Business Ethics
THE COLLAPSE OF ENRON

Critically evaluate the reasons for the collapse of Enron in 2001.  Your evaluation must include both the actions and decisions taken by the senior management team, but also the failures of those charged with protecting the interests of the shareholders and other stakeholders.

 

Introduction

Prior to the crises in 2001, Enron Corporation used to be a famous and respectable energy, commodity and services related company in America. It is the famous company awarded by Forbes as America Most Innovative Company for several years (Schneider, 2005). However, at the end of 2001, the accounting fraud of Enron is no longer sustainable, and the serious corporate scandals are discovered. As a result, Enron filed for bankruptcy, and the scandals had affected many innocent people, and had created huge harms to the society. In this article, the various reasons causing the collapse of Enron will be discussed. It is found that both the management team and the directors, who are suppose to safeguard stakeholders and shareholders’ interests are to be blamed. By understanding how the crises and scandals are created, policy makers can then make changes to the corporate governance structure of publicly listed companies in the future, for prevention of similar scandals in the future.

Reasons of Scandals in Enron

There are various reasons leading to collapse of Enron. Generally speaking, it can be observed that the occurrence of such scandal indeed consumed a long time frame. Ineffective policies and weak corporate governance, coupled with unethical management teams are the root causes for fraudulent activities in Enron. These reasons will be discussed in the following paragraphs.

Lack of transparency in financial statement and adoption of aggressive accounting practices. Enron’s financial statements were largely not transparent. Besides, as the business model of Enron is remarkably complex, it is not easy for outsiders to understand the financial statement presented by the management. Thus, all of these create the opportunities for management to misrepresent or outright manipulate the accounting figures. Aggressive accounting practices are employed. Thus, the scandals had started long ago when even the non material misrepresentation of information had occurred long time ago (Brown, 2007). When such habits and unethical behaviors were not monitored or handled at the very first few years questionable management behaviors occurred, the problem become more serious, and ultimately, spiraled out of control (Baker et. al., 2005).

Huge pressures from high expectations of Wall Street analysts. In fact, it is also very hard to the management to meet the very high expectations from Wall Street analysts and fund managers. Inability to meet the expectations of Wall Street will often spell disaster to the stock prices of Enron, and given that such a situation was definitely not to be desired by Enron management, the management team sooner or later have to adjust the accounting figure, through aggressive accounting practices, such as early revenue recognition, questionable mark to market accounting, creation of off-balance sheet liabilities to outright manipulation of accounting figures to impress or meet Wall Stress’s expectations (Madsen et. al., 2009). Thus, the management obviously sacrifices the long term stability and viability of the business for short term benefits. In a sense, the management practices of providing earning guides to Wall Street analysts had ultimately cause biggest harm to the company, as the management had to do whatever it takes to meet their estimates and for short term positive impacts to stock prices.

Unethical management team. Much of the literature on Enron argued that one of the key root causes creating such a huge scandals in Enron is due to unethical management team, namely: Lay, Jeffrey Skilling, Andrew Fastow, and other executives (Gillespie, 2004). For example, Lay, serving as the chairman prior to Enron collapse, negligently approving the unethical actions or behaviors of Jeffrey Skilling, and Andrew Fastow. As such, Fatsow was then set free to do whatever it takes to meet Wall Street expectation, and focusing on application of creative accounting to manipulate the financial reports disclosed to investors.

Negligence of U.S. Securities and Exchange Commission (SEC). It cannot be denied that the U.S. Securities and Exchange Commission (SEC) had its roles to play in contributing to Enron scandals. Accordingly, SEC had approved one of the early and aggressive revenue recognition method used by Enron in the year 1992 (for Enron trading activities on its natural gas futures division) (Nigrini, 2005). Upon the approval of such aggressive revenue recognition method, the management further extends such revenue recognition method to other divisions in the company, in order to meet the revenue projection and estimates by Wall Street analysts.

Usage of special purpose entities for manipulation of accounting statements. In order to hide the extra debt incurred, management had been using special purpose entities as a way to hide the liabilities. The details about special purpose entities are not disclosed. Besides, the many analysts did not really question the applicability of the usages of special purpose entities in Enron (Newman, 2007). Prior to the collapse of Enron, it can be seen that as many as hundred of special purposes entities are created to hide the huge debt incurred by the management. When such practices are not being monitored and questioned, the usages of special purpose entities were extended towards creative accounting to not only understate the liabilities of Enron, but also to overstate the earnings of Enron.

Unethical auditors assisting Enