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What went wrong?
The Enron scandal emerged in 2001 and led to the collapse of Enron Corporation, one of the largest America’s companies at the time. The scandal involved Enron and its external auditors, Arthur Anderson, and it was associated with audit failures about the company’s operations and cash flow. The company filed for bankruptcy after a sharp decline in the value of its shares and problems financing debts. Andersen was convicted of obstructing justice for destroying files on Enron audits with the knowledge that the evidence would be required in investigations by regulators.
Enron Scandal Research Paper
As of 2000, Enron was ranked number seven on the Fortune 500 list of the most successful companies and in August the same year, its share priced reached a peak of $90.75, but sharply fell to $0.67 by January of 2002 (CNN Library, 2015). The scandal started unraveling in 2001 when financial analysts started questing after the company’s way of reporting its accounts and its sources of earnings. These queries were dismissed until the Security Exchange Commission (SEC) started investigations following the resignation of the CEO, reduced earnings and a decline in the company’s share prices. In December 2001, Enron filed for bankruptcy protection, making it the largest bankruptcy in the US history at the time (CNN Library, 2015). The investigations into the scandal found the top executives guilty of fraud related charges for their role in the company’s downfall.
The company’s bankruptcy is mainly associated with the management of its operation debts using its subsidiaries, referred to as the Special Purpose Entities. Enron would create smaller companies, SPEs, to serve in facilitating its deals without recording the related costs of the deals. However, these companies were funded using Enron’s stock or the company served as their guarantor when dealing with external financiers. Therefore, when these entities incurred losses, the parent company was affected on the value of its stock, but could not record the losses in its financial reporting. By managing risks using its own subsidiaries, Enron retained all the risks associated because of its responsibilities in funding and guarantee for these entities’ operations. Many of the operations financed through SPEs collapsed, but the company did not indicate the losses in financial reporting. Practically, these entities were used to transfer and hide losses that would have appeared in Enron’s financial reporting. Also, the company had used an accounting system that inflated its market value to unsustainable levels.
Where did internal controls fail?
The company failed to manage its business model. The employees at Enron did not have the necessary skills to deal with risks related to intangibles in the diverse business model (Cunningham & Harris, 2006). Enron began in 1985 as a company in the energy industry but later diversified to operate as a service company and was applauded for its innovative approach to exploiting new markets. It started dealing with projects in natural gas and electricity and then diversified to include projects on internet broadband and intangibles. However, the management was not prepared for the change in business model and did not understand the risks. According to Cunningham & Harris, many top executives interpreted the new business model in terms on managing reported cash flow and managing numbers, instead of selling goods and services (2006).
The organizational culture at Enron promoted unethical business practices as executives and employees were preoccupied with making deals without considering the risks and the status of the company’s cash flow. The Board had approved the exemption of the Chief Financial Officer from the company’s code of ethics on issues related to conflict of interest, so as to facilitate the creation of the special purpose entities (Cunningham & Harris, 2006). This move was to allow the chief financial officer to operate and control the special purpose entities. By exempting the chief financial officer from the requirements on the code of ethics, the board encouraged an unethical conduct in managing the company’s operations. According to Cunningham & Harris, there was an organizational culture change at Enron when the company started dealing with intangible assets and the executives at the company were highly focused in generating revenues without accounting for risks and operational costs (2006). Similarly, the involvement of Arthur Andersen in consultancy services weakened its organizational culture as an audit firm.
Where did internal or external auditors fail?
The internal auditors promoted the wrong accounting approach for the company’s nature of business. Enron used the “mark-to-market” accounting practice in a scheme that was used to inflate the value of the company. The mark-to-market practice involves determining “what the actual value of the security is at the moment” (Seabury, 2016). In the case of Enron, this practice would be used to add the projected profits from certain projects to the company’s earnings even before the projects started delivering. The main aim of this approach was to increase the value of the company’s shares in the market. Also, the company’s executives used special purpose entities (SPEs) to hide losses from financial reporting. These SPEs were meant to serve as hedge entities but in reality, they were owned by Enron and thus could not guarantee its financial stability.
The auditors failed to uphold professional ethics on conflict of interests and honesty. One of the major roles of external auditors is to point at the weaknesses of internal control systems in their client companies, but Arthur Andersen ignored the weaknesses in Enron (Cunningham & Harris, 2006). The failure by the external auditor to report on problems in the internal auditing system is associated with its interests in providing consultancy services to the same company. Andersen received 70% of its fees from Enron through consultancy services (Cunningham & Harris, 2006). The role of an external auditor to a firm and as a consultancy at the same time creates a conflict of interests when reporting internal issues. The Enron scandal shows that the external auditors had the knowledge of the accounting issues in the company but failed to uphold their professional standards on reporting.
What was the remedy?
The Enron scandal had a lot of negative impacts, and this led to various changes in the regulation of public companies and operation of auditors in public firms. The Enron scandal affected many people including the company’s thousands of employees whose pension had been invested in Enron’s stock. The company had managed to misrepresent its accounting status to investors and the regulators using accounting systems that could hide the operational losses and inflate the value of the company. The scandal exposed weaknesses in the US regulation system in dealing with off-balance-sheet operations and the weaknesses in accounting standards in enforcing professional conduct (The Print Edition, 2002). The executives at Enron were able to mislead regulators and investors using various loopholes in the regulations on auditing.
The Enron scandal led to the establishment of the Sarbanes-Oxley Act of 2002, to protect investors from corporate fraud (Cunningham & Harris, 2006). The Act provides guidelines on company financial disclosures to the public. The requirements for financial disclosure are meant to ensure public companies are transparent in their financial status and value of their shares in the market. To ensure the implementation of the new accounting and reporting standards, the Sarbanes-Oxley Act established the Public Companies Accounting Oversight Board to oversee the operations of audit firms involved in public companies. Currently, the SEC and state securities agencies indicate the nature of the information that should be provided in financial reporting by public companies. Besides, the Financial Accounting Standards Board (FASB) raised its requirements on ethical conduct among accountants (Seabury, 2016). The ethical standards are meant to guide accountants to maintain professionalism in their work. The Enron scandal shows ethical failures in reporting and conflict of interests by the external auditors in the firm. Also, the new ethical standards promoted the use of the Generally Accepted Auditing Standards in public firms from 2002 (Cunningham & Harris, 2006). Until the collapse of Enron, auditing was largely self-regulated, and audit firms could engage in services that affected their role of auditing. For instance, Arthur Andersen compromised its role as an auditor by doubling up as a consultancy to the same firm.
- CNN Library. (2015). Enron Fast Facts. CNN. Retrieved 18 March 2016 from http://edition.cnn.com/2013/07/02/us/enron-fast-facts/
- Cunningham, G. & Harris, J. (2006). Enron and Arthur Andersen: The case of the Crooked E and the Fallen A. Global Perspectives on Accounting Education, 3, 27-48.
- Seabury, C. (2016). Enron: The Fall of a Wall Street Darling. Investopedia. Retrieved 18 March 2016 from http://www.investopedia.com/articles/stocks/09/enron-collapse.asp
- The Print Edition. (2002). The lessons from Enron. The Economist. Retrieved 18 March 2016 from http://www.economist.com/node/976011