Case Study of Enron Corporation

Answer

Case Study of Enron Corporation

Enron Limited Company was formed in the year 1985, as a result of merger between Houston natural Gas Company and Omaha-based Inter North Incorporation. As a result of this merger, Kenneth Lay, who had been the company’s Chief Executive Officer (CEO) of the Houston Natural Gas Company, became Enron’s new CEO. The chairman quickly rebranded Enron into an energy trader and supplier.  Deregulation of the energy markets allowed companies to place bets on future prices and Enron was the one targeted to benefit most (Brost, 2017). In the year 1990, the company’s CEO created the Enron Finance Corporation, to head it. He further appointed Jeffrey, whose consultancy firm has impressed him. One of Jeffrey remarkable and prioritized contributions, was to move Enron from the traditional cost accounting, method, to the modern accounting system, known as market-to-market (MTM) accounting method. This new method of accounting was approved in the year 1992, and the company started employing it immediately (Brown, Daugherty & Persellin, 2014). Market-to Market accounting is defined as an accounting method in which the fair value of the accounts, which can change over time, such as assets and liabilities.

According to Curtis (2009), market to market accounting usually aims at providing a realistic appraisal of an institution or company’s current financial position.  It is a very legitimate form of accounting system, and it is widely accepted within the field of accounting. However,  this form of accounting is subject to manipulation, since is usually not based on the actual cost on the fair value, which is more difficult to pin down,  Some professionals argue that the beginning of Enron Corporation’s fall was marked by adoption of this system. This is due to the fact that the company started logging the estimated profits as the actual ones.   By the year 2000, the company had started crumbling.The company’s CEO had a way of hiding losses of the trading business and other company’s operations.  The company ultimately became bankrupt, leading to a number of people who were shareholders losing their investment. This paper therefore analyzes the fall of Enron Corporation, in relation to the accounting practice which the company adopted.

The Parties Responsible for Enron’s fall

As has been stated above, it is believed that the Market to Market accounting system, formed the main basis for the company’s fall. This system, was created in order to hide the company’s losses, as the company would report the profits in form of the estimates. It is due to this scandal, which greatly reduced the public’s confidence on limited companies, that Sarbanes-Oxley Act was enacted. This act aims at the publicly held companies, their internal financial controls, and their financial reporting procedures as performed by an external auditor. The following people are therefore responsible for the company’s fall.

The company’s Chief Executive Officer

The inability of the company’s Chief Executive Officer to have a firm stand on financial decision making process, was detrimental to the company. This is despite the fact that he had a great experience in management. The CEO of Enron Limited Company made a decision to keep John Wing as a consultant for the company, despite being a former employee of the company, and being fired by the board of management. In such as a case, it was impossible for the John, who was hired as a financial consultant, to be able to handle the company’s assigned roles without biasness (Brost, 2017). The Company’s CEO compromised the ethical requirements of management and accounting, which explicitly forbid hiring of former employees as consultants. When the company’s chief accountant raised major concerns on the effectiveness of the market to market accounting system, which had been adopted by Enron Limited, the CEO, failed to take any action to rectify the system.

The mess to be created by market to market accounting was foreseeable, as this accounting system, would lead to reporting of the un-existing profits.  Bankruptcy and collapse of Enron Limited was an orchestrated process, and the CEO was in a clear position of seeing danger coming, but he chose to keep quiet and reported nothing, neither to the board of directors, nor to the shareholders (Brown, Daugherty & Persellin, 2014).  It is very evident that the company’s chief executive officer, chose to turn a blind eye to the fraudulent acts which were being performed by his employees or juniors.  This is a clear indication that he was having full knowledge of the same.

