Imagine over $60 billion of shareholder value, almost $2. 1 billion in pension plans, and initially 5,600 jobs – disappeared (Associated Press, 2006). One would have to wonder how that is possible. These are the consequences the investors and employees of Enron Corporation endured after the Enron scandal started to unravel. This paper will focus on the infamous accounting scandal of Enron Corporation. It will also discuss how the company was able to fool investors by producing misleading financial statements, why they were not caught sooner, and new regulations enacted in response to the scandal.
Enron Corporation was a leading American energy company located in Houston, Texas. The company was started in 1985 when Houston Natural Gas Omaha-based InterNorth merged together (Thomas, Rise and Fall of Enron). Today, Enron Corporation is most widely known for their 2001 accounting scandal, which led to the biggest audit failure and largest bankruptcy in American history. After Mr. Jeffrey Skilling, Enron’s President, was hired, he began to build up a staff of top executives that were able to conceal billions of dollars of debt the company had incurred from failed projects and deals.
Therefore, even when Enron was failing, they appeared to investors as profitable and growing. The staff worked together and was able to cover their debt through the use of complex accounting methods, special purpose entities (SPEs), various loopholes, and poor financial reporting standards. Enron aggressively recognized revenue using the merchant model (Haldeman, Fact/Fiction) which inflated trading revenue and helped create the notion that Enron was experiencing high growth and remarkable business performance.
They adopted mark-to-marketing accounting which requires that once a long-term contract is signed, income is estimated as the present value of net future cash flows (Haldeman, Fact/Fiction) which also contributed to misleading numbers on Enron’s financial statements. Enron also used hundreds of special purpose entities, which are limited partnerships or companies created to fulfill a temporary or specific purpose-to fund or manage risks associated with specific assets, to hide its debt (Thomas, Rise and Fall of Enron).
The company contained a compensation and performance management system that focused on temporary earnings to maximize bonuses, which only helped foster the reasons for the executives to conspire and mislead everyone, including Enron’s board of directors and audit committee of any accounting issues and Enron’s actual financial condition. Enron executives pulled every complex tactic in the book. Even though the Enron executives were able to mislead Enron’s board of directors and audit committee, they should have been stopped.
Public companies are audited on a yearly basis by external, independent auditors or CPA firms. During the external audit, auditors are reviewing the company’s financial statements to ensure that they are consistently following Generally Accepted Accounting Principles (GAAP), which are a dynamic set of both broad and specific guidelines that companies should follow when measuring and reporting information in their financial statements (Federal Accounting Standards Advisory Board).
Businesses may deviate from GAAP however, they are responsible for explaining why they have deviated and that their current non-GAAP practice is ethical and appropriate for their situation. These audits take place to ensure that the company’s financial statements are as accurate and reliable as possible for investors and the general public. While GAAP provides guidelines on how financial statements should be presented, Generally Accepted Auditing Standards (GAAS) on the other hand are standards for the audit cycle of a company such as which tests to perform and to what extent (Business Definition).
Arthur Andersen was the CPA firm responsible for auditing Enron’s financial statements. Under GAAS, they had a responsibility to investors and the general public to ensure that Enron’s financial statements were accurate and reliable as there were many people who relied on Andersen’s professional opinion of Enron’s financial statements. One of the major items in GAAS states that auditors must remain independent in both fact and appearance. However, Arthur Andersen was not only auditing Enron, they were consulting for them as well.
The consulting that Arthur Anderson was doing for Enron brought in a lot of revenue therefore, they did not appear independent. Although various auditors documented conflicts with the audit committee of Enron and several other concerns, the leading partner on the audit, David B. Duncan, overturned the issues and concerns. Due to the active role Arthur Anderson had in Enron Corporation, they overlooked many accounting concerns and the fraud was undetected for a long period of time. However, the truth about Enron was eventually brought to light for the investors, employees, and the general public.
The accounting misstatements were discovered Enron told investors they were going to restate their earnings for the past few years. Shortly after Enron restated their earnings, the company declared bankruptcy. Also, Sherron Watkins, an Enron Vice President, wrote an anonymous letter to Kenneth Lay who stepped up as Enron’s CEO after Skilling left due to “personal reasons”. Sherron Watkins’ letter questioned Enron’s accounting methods and also proposed that Skilling left due to dishonest accounting and other illegal actions (Frey, Woman Who Saw Red).
