The Enron Scandal
In a world where individuals are constantly aiming at enriching themselves and where human beings have become remarkably crafty, cases of fraud have gone up significantly. Subsequent studies have established that accounting fraud has been reported as one of the most prevalent among ethical issues reported in the United States. Accounting ethics scandals have been on the rise with more companies landing in trouble for such cases.
Enron which was classified as one of the largest and fastest growing company in the United States found itself entangled in an accounting scandal involving misrepresentation of financial statements and evasion of tax. This paper seeks to analyze this scandal showing the various issues involved before the giant company finally collapsed. An analysis of individuals, organization culture, regulatory environment, social factors and political factors will be conducted so as to determine how each contributed to the scandal. Description of the Case
The Enron scandal has been branded as the one of the biggest scandals in the history of America. Enron officials found themselves in trouble when investigations unearthed a host of accounting malpractices which included questionable accounting practices, misuse of company funds and tax avoidance (Natta, 12; Sterlin, 6). The company had also invested employee savings and benefits in risky investments. More than 21,000 employees consequently lost their benefits once the company was declared bankrupt (Sterlin, 13). It all started when the company took up so many activities that a single unit could not easily manage them financially.
As a result, special purpose entities; also known as partnerships were set up from where some of the activities would be conducted and finances obtained. These partnerships also acted as off-shore platforms from which Enron could avoid taxes. Increased expansion, debt and unscrupulous activities where company officials manipulated the company accounts to fraudulently obtain money at the expense of the company led to severe losses at the company. The management was however determined to make sure that the shareholders did not get wind of this through presenting inflated balance sheets to maintain the image of the company.
According to (Natta, 11) Enron’s special purpose entities were to a large extent responsible for the profits and that the company reported in its financial statements. While, the company was actually making losses all this time, partnerships’ profits were being used to conceal the losses. The management used these financial statements to manipulate its stock prices so that they kept on rising. This illusion was meant to attract investors to the company even though it was highly debt-ridden and making losses.
The company avoided presenting its earnings statements together with its balance sheets for financial analysis; a notion that Richard Grubman (a Wall Street analyst) questioned in a conference call (Alderman, 18). This must have triggered the investigations that later followed to unravel the mystery of Enron’s accounting scandals. As the company officials continued to inflate the company’s profits, share prices continued to rise and many investors struggled to purchase these shares which were expected to rise more in the future.
The shares reached a high value of $90 in August 2000 and insiders and officials at Enron started selling their shares; aware that the company would collapse at any time due to the losses it was making. Even as shares started plummeting; press conferences and notes to investors indicated that Enron was still doing well. When the company finally gave in to financial pressure, investors incurred high losses while employees lost their benefits and savings which had been invested in risky activities. It is this scandal that led to the bankruptcy of Enron which at one time was considered the most innovative company.
Individual Analysis The management played a significant role in the Enron scandal and this is associated with the benefits they stood to gain from the company’s profitability. Executive compensation consisted of hefty packages, holiday treats and most of all stock options. Kenneth Lay (Enron’s Chief Executive Officer) for example held shares worth $659 million in 2001 while Jeffery Skilling held $174 million shares (Alderman, 15). Squibb (29) notes that the stock options that management officials constantly received could be viewed as one of the reasons why the management was so determined to create rapid growth expectations.
In their forecasts, high share prices meant more wealth for them and they needed to do their best to make this happen. By manipulating profits, the management was sure that the company would be highly placed and that share prices would continue rising. A turn of events such that share prices started depreciating satisfies the illusion of control bias which prevented the dishonest actions from going on when the company eventually collapsed. The profits they expected to gain from the shares were lost and they were also faced with charges where they had to use a lot of money. Several of the major players in the scandal are discussed below.
Kenneth Lay – Founder and CEO Kenneth Lay who was the Enron CEO at the time had tried to lobby Paul O’Neill (the Treasury Secretary) and Don Evans (the Commerce Secretary) about a possible bailout to save the company from possible collapse due to the company’s shaky finances (Kadlec, 3). He also called Peter Fisher – a deputy to O’Neill and who had helped to organize bailout for Long-Term Capital Management when it suffered financial distress. It was however ruled that Enron’s position did not pose much threat to the financial system and was therefore not eligible for government bailout.
Lay’s action was undermined by the optimism bias where one develops a tendency of being optimistic that a certain action will bring about a particular outcome (Smith, 36). From his political connections and from the experience of Long-Term Capital Management, he believed that approaching these government officials would help. Alderman (12) argues that had the government agreed to bail Enron out, it is possible that the public would never have known about the accounting malpractices at the company. The company would have continued misguiding shareholders, placing employee savings in risky investments and avoiding tax as it was doing before.