The Board of Directors

Being very desperate for profit, the company’s board of directors made a decision to enter into a merger with Houston Natural Gas Limited, even without following the proper and laid down due process.  In the normal corporate practice, a bigger company, should be the one proposing or lobbying for a merger with a smaller company and not vice-versa. In case which led to formation of Enron limited, however, the opposite took place, where a smaller company lobbied for a merger with a bigger company. This led to shooting of the operational costs, hence the bankruptcy witnessed (Brown, Daugherty & Persellin, 2014). Upon formation of Enron Limited, the board of management or directors, were not careful enough to analyze the proposed accounting system before adopting. The Board of directors are mandated by the shareholders, to clearly analyze the proposed policies as well as the financial statements, before they are voted.

The board hurriedly endorsed market- to-market accounting, without thoroughly analyzing it to understand its dangers.  Besides, the financial statements (the income statement), reported the company’s profits based on estimates, while in real sense, the company was realizing losses.  The board of directors failed to report this on time. Hence leading to the Enron’s collapse. This means that the company’s board of management performed   their oversight roles incompetently. This is what actually led to inclusion of proposal of formation of the audit committee Sarbanes-Oxley Act (Brost, 2017).). Even at the point that bankruptcy had been sensed and the court declared the company bankrupt, the members of this company’s board, were very hesitant to give the true and fair information on what transpired. It is the role of the board of directors to ensure that the hired independent auditor is absolutely independent.  This company’s board decided to hire a former employee of Enron, who could not be independent whatsoever

The Finance Manager or the Chief Finance Officer (CFO)

According to the International Financial Reporting Standards, the board of the directors, through the managing director, are the ones responsible for preparation of the financial statements, and ensuring that they present the true and fair view of the company. Enron’s finance manager, made a decision to use market-to-market accounting system, while it was very clear that this system would reduce drastically the financial management competence(Brost, 2017).). The finance manager was very much aware from the financial reports presented to him by the accountants, that the company was realizing losses and that it risked being declared bankrupt, owing to its liquidity position.  However, he decided to collude with other board of directors, to report estimated profits, instead of the actual losses which Enron was realizing. Despite being in financial turmoil, the finance manager advised and endorsed payment of bonus to the company’s employees. This further increased the operational expenditures and losses thereof.

Other employees, the company also decided to give bonus to its traders.  This also reduced the realizable revenue. The employees who were given bonuses, left the company only after three months, despite the company spending up to $ 105 million in awarding them the bonuses.  It is also worth to note that there was nothing which warranted the bonus which the company gave to its employees. This is due to the fact that, the company was actually realizing losses.

The External Auditor

Auditing refers to independent examination of the financial statements and expression opinion as to whether the financial statements present the true and fair view of the company.  The oversight role of the auditors is delegated by the shareholders, to examine whether or not the board of management are using their investment appropriately, to maximize profit (Brown, Daugherty & Persellin, 2014). While it is not the role of an auditor to detect fraudulent acts, he or she is obliged any fraudulent act detected. It is also required by law that the auditor be independent and not to collude with the board of directors to conceal fraudulent acts. Enron’s independent auditor was neither independent, nor did he report the fraudulent acts which he detected. The auditor instead, colluded with the management to conceal frauds and produce audited reports which revealed that the company was realizing profits, while in actual sense losses were being realized.

Recent Services Offered Currently by Auditors

Traditionally, the audit services was limited to examination of the financial reports and expression of opinion. However, of late auditors have included on top of their typical service, the following services:

Book-Keeping Services

Currently, the auditors offer book-keeping services, which is typically the work of the company accountant. This service is offered, when the auditor is requested by the client (Holtz & Neto, 2014). It is a great threat to the auditor’s independence, as the auditor will actually be examining his or her own work. Book-keeping is done by the auditors at an extra fees, on top of the quoted audit and assurance fees.  This service also makes the auditor to be vulnerable to manipulation by the board of directors.  The International Auditing Standards (IAS), argues that there is a thin line between offering extra services to the clients and maintaining the auditor’s independence.  In this regard, the underlying position historically taken by the General American Accounting Principles (GAAP) and the International Auditing Standards is that the auditors are prohibited to offer any book-keeping or any other service which is part of the financial reporting procedures (Simunic, Minlei & Ping, 2015)

The precise rule is that, an accounting firm cannot remain independent, with regard to the examination of the financial statements if the same firm has participated closely, either manually or through its computer services. This is also in line with the provision for the Security for Exchange Commission (SEC), rule 2-01(c). The point at which accounting assistance or advice creates independence problem is no clear cut.  Instead, it is a matter of professional judgement. However, it is in relation to the same, it is dependent on whether the assistance constitutes close participation or not. Book keeping is therefore, a practice which is not allowed as one of the audit services.