From there, other people began to speak up and question how it was possible that Enron was continuing to make money. Eventually, an investigation by the SEC was initiated to review Enron’s accounting procedures and their partnerships. Shortly after the investigation, Enron officials admitted to overstating the company earnings for multiple years. Today, Enron no longer exists and Arthur Anderson is no longer performing audits. The monetary damages suffered by investors, employees, and other companies in the Enron scandal are monstrous.
With so much doubt lurking over investors, the government needed to react. After the public was made aware of the Enron scandal, and other recent scandals such as WorldCom and Tyco, a flood of proposals and legislation were produced by Congress and the Security and Exchanges Commission (SEC) about how to deal with the situation. Of the changes brought about, the Sarbanes-Oxley Act was by far the largest. The Sarbanes-Oxley Act of 2002 is named after its sponsors, Senator Paul Sarbanes and Representative Michael Oxley (The Sarbanes-Oxley Act).
The act is administered by the SEC, and is legislation that was enacted to help protect investors and the general public from accounting errors and fraudulent practices. The SEC sets the deadlines for company compliance along with the rules on its requirements. The Sarbanes-Oxley act changed how executives and corporate boards interact with each other and corporate auditors, it ensures that top company executives such as CEOs and CFOs are held responsible for the accuracy of their financial statements, the Act provides new internal controls and procedures which companies must follow, and also provides penalties for wrongdoings.
The Sarbanes-Oxley Act was enacted January 23, 2002 and contains 11 titles (sox-online). Each title describes specific requirements companies must follow for financial reporting and each title contains multiple sections which have been summarized below. Title I – Public Company Accounting Oversight Board (PCAOB). Title I of the Sarbanes-Oxley Act contains nine sections. Title I establishes the Public Accounting Oversight Board to oversee activities of the auditing profession and protect the interest of investors and the general public.
The Board is responsible for registering public accounting firms and they also conduct inspections of the firms. When an accounting firm applies for registration, they must include information such as the names of all companies they prepared or issued audit reports for in the preceding calendar year, which companies they expect to prepare or issue reports for during the current calendar year, annual fees received by the firm from each company, a statement of the firm’s quality control policies, a list of all accountants, and the list goes on.
The Board must perform annual reviews of registered public accounting firms that regularly provide audit reports for over 100 issuers, or not less than once every 3 years for firms who regularly provide reports for 100 or less issuers. The PCAOB is also responsible for establishing standards for auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports, and enforcing compliance with the Sarbanes-Oxley Act.
While enforcing compliance, the Board can impose various disciplinary actions including suspension or permanent revocation of registration, temporary or permanent suspension on activities, or even monetary fines. Title II – Auditor Independence. Title II of the Act also consists of nine sections. Title II establishes standards for external auditor independence. The provisions under this title restrict auditing firms from carrying out compensated activities for the companies they audit which fall outside the realm of auditing. This provision is to help limit any conflicts of interest that may arise.
Some activities external auditors may no longer provide to companies they audit include bookkeeping services, financial information systems designs or suggestions, and actuarial services. If the firm does want to engage in a non-audit service such as tax services, approval by the audit committee of the issuer must be obtained first. Other provisions of Title II require that audit partners are rotated after five years of auditing a client, it establishes auditor reporting requirements, and also prohibits financial officers of the audited company from having been employed by the audit.
Other provisions of Title II make it a requirement that audit partners rotate auditing clients after five years, it establishes reporting requirements for auditors, and also prohibits financial officers of the public company from having worked at the auditing firm. Title III – Corporate Responsibility. Title III consists of eight sections and ultimately requires that top executives take responsibility for their financial reports. It states that the principal executive and principal financial officers must sign the financial statements to reflect that they are current, accurate, and complete.
Title II holds top executives personally responsible and describes repercussions such as removal of bonuses or incentives if misconduct is found. It also requires companies to form audit committees, made up of independent board members, for the public accounting firms to report to. Title IV – Enhanced Financial Disclosures. Title IV consists of nine sections. The purpose of Title IV is to help ensure that financial transactions are reported accurately including off-balance sheet transactions, pro-form figures, and special purpose entities.
