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This essay briefly discusses the events that led to the bankruptcy of Enron - Americas seventh largest corporation CNN money, online and dissolution of Arthur Anderson - one the World's top 5 audit and accountancy partnerships in 2001. It aims to critically evaluate developments in the audit profession and framework in regard to corporate governance, internal controls and role of ethical judgments after the exposure of Enron's scandal. It further discusses whether such developments and regulatory frameworks provide assurance that the history of Enron could never repeat itself in the UK.
The Historic Failure
The executives at Enron -'The Most Innovative Company in America' according to Fortune's Most Admired Companies Survey (Stein, 2000) adopted a diversification strategy and worked diligently to keep their stock prices up. They manipulated their accounts, showed assets at inflated values and kept considerable debts off their balance sheet. Even failed projects that resulted in losses were shown as profitable due to their mark-to-market accounting policy. This policy allowed them to currently record profits on the basis of future anticipated revenues whether or not such profits could actually be realized (Thomas, 2002). The inability to trace the exact source of income to Enron profits raised a lot of questions in the minds of analysts and investors. Even the appointed audit firm - Arthur Andersen which was one of the world's top 5 audit firms behaved unethically towards the responsibility entrusted upon them. They failed to disclose the correct financial position of Enron due to the material benefits they were receiving from the client which ultimately led to their dissolution and 85,000 employees losing their jobs (Jackling et al, 2007). As a result, in December 2001, Enron was declared bankrupt (BBC News, online) and this came to be known as the largest corporate bankruptcy in US history and the biggest audit failure at the time.
The Need For Reforms To Corporate Governance
The UK has not remained immune to such exorbitant scandals. The Cadbury Report in 1992 and Hampel Report in 1998 were results of the contiguous reforms needed to the corporate governance in the UK after the case of Maxwell Communications and Polly Peck of the 1990's.
Post Enron 2001, WorldCom, Global Crossing, Adelphia and many other corporations shortly fell in the US within the span of one year. Italy's Parmalat and Australia's HIH Insurance and One Tel followed the same league (Jackling et al, 2007)
Such scandalous bankruptcies and collapses led to the audit profession's effectiveness coming under great criticism and scrutiny and the loss of confidence in the financial reporting and accountability by investors and other stakeholders.
The US, to reinstate investor confidence through corporate governance responded by passing The Sarbanes-Oxley Act in 2002 which disallowed an external auditor to perform both auditing and consulting services to the same client.
Corporate governance is the process by which organizations are directed, controlled and held accountable for the decision making, control and behavior at the top of the organization (Collier, 2008).
In large corporations and publicly listed companies there is a separation of ownership and management which gives rise to the agent-principal relationship. The managers (agents) are appointed by shareholders (principals) to take care of day to day operations in a way that they safeguard the interest of the shareholders. However, sometimes managers may act in self interest neglecting their responsibility towards the owners of the firm. This gives rise to a conflict of interest.
Traditional corporate governance was aimed at resolving conflicts of interest on the basis of this agent-principle relationship. Due to mistrust that the shareholders may have on the managers, they appoint independent auditors to examine the operations and financial statements of the firm to ensure the interest of shareholders is safeguarded and managers are not working in self interest.
This traditional theory of managers being responsible for increasing shareholders wealth has expanded to a much broader concept today. Managers are now not only accountable to the shareholders but to all those parties that are affected by the operations of the organization. This signifies a shift from a short term strategy of protecting the interest of shareholders alone to a long term strategy where the interest of all stakeholders of the firm are protected (Brenan and Solomon, 2008).
Assigning responsibility to managers and making them accountable to internal (executives, board of directors and employees) and external stakeholders (shareholders, debt holders, creditors, suppliers, customers and society) forces them to be socially responsible, transparent and disclose all material information in the financial statements that may be considered vital to stakeholders in making a choice of dealing with the firm.
A company operates as a legal entity and is subject to different laws and regulation. Such principles and codes of corporate governance differ from country to country as they are issued by their respective stock exchanges, institutional investors or associations with support of the government and international corporations. Firm's compliance to these codes of practice is not mandatory. However if the firm wishes to be listed on the stock exchange it needs to comply with their regulations and any case of non-compliance needs to be disclosed with justifiable explanations. Despite the fact that Enron disclosed their move to adopt the mark-to-market accounting, the SEC nor the external auditors used their professional skepticism to inquire details of their cash flows.
Though corporate governance failed to prevent fraudulent and malpractices in the Enron case, its importance cannot be dismissed. Various mechanisms like appointment of non-executive directors, splitting the role of the Chairman and Chief Executives and introduction of board sub committees such as the audit committee have proved to be effective measures to improve managerial performance. SOX have also put a cap on the fee which an audit firm can receive as a percentage of their total fees from one client to ensure independence while carrying out the audit. US Treadway Commission of 1987 and the UK Turnbull Report of 1999 and 2005 have also highlighted that internal control forms a key aspect of the corporate governance framework (Brenan and Solomon, 2008).
Internal Control Over The Years
As the term suggests, internal control is the system of controlling from within. It works to help the organization meet its goals and objectives in an effective and efficient manner. Its primary responsibility is to ensure financial reports are reliable and provide accurate information and that the organization is complying with the laws and regulations governing their operations (Fadeil, Haron and Jantan, 2005). They are also responsible for providing reasonable assurance (not absolute assurance) that the financial statements are complete, free of error or fraud and the assets of the firm are safe from loss or theft (Jones, 2008).
Many at times there exists an expectations gap due to misunderstanding the role and responsibility of external auditors. Detection of fraud is not the primary responsibility of the auditors but of the management. The responsibility of the external auditor is to merely ensure and attest whether the financials are free of fraud or not.
Control environment, risk assessment, information regarding financial reporting and communication, monitoring through internal audit and control activities form the 5 components of internal control (Jones, 2008).
The scope of internal control has expanded massively after the Enron scandal. Now internal control has become a key component of risk management. The limited liability of directors served as an immunization tool for their reckless behavior and working for personal motives. By assigning accountability to the stakeholders and making the directors liable for deliberately misleading the users of financial statements will force them to act responsibly and reduce fraud. Enron shares that were selling at above $90/share in 2000 became worthless and their value fell below $1/share in 2001 after the exposure of Enron's real financial position and this had devastating effects on its stakeholders. There has already been a significant move towards a more controlled environment in the US like it is in the UK as it is believed that it will act as a shield to fraud and prevent malpractices from recurring (Spira and Page, 2003).
Nowadays, after the passing of the Sarbanes-Oxley Act, under section 404, external auditors are required to report on the functioning of their client's internal control systems and must certify if they are effective in performing their duties. Prior to SOX, management had an option not an obligation to adhere to the changes suggested by the external auditors.
The External auditors are allowed to work alongside the management and assist them to restructure their internal control systems. This is in contradiction to the SOX as under this Act the External Auditor is not allowed to perform non-audit services due to independence being jeopardized and the auditor will be assessing and judging his own work (Tackett, Wolf and Claypool, 2006).
The Internal Auditors act independently and supervise the functioning of the Internal Controls acting as a policeman looking for flaws in the system. They also act as business partners helping the firm meet its goals (Fadeil, Haron and Jantan, 2005).
Role Of Ethical Considerations
Ethical considerations from an accounting point of view would require an increase in the morality of accountants and auditors towards their duties and responsibilities. One of the biggest problems at Enron was the lack of moral and ethical responsibility. Like managers are accountable to not only shareholders but to all the stakeholders, accountants and auditors have an ethical responsibility of disclosing all material information to the stakeholders who may use the financial statements as they perform the duty of intermediaries between them and the management. Any wrong information that is attested by the auditors could cause adverse affects to the stakeholders.
Ethics help to make a clear distinction between what ought to be done and what is the right thing to be done. Accountants/auditors must adhere to their standards of professionalism set out by their professional bodies and act independently to apply the best decisions to their practice.
Barlaup, Dronen and Stuart (2009) described ethics as the right thing to be done and identified 3 basic theories to explain them:
Egoism - the theory of self interest where the right thing to do is benefit yourself.
Utilitarianism - where the right thing to do is that which brings happiness to most of the people.
Deontology - where the right thing to do is speak the truth regardless of its consequences.
As far as possible accountants and auditors are expected to adopt the theory of deontology as acting in self interest and making incompetent professional judgments may lead to ethical fallouts.
After Enron, professional accounting bodies have played an important role in trying to reduce creative accounting practices through educating their members about their ethical responsibilities to the society. They have tried to inculcate professional values such as integrity, objectivity, professional competence and due care, confidentiality and professional behavior of complying with the rules and regulations. They also train, support employees within an organization to be truthful and tackle difficult situations that may require ethical responses.
This measure will help professionals to be more sensitive to ethical issues and apply the right professional judgment in their work place (Jackling et al, 2007).
There have been many claims that what happened at Enron in the US ten years ago could never happen in the UK (Holt and Eccles, 2002). There are various reasons why this may hold true. Firstly, accounting in the UK is based on generally accepted accounting principles not on detailed prescriptive rules like in the US. Basing accounts on general principles allows accountants to use their professional judgment while dealing with various items to show a true and fair view. Secondly, mark-to-marketing accounting would never be allowed in the UK as it assumes very favorable conditions to trade which cannot be guaranteed in an ever changing environment. The corporate governance measures in place, increasing role of internal controls, supervision through internal and external auditors with an independent perspective, revised accounting standards and growing awareness of ethical and moral responsibility act as a deterrent to committing fraud if not completely eliminating them. Thus it would be safe to say that with the current accounting framework it is highly impossible for a fraud of a caliber like that of Enron could be repeated. Not only in the UK but provisions to the accounting framework have been made all around the globe and are always under constant revision. It is expected that by 2014 even the US will accept the IFRS and govern its accounting on the basis of principles not rules.