron's stock price are deflated by its actual price on the forecast date. This is because of the potential conflict of interest from investment banking; price appreciation expected by analysts of investment banking with no banking ties is different from the analyst of investment banking with banking; analysts with no investment banking business were subject to optimistic bias. Some academic research has been carried out and it shows that sell-side analysts are influenced by their proximity to investment banking. Lin and McNichols (1998a, b), Michaely and Womack (1999) and Dechow, Hutton and Sloan (2000) show that analysts who work for lead underwriter banks are more optimistic on the long-term earnings forecasts and investment recommendations. The decline in sell recommendations by analyst over time and the poor record of analysts that covered dot-com stocks is mainly because of the conflict between research and underwriting. Furthermore, sell-side analyst also faced many potentially serious conflicts. First, analysts are too relied on access to management for inside information to make the feedback on their analysis and research. The problem is that the management is less likely to allow the analyst to access to the company's prospect which is on critical and negative. Sell-side analysts do not make their projection on their own. They make it in a network which relates the relationship of the investment bankers in their firms, the management of their companies and also their customers who read their reports.

Responses

The investor basically wants a financial transparency which means that they need adequate information on how reliably a company is being run and also its prospects and risks. But the audit committee's role is limited to assuring that the firm is following the general accepted accounting principles as certified by the outside auditors. Thus, many have proposed that the audit committee be renamed to transparency committee where the auditors realize on their responsibility lies with the board but not with pleasing the top management. Besides that, there is a conflict between auditing and consulting practices. But the most important thing is that auditors have to realize that their existence is to help investors identify stocks that are in a good investment. Furthermore, the auditor independence can be only achieved when auditors treat audit committee as their real clients but not the top management. There are also proposals which subject auditors to increased litigation risk. This is due to all business activities which are designed to create value must consist of its own risks. Besides that, firms should be able to walk away from the clients that are pursuing non-value creating business strategies although they are no accounting disagreements. Then, we also need to handle our business failure properly. The business failures not only can be responded through litigation but it is also can be responded with the proper analysis from an independent body of experts.

Finally, we can conclude that the failures in supply of information which is needed by the auditors and the audit committee are very important. Besides that, the failures in the demand of information also lead to the very high levels of Enron's stock price which are based on unrealistic performance expectations. In the nutshell, we still need to have a deeper consideration of the goals, incentives and interactions of these capital market intermediaries although there is a quick fixes such as separating auditors from consultants or sell-side analysts from investment bankers may be worthwhile.

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