Discussion on the collapse of Enron

  1. Introduction:

The collapse of Enron in 2001 raised many questions regarding the corporate accounting and corporate governance. Enron was the energy leading company, merged with Houston Natural Gas and Internorth in 1985, made money through buying and selling financial contracts linked to the value of energy assets rather than ownership of physical assets. In October of 2001, the company reported their first quarterly loss from 1997, following by their bonds rated downgraded to the junk bonds. Finally, the company was reported to bankruptcy in December 2001. Thus the topic was raised by the public regarding the corporate accounting, audit, and corporate governance. It also pushed the SEC and FASB to pay attention about the accounting standards whether the current accounting standards are being managed as a special purpose vehicles or the effective reporting. The following part will be based on the literature and develop a deep discussion on the reason the collapse of Enron.

  1. Literature Review

The one of many reasons that attributes to the collapse of Enron is the poor corporate governance. Colley et al. (2003) defined that the corporate governance matters the success of individual commercial enterprises. It is an examination of business that sustained success over long periods reveals boards have governed the business effectively. Monks et al (2008) state that establishment a system of accountability is one way to govern the corporation behave consistent with the public good. The system of accountability is the legitimacy and authority of corporate power based on accountability. Corporate management is asked for effectively accountable to the independent, competent, and motivated representative. They make sure the corporate governance to maintain the legitimacy and credibility.

Adams (2003) pointed out that the corporate structure has three components: shareholders, a board of directors, and officers. A distinctive characteristic of America company is that corporate ownership and control are dispersed across a relatively large number of shareholders. Elson and Gyves (2003) concluded that directors typically review the business strategies, evaluate the company’s outside auditor, and compensate the executives, and ensure the corporate performance. This means the directors have the responsibility to monitor and ensure the operation of company. However, the senior executives especially CEO Arthur Andersen intervene the company’s business model.

The other reason attributes the failure of Enron is creative accounting adopted by the senior management team. The accounting principle in US is very different from UK. In UK GAAP, it required the true and fair override to presented financial report, while IFRS requires financial statement fairly presented instead of true and fair view. This gave the opportunity for the company like Enron to make the creative accounting in the financial reports. This in turn leads to their final failure. Abbas et al (2010) suggested that effective financial reporting is fundamental to investor confidence as well as good corporate governance. The usefulness of financial statement could be defined by means of the usefulness of financial information and the globalization of accounting standards. (Hu, 2002) Usefulness of financial statements could help shareholders and investors to understand the current position, situation, and prospects of the company. Moreover, Benston (2003) found that the usefulness of financial statements provide evidence of an audit and revealing the presence or absence of significant conflicts of interests and misappropriation of resources, disclosure of important information, compliance with GAAP, confirmation of the promised performance, and a good measure of economic performance. However, Enron is a good example of creative accounting, which could use the financial reports to mislead the public. McLeay and Riccaboni (2001) pointed out that creative accounting involves accountants using their knowledge of accounting rules to manipulate the financial reports.

Below part will discuss why the senior management team would like to make decision to adopt the creative accounting and the failure of those charged with protecting the interest of the shareholders and other stakeholders.

  1. A detail discussion on the collapse of Enron

Christopher et al (2003) pointed out that Enron’s senior management and others tried to use various accounting and reporting techniques to mislead investors. According to Elson and Gyves (2003), the key executives repeatedly entered into the improper transactions designed to mask the company’s problem by keeping debt off the company’s balance sheet, thereby maintaining the good credit rating and artificially manipulating the stock price. Furthermore, the CEO Andersen even controlled the company’s internal and external auditing matters with the famous auditing company.

On the one hand, the above fact reflected one reason caused the collapse is lax oversight of corporate activities and CEOs particularly. Currall and Epstein (2003) found that the Enron Board appeared to have excessive trust in Enron’s top executive team. This reflected by the five ways: the waiver of company Code of Ethics, stock sales by executives, the company’s external auditor consulting large fee, the external auditor acted as the internal auditor, and financial personnel with connections to external auditor. (Elson and Gyves, 2003) The waiver of company Code of Ethics is very unusual because the board needed to know the exact reason to reach that decision, but the Boarder of Enron allowed the CFO to conduct the off-balance-sheet activities. The stock sales by executives exceeded the normal sale, which did not draw the board’s attention. The external auditor ideally should be independent of the company, but Enron hired the external auditor at the same time doing the consulting working and paid the huge consulting fee. This in turn led to the external auditor company worked as the internal auditor to help the company hide the important issues. It seemed the auditor work like an integrated auditing, actually it is risky in that it would reduce the efficiency of the auditor’s working and the auditor even may forgot their role to audit not hide something for the company. Moreover, Gordon (2003) concluded that Enron top management team chose to fraud by the complex private entities rather than the market driven structure, the board fail to conduct the critical faculties.

Therefore, the neglect and excessive trust of the board of Enron as well as the over powerful within the top executives had account for the later failure. Traditionally, the board existing is responsible for the monitor to protect the interest of shareholder. Once they failed their responsibility and gave too much power to the top decision makers, then the decision makers would take the opportunity to manipulate the situation especially in the accounting part by using the creative accounting. Gordon (2003) suggested that a reliable corporate governance system ought to catch wrongdoing before it becomes pathological and carries such destructive consequences for the shareholders, not to mention the other stakeholders. The board needs to keep an eye on the stock movement or other things to see the change of the market no matter in the booming or bear market.