Jeffery Skilling – Former CEO Skilling who was replaced by Lay was highly involved in the manipulation of the company’s financial statements so as to report profits and thereby attract more investment. He engineered financial reporting tactics which were to be used by the finance department to inflate profits and keep the company’s shares rising. Skilling’s efforts were frustrated when the company started suffering financial difficulties and shares prices started falling. He was charged with a total of 35 fraud counts (Alderman, 12).
Apart from this, Skilling used insider information to trade his shares one month after resigning from Enron. While he sold the shares for $60 million, he used $40 million and $23 million in trial preparation and defense lawyers’ retainer respectively (Squibb, 32). The Dunning-Kruger effect can therefore be said to have occurred. This effect occurs when people come up with strategies for satisfaction and success only to make conclusions that are erroneous or be unable to realize their dreams. Skilling for example lost to legal fees instead of gaining from the shares as he had anticipated.
Andrew Fastow – Enron Chief financial officer Fastow was a major figure in the web of accounting irregularities discovered at Enron. Being the CFO, he had access to all records and controlled the finance staff giving only the senior staff members the details on how the records should be treated (McNeill, 15). He is the one who designed the network of offshore partnerships which generated profits and hid the company’s losses. He also facilitated wire transfers and loans for the partnerships which were then channeled to Enron (McNeill, 16). He was well favored by the founder and Skilling who was the CEO at the time.
His ambition was probably to climb higher in his career and earn more as the company continued profiting. This however was not to be and he was charged with fraud receiving a ten year sentence. Wesley Colwell – Enron North American chief accountant Cornwell just like other employees may have been acting under the authority of his seniors. He responsible for the movement of large amounts of finances from the company reserves which Enron used to hide internal estimates (McNeill, 17). He had replaced Wanda Curry who was said to be incapable of aggressive accounting decision making.
Cornwell probably thought that his bosses would be responsible for any actions that he took. This was however wrong since he agreed to take part in illegal activities. Culture of the Organizations Enron By the time of the scandal, Enron was by far one of the largest growing firms in the US and its share prices were going up at a high rate. Maintaining this position or improving it even more was a priority for the company and they had to do everything possible. At Enron profitability was a vital success factor and it is in their quest to maintain it that the offshore entities were created.
The company officials used these units to avoid tax so that their profits were maximized (Kurdina, 1). The units were used to form an illusion of profits for the company while it was actually making losses. According to Squibb (21), these losses were fuelled by the company’s fouled accounting system. Enron adopted an accounting system that was said to be dangerous for any company. Enron which mostly dealt with long-term contracts would estimate expected profit from the contract and record this in its financial statements. This was despite the possible risks involved in the contracts that could affect profitability.
Enron had been using a form of accounting known as ‘mark to market’ where anticipated profits were recorded even before they were realized. Some however turned into losses in the future and the company had to cover up for them. In each accounting period, senior officials would manipulate the company’s accounts so as to cover up for such eventualities (McNeill, 14). This practice is believed to have driven the company deeper into more intricate tactics to hide their losses. Arthur Andersen Enron made use of Arthur Andersen’s auditing services and the scandal contributed highly to the closure of the accounting firm.
Questions were raised on why the accounting firm did not recognize the irregularities in Enron’s financial statements. McNeill (19) however blames this on the culture at Arthur Andersen. Prior to the Enron case, Arthur Andersen had been brought to book for approving accounts statements that were of questionable nature. Surprisingly, the accounting firm paid up fines without accepting liability. Arthur Andersen once paid $7million after suspected fraud on Waste Management’s accounts whose audits the company had conducted.
Previously, Arthur Anderson had paid $110 million in fines when shareholders of Sunbeam brought a case against the company for alleged misstatement of financial results (Kadlec, 3). Again, Arthur Andersen paid the fine without admitting guilt; which raised questions on why it was trying to eliminate the case so quickly. Records showed that in 2000, Arthur Andersen had received $25 million and $27 million as audit fees and consultancy and other services fees respectively (Alderman, 17). This is a huge amount for any accounting firm and could raise suspicion as to the intention of the client firm.
From this, there is reason to suspect foul play and that Arthur Andersen had developed a culture of hiding unscrupulous accounting activities for large companies in exchange for money. Furthermore, the company ordered its employees to destroy all physical and electronic records such as emails and audit material that contained information about Enron so that the investigators had little to find from investigations conducted at the company (Alderman, 18). It is therefore possible that the company had been helping large companies get away with accounting scams so as to obtain cash from them.