Accounting Advisory Services

Accounting advisory services refers to refers to consultancy services on which revolves around book-keeping, accounting practice and preparation of the financial reports. Advisory services revolves around formation of accounting policies and their application thereof.  Some of the specific services which are offered in accounting advisory services include;   advisory on tax payable and calculation, advisory on tax avoidance, advisory on how to manage the cash and cash balance, advisory on working capital, advisory on calculation of depreciation and the best method which can ensure that the company does not have an overstated expenses, advice on leverage among others. As had been stated earlier, an auditor can only be able to maintain independence the auditing company is not involved whatsoever in any activity of preparing the financial statements and reporting thereof.

Depreciation accounting, calculation of tax due, operating of cash and cash equivalence accounts, is part and parcel of preparation of the financial statements.  This therefore, means that involvement of the auditor or the auditing company on these services will obviously mean that he or she will have participated in preparation of the financial statements.  In offering of the audit services, the auditor is supposed to audit both the liquid assets and the non-liquid assets. It is worth to note that liquid assets, such as  cash and cash equivalence are elements which determines whether or not the company is in a position to meet the short term obligations or not.  Inability to meet the short term obligations obviously exposes the company the company to liquid risks, which may lead to ultimately make the company to have a diminishing going concern. Going concern in this case refers to the ability of the company to exist for a foreseeable time period.

According to the International Audit Service (IAS), the work of the auditor is limited to examination of the financial statements and expression of opinion. In expressing opinion, the auditor must state whether or not the subject company complies with the set the International Financial Reporting Standards (IFRS), and other accounting policies (Simunic, D Minlei & Ping Zhang, 2015). In case the auditor is the same person offering the same advisory services of how to adhere to the auditing and accounting services, then it will be impossible for him or her to state any anomaly  if any.  The payment of an auditor otherwise known as the audit fees is guided by the International Auditing Standards. Due to the fact that this extra service make the auditor to be paid an extra amount, he or she will be vulnerable to manipulation of by the board of management. The recent recommendation, is that the auditors must ensure that they offer only the services which revolve around examination of the financial statements and expression of opinion thereof.  Extra services, which is not in line with examination of the financial statements and expression of opinion is opinion should be avoided by the company.

Regulatory and Compliance Services

Regulatory services refers to the financial reporting practices which ensure that the financial statements are in line with the International Financial statements (Seay & Ford, 2010).  Though a company can hire an auditor to specifically examine its compliance with the set auditing standards, it can be included in the normal auditing service.  One of the factors which influences the nature of the opinion which an auditor gives, is the level of compliance with the regulatory services. This can either be expressed in the audited financial statements or the management report which the auditor gives the company’s management after or before or even together with the audited financial report. This is a service which is defined within the law, and it does not compromise the level of the auditor’s independence whatsoever.

According to the International Auditing Standards (IAS), the auditor is supposed to express opinion on how the company which is being audited manages its Internal Control System (ICS). This service does not make the auditor to get an extra pay, neither does it make the auditor ton interact more with board of management. Based on this, it therefore, factual to state that this service not reduce the level of an auditor’s independence.

Conclusion

Based on the above analysis, it is therefore possible to conclude that the fall of Enron Corporation was due to failure of the auditor, as well as the professionals in charge of preparation of the financial statements, strategy formulation and its day to day operations.  It is therefore prudent that the level of auditor’s involvement in the company activities be limited to what the auditing standards recommends, and the statutory guidance on auditing and accounting standards.  All companies must also comply with the Sarbanes-Oxley standards. Besides, the managers should shun at all costs their conflicts of interest.