On the other hand, the shareholders and stakeholders also played a vital role in the failure of corporate governance regarding the Enron Case. Currall and Epstein (2003) concluded that the investors like stakeholders or shareholders were lack of the knowledge about the Enron business model. Enron sold a good prospect to the investors based on the run up stock price and the decorated financial report. For one thing, the stakeholders and shareholders did not know the exactly the business model of Enron and critically review the model, then they just according to the past performance of the stock price movement thought the stock price would go up. Many investors admitted that they did not know the business of Enron but confident with the stock. For another thing, the Enron gave the pressure on the professional investors like Wall Street analyst who may deviating from what Enron told, then the analyst had to give up their critical review. Enron imposed the confidence to the investors by the rapid rise of stock price, at the same time hided the information like off-balance-sheet activities and make-to-market accounting to the investors. (Christopher, L. et al, 2003) Therefore, the Enron used these creative accounting methods to raise the stock price rather than the transparency disclosure. These creative accounting methods such as wash and round trips mislead the public that the real operating performance the transaction is not real because Enron sold it to its overseas subsidiaries, to some extent, it is like trading with itself. The imposed pressure, and the lack of transparency did not draw the shareholders and stakeholder’s attention that Enron hided so many information and used the creative accounting to mislead them. Instead, the investors chose to believe the company blind, rather than critical review the operation of the Enron. Thus, Enron have the confidence or motivation to use the creative accounting to decorate the financial report because the company knew others did not pay attention the real operation of the company, the investors just care the stock price and the prospects. Since the company would issue the annual report, if the investors neglect or cannot understand the report, this gave the chance to the company to fool the investors. Investors need to critically review the company’s financial report and ask the additional disclosure when they found the improper part. By doing so, it can prevent them from the loss and protect their interest because additional disclosure or understanding of financial report will constrain the company to use the creative accounting methods because they know they will not cheat the shareholder and stakeholder anymore.

As for the shareholders and stakeholders is the other part outside the board to monitor the top management team operation, their focus not only need to be focus on the return on investment, but also more importantly pay attention to the abnormal movement of the stock price. They need to understand the additional information that the company release or asked the company for the additional disclosure regarding the abnormal movement. If trusting blindly, it will result the potential risk like the series of financial risks following after the collapse of Enron. The long run business relationship is established the effective and efficient monitoring mechanism. The shareholders and stakeholders shall not focus on the short term profit, while need to develop a long run business with a critical review.

  1. Conclusion:

All in all, the collapse of Enron shocked the world regarding the effective corporate governance. Instead of blaming the CEO or the top executives, it gave an alarm about the importance in the corporate governance. It should establish the effective principal of corporate governance to ensure the director must be independent of the senior management team and pay attention to the operation of the company. For example from the view of the board, it should establish the mandatory disclosure system supported by the antifraud rules to ensure the information they got is correct and transparent. Undoubtedly, the top management team, the board, shareholders hold the company’s share all the time, on the one hand, it gave the top executives incentive to manipulate its financial report by creative accounting, which in turn conveyed to the public by the ‘good story’. Therefore, constrain the over power of top management teams is quite essential. The director member of the board needs to be independent of the management director. Thus could ensure an effective monitoring to prevent the top management executives adopt the creative accounting or fraud. On the other hand, the directors and shareholders have to push the company compliance with the self regulation and critically review the stock price movement. If the abnormal movement took place, the board and shareholders could track and ask for the disclosure. Last but not least, for the better corporate governance, the US GAAP could adopt the true and fair view override instead of present fairly to ensure the quality financial report and additional disclosure when the company deviates from the some principal.

 

Reference:

Abbas, A.M et al. (2010). International Financial Reporting Standards (IFRS) Workbook and Guide: Practical Insights, Case Studies, Multiple-Choice Questions, Illustraions. New Jersey: John Wiley & Sons Inc. pp. Forward.

Adams, E.S. (2003). Corporate Governance after Enron and Global Crossing: Comparative Lessons for Cross-National Improvement. Indiana Law Journal. Vol. 78. pp. 723-781

Benston, G.J. (2003). The Quality of Corporate Financial Statements and Their Auditors before and after Enron. Policy Analysis. Vol. 497. pp. 1-29

Christopher, L. et al. (2003). Corporate Aftershock: The Public Policy Lessons from the Collapse of Enron and Other Major Corporations. New Jersey: John Wiley & Sons Inc. pp. 28-48

Colley, J.R. et al. (2003). Corporate Governance. New York: the McGraw-Hill. pp. 11-13

Currall, S.C & Epstein. M.J (2003). The Fragility of Organizational Trust: Lessons From the Rise and Fall of Enron. Organizational Dynamics. Vol. 32(2). pp. 193-206

Elson, C.M & Gyves, C. J. (2003). The Enron Failure and Corporate Governance Reform. Wake Forest Law Review. Vol. 38. pp. 855-884

Gordon, J.F. (2003). Governance Failure of the Enron Board and The New Information Order of Sarbanes-Oxley. Connecticut Law Review. pp.1125-1144

Hu, D. (2002). The usefulness of Financial Statements under Chinese GAAP vs IAS: Evidence from the Shanghai Stock Exchange in PRC. Working Paper, China

McLeay, S. & Riccaboni, A. (2001). Contemporary issues in accounting regulation. Norwell: Kluwer Academic Publishers. pp. 155-166

Monks. R.A.G et al. (2008). Corporate Governance. West Sussex: John Wiley & Sons. pp. 18-19

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