This had been done over several years; an indication that the Arthur Andersen was well aware of the nature of the company’s financial reports. Regulatory Climate/Social and Political Climate The financial auditing system formed a supportive platform for the accounting irregularities witnessed at Enron. It is argued that the system has a duty to maintain credibility and ensure that auditing bodies perform as they are expected to. It is questionable how Arthur Andersen could approve Enron’s accounts and allow it to omit losses made by some of their partnerships from the balance sheets.
The question of independence in auditing also arises given that Andersen had received five million dollars to perform company audits in the year 2000. In the same period, the auditor received twenty seven million dollars in consultancy fees and other services (Alderman, 17). Given this large amount, it is possible that the auditor was not acting independently and that the management could have been using its influence to determine the outcome of the audits (Kadlec, 4). This is prohibited in the auditing profession and constant inspections by the regulating bodies should have unearthed such a misdeed.
Investigations following the Enron scandal and other lesser scandals is what led to the passing of the Sarbanes-Oxley Act (SOX) in the year 2002 (Squibb, 25). This law prohibited companies from seeking consultancy services from the same company that was inspecting its books of accounts. This is because the relationship between auditors and the company must be completely independent which could be ruined by large amounts of money paid for consultancy and increased contact between the audit firm and the client firm.
Squibb (26) argues that if this law had been implemented before, probably the chances Arthur Andersen facilitating the scandal could have been avoided. Loopholes in tax regulations concerning fund transfers facilitated the scandal to a large extent. Alderman (14) notes that Enron enjoyed unrestricted freedom in the movement of currency such that the funds obtained from the offshore entities did not attract any taxation charges. This way, the company was assured of tax-free profits which they used to further hide the company’s losses from the public.
Laws requiring disclosure of any relations that a company had with unconsolidated entities were not strict so that money could easily change hands from Enron’s offshore partnerships to the company thus inflating its profits. Section IV of the SOX Act now requires firms to disclose these kinds of relationships. Enron made large contributions to campaign candidates in order to gain favor from government officials (Sterlin, 79-80; Kadlec, 2).
In an article published by the New York Times, Natta (12) noted that about three fourths of the Senators and almost half of the House members at the time had received campaign checks from the company. George W. Bush received up to a tune of $70000 from Enron and its officials for his campaigns since 1993 (Kadlec, 2). John Cornyn – the Texas Attorney General had also received $158,000 from the company as campaign contributions since 1997 and so had many other politicians such as John Ashcroft who had received $ 57,499 for his re-election bid in Missouri which he lost (Kadlec, 2).
Ashcroft was the U. S Attorney General during the Enron scandal hence the connection. These contributions which were mainly aimed at attracting ‘good will’ were usually given to both parties so that the company was covered irrespective of which side wins (Sterlin, 83; Natta, 13). Their contributions together with its wealth placed Enron at an advantage of being able to access government officials. This almost assured the safety of the company from legal tussles and convictions since the company officials could maneuver around using political connections thus keep the company’s name clean.
It is therefore argued that the company officials could have been taking advantage of the fact that they had political allies with high levels of influence on the government functioning to go against the expected business standards (McNeill, 61). This to a large extent assured them of protection from the law in the event that anything went wrong. Final Thoughts/Conclusion The Enron unethical activities led to the one of the largest scandals in the United States. The worst realization is that the lax laws and loopholes available in the system permitted the scandal to take place.
The company could use their offshore units to create false illusions which led to losses for the investors. This is unethical considering that investors rely heavily on the company’s financial records and the management to make investment decisions. Arthur Andersen played a big role in the accounting scandal by co-operating with Enron management. If the accounting firm would have reported such a case by acting independently as auditors are required to act, the problem could probably have been handled before it escalated to dangerous levels.
The action by Arthur Andersen can therefore be said to be highly unethical besides breaking the general principles of accounting. Word Count: 2782 Works Cited Alderman, Paul. The Enron Scandal: Issues and chronology of events. New York Times, July 5, 2003. Kadlec, Daniel. (2002). Enron: Who’s Accountable? Time Magazine, January 13, 2002. Kurdina, Anastasia. The Collapse of Enron: Managerial Aspects. , 2005. Retrieved on July 28, 2009 from http://ezinearticles. com/? The-Collapse-of-Enron:-Managerial-Aspects&id=59932Sample Essay of Paperial.com