The Title also mandates that companies make their code of ethics public and that they disclose any changes in financial condition in real time. Another important requirement of this title is that all annual reports of a company must include a report on their internal controls which must be established, maintained, and assessed every year. Title V – Analyst Conflicts of Interest. Title V consists of only one section and addresses securities analysts who recommend the purchase of securities to the public.
The Title defines the codes of conduct for securities analysts to help prevent conflicts of interest. If there are any knowable conflicts of interest, it requires that they be disclosed. Title VI – Commission Resources and Authority. Title VI consists of four sections and is meant to help restore investor confidence in securities analysts. It gives the SEC authority to monitor and even bar securities analysts from practice under certain conditions. Title VII – Studies and Reports. Title VII consists of five sections.
This title requires the Comptroller General and the SEC to perform a variety of studies and report on their findings. The studies conducted are to identify the effects of public accounting firm consolidation, the role of credit rating agencies in the securities markets, security violators, their violations, and enforcement, and whether or not investment banks helped public companies manipulate their earnings. Title VIII – Corporate and Criminal Fraud Accountability. Title VIII consists of seven sections. Title VIII lays out the criminal penalties associated with accounting fraud.
This Title makes it a felony to knowingly alter, destroy, mutilate, conceal, cover up, or falsify and record, document, or tangible object with an intent to throw off investigations. It also extends protection to employees who provide evidence of any fraud (whistle-blowers). Title IX – White-Collar Crime Penalty Enhancements. Title IX consists of six sections and describes the increased criminal penalties associated with white-collar crimes such as misstating financial statements, mail and wire fraud, and tampering with records.
It also states that if corporate officers fail to certify their financial reports, they have committed a criminal offense which is punishable by fines and jail time. Title X – Corporate Tax Returns. Title X consists of only one section and it simply requires that the chief executive officer of a company must sign the corporate income tax return. Title XI – Corporate Fraud Accountability. Title XI consists of seven sections and specifically amends the U. S. Code to make tampering with records and interfering with official proceedings a crime.
It also lays out the penalties associated with those crimes which could consist of temporarily freezing extraordinary transactions or payments during investigations (sox-online). The Sarbanes-Oxley Act was put into place to help deter companies from committing accounting fraud and misleading investors and the general public. The biggest question asked now is, does the Sarbanes-Oxley Act work. There are pros and cons associated with the Sarbanes-Oxley Act. The biggest negative associated with Sarbanes-Oxley is the high cost to comply.
When the legislation was passed, each company was left to create their own methodology for ensuring compliance. This was expensive and time consuming. Companies now had to implement various IT systems and complex record keeping systems to ensure they maintained in compliance with the new Act. Some companies had to hire more employees whose job was to ensure that their processes and procedures remained in compliance with the Act. The companies were now responsible for not only having internal controls but reporting on them annually along with have them reviewed by independent audit firms who opinioned on them.
Companies had to make many changes once the Sarbanes-Oxley Act was passed. However, if it can help prevent scandals such as Enron’s, most agree that the price is worth it. However, another issue that comes up regarding the act has to do with ethics. The opportunities for fraud at Enron exist in many other companies that don’t go down filing bankruptcy. The main difference being that they do not employee unethical personnel in the top positions of their companies. Therefore, it is safe to say that ethics, or lack of, played a big part in Enron’s collapse.
Many people say that legislation will not make executives “more” ethical. I agree with this statement however, I believe that the Sarbanes-Oxley Act takes away many of the opportunities the executives had to commit the fraud. Without any opportunities, it is much more difficult to commit fraud. Since Sarbanes-Oxley has been in effect, investor confidence has been restored which is the biggest pro and primary purpose of the Act. The Act has also caused many companies to really take a look within their company and become more aware of things they were before oblivious to.
These companies now have better internal control environments which will result in more accurate and reliable information being available to investor while also reducing many of the opportunities to commit fraud. And since the Act has no exceptions, companies have really stepped up to ensure that they are and remain in full compliance with the Act. Finally, it holds individuals accountable for their accounting and auditing actions. No longer can they pretend to be oblivious or hide behind one another. Overall, I believe that Sarbanes-Oxley is a big step in the right direction.
After the scandals of Enron, WorldCom, Tyco, and others, it was imperative that the government step in and make changes. Sarbanes-Oxley does a great job of laying the ground work for ethical accounting and auditing behavior.
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