Enron's Downfall: Risky Financial Deals and Poor Disclosures - Essay Sample

Introduction

Although attitudes and motives of the events and decisions that led to the downfall of Enron appear simple, many stakeholders, including stockholders believed that the company was too good to be true. Shareholders continued to buy stock, while the company continued to engage in risky financial deals. Some of these transactions were beyond the company’s risk control process (Thomas, 2002). Unfortunately, the company used erroneous methods to disclose its complicated financial dealings to its shareholders. Consequently, they appeared downright deceptive. These dealings led to the omission of billions of liabilities and losses, leading to the demise of the company.

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Description of the Related Party Transactions Arthur Anderson & Company Reported

The beginning of the fall of Enron is associated with related-party transactions. The Special Committee Report demonstrated pitfalls in the related-party transactions. The first one was the Chewco transaction. The restatement of the company’s financial statement in November affirmed that Chewco was a related party that did not meet the accounting rules and regulations, permitting an entity to remain unconsolidated. Since the transaction did not meet the special purpose entity rules, the company had to restate its financial statements (Thomas, 2002). The board found that no evidence presented to the board regarding this transaction; thus, shocking stakeholders. Understandably, the board relied on advice from senior management and external advisors, such as Arthur Anderson to structure the Chewco transaction. Consequently, Chewco was unaffiliated with Enron. The internal and external controls failed to mention to the board that Michael Kopper had an interest in Chewco despite being an employee of Enron.

The other related-party transaction is how Enron conducted many business transactions through special purpose entities to end precipitous fall in stock value. However, the most controversial and problematic transactions were LJM Cayman LP and LJM2 Co-Investment LP. Enron employees, including Fastow, had an interest in the transactions. Surprisingly, Fastow was managing these two entities at the time of the transaction. They paid him $30 million from 1999 to 2001 (Thomas, 2002). The sum is more than what Enron paid him. The firms conducted business with the company supposedly with the approval of the board of directors and the top management team.

Additionally, LJM’s partners developed another investment group called Raptor vehicles. It was designed to hedge Enron a bankrupt broadband company, known as Rhythm NetConnctions. Consequently, Enron issued a note receivable of $1.2 billion in exchange for common stock in response to the capitalization of Raptor entities. Furthermore, Enron increased notes receivable, as well as shareholder equity to reflect on these transactions. It was a major violation of accounting principles (Thomas, 2002). Worsening the problem is the fact that Enron failed to consolidate LJM and Raptor SPEs in its financial statements. It happened during the investigations that the information could have been consolidated in the statements. Although some employees knew that the transaction was unfair to the company and violated accounting principles, they did not disclose the information. These dubious transactions damaged the company’s reputation, leading to its losses.

Description and Evaluation of The Flaw in the Accounting Firm's Logic

The primary flaw in the accounting system of Enron is non-consolidation, contributing to the lack of transparency in financial reporting. The accounting officials of the company deliberately violated accounting principles, including conflict of interest that led to the non-consolidation of some transactions. These transactions led to serious financial implications since they damaged the company’s reputation (Mohammadi & Nezhad, 2015). For example, the company did not consolidate transactions LJM and Raptor SPEs that involved significant resources affecting the ability of the company to pay its shareholders and sustain its operations. Therefore, internal and external auditors should emphasize the importance of consolidation and full disclosure.

Enron violated the Generally Accepted Accounting Principles by failing to uphold ethical practices in report financial statements. The first violation was incorrect accounting of transactions of special purpose entities (Azim & Ahmed, 2015). For example, Enron did not consolidate its transactions with LJM and Raptor SPEs until when information revealed that it should have consolidated the transactions. Failing to provide complete disclosure in financial statements is a serious offense in accounting. It does not only violate accounting principles but also damages the company’s reputation leading to a decline in the value of its shares.

The crime Enron committed was not a major crime, but it was not an obvious one. The financial statements of the company mislead its stakeholders due to misrepresentation. According to US law, misleading representation is not necessarily a serious crime, but fraud is a crime. It is difficult to prove intent to defraud (Mohammadi & Nezhad, 2015). The investigative report found Arthur Anderson guilty of obstructing justice. Some employees of the company pleaded guilty of conspiracy to mislead stakeholders by omitting critical information in the financial statements. Somme employees knew of the unfair financial dealings but failed to blow a whistle. It demonstrates that the company did not have trustworthy employees, especially in the finical departments.

Proposed Checklist for Special Projects Performed By External Auditors to Limit Errors and Risks

The Powers Report indicates that consequences that affected Enron are as a result of greed among its employees and a violation of the accounting principles. Also, there is laxity in top management since the board failed to oversee the company’s transactions. In this regard, the first checklist is that the chief financial officer should ensure disclosure of all business transactions featuring in any project. There should be detailed information about the transaction and should be reflected in the financial statements (Mohammadi & Nezhad, 2015). Furthermore, there should be adequate information about related-party transactions to ensure no conflict of interest. It is an outright form of negligence for the board for not knowing that Fastow was the manager of two special purpose entities. The fact that the entities paid him $30 million from 1999 to 2001 is a clear indication that he could not prepare fair and justified financial reports.

The second checklist for special projects is modernization of the financial reporting system in the United States to ensure timely and relevant financial reporting. Financial reporting information should include non-financial transactions. The primary purpose of streamlining financial reporting systems is to eliminate disparities that contribute to loopholes for fraud (Azim & Ahmed, 2015). For example, all companies should report all related-party transactions since this is one area that allows an opportunity for conflict of interest. Furthermore, streamlining accounting standards would make the firm and other companies to be responsive to technology-driven changes in the accounting profession.

Thirdly, the American Institute of Certified Public Accountants has engaged in development measures, seeking to restore and improve confidence in the accounting profession. The websites display Enron banner, the profession, and public interest. The new draft includes more control measures as currently stated in SAS no. 82, Consideration of Fraud in a Financial Statement Audit. Furthermore, the institute focuses on a review of quarterly financial statements to enhance the auditing process. The measure would improve the conduct of internal and external auditors (Azim & Ahmed, 2015). From this context, auditors colluded with the financial management team to engage in unethical and unprofessional practices. With these new measures in place, the company will prevent potential future risks due to transparency and fairness in disclosure and whistle-blowing when there is unethical conduct of some auditors and financial managers.

Proposed Rules or Laws to Prevent Similar Occurrences in the Future

The first law that prevents fraudulent and non-disclosure issues in financial reporting is The Foreign Corrupt Practices Act of 1977. The act was developed to validate lawful and unlawful acts when engaging in related-party transactions to contain issues of fraud in financial reporting. The law protects employees and senior management officials from engaging in a conflict of interest activities (The United States Department of Justice, 2020). For example, they should disclose all financial matters in financial statements for effective decision-making. For example, employees should avoid trading with third parties since they could not make independent decisions. Therefore, the law promotes transparency and accountability in reporting.

The second law strengthening financial reporting is the Sarbanes-Oxley Act of 2002. The law seeks to improve corporate governance and ensure strict adherence to national and international policies. The law protects investors from fraudulent activities by ensuring accurate financial reporting and appropriate disclosure (Wagner & Dittmar, 2006). The law was developed in response to financial issues that involved companies, such as Enron. The high-fraud activities in the company affected investor confidence and eventually leading to the demise of the company. Principles included in the law include corporate responsibility, increased criminal punishment, accounting regulations, and new protections. For example, employees and the board of governors should avoid conflict of interest situations. Financial managers should ensure accuracy in financial reporting, as well as the inclusion of detailed information on related-party transactions.

Conclusion

Enron Company failed because of top management negligence and greed among employees. The company did not follow standard accounting principles when engaging in financial deals and reporting. The finance team was aware of unfair and unethical business practices, involving special purpose entities and a lack of disclosure of all crucial facts to the board. These and other unethical practices led to the fall of the company. The report recommends that the company should align employee practices with ethical standards, as well as standardization of financial reporting principles to prevent such risks in the future.

References

Azim, M., & Ahmed, H. (2015). Perspectives of accounting principles, rules, ethics & culture. International Journal of Economics, Commerce and Management, 3(1), 1-10.

Mohammadi, S., & Nezhad, B. (2015). The role of disclosure and transparency in financial reporting. International Journal of Accounting and Economics Studies, 3(1), 60-62.

The United States Department of Justice. (2020). Foreign corrupt practices act. https://www.justice.gov/criminal-fraud/foreign-corrupt-practices-act

Thomas, W. (2002). The rise and fall of Enron. Journal of Accountancy. https://www.journalofaccountancy.com/issues/2002/apr/theriseandfallofenron.html

Wagner, S., & Dittmar, L. (2006). The Unexpected Benefits of Sarbanes-Oxley. Harvard Business Review. https://hbr.org/2006/04/the-unexpected-benefits-of-sarbanes-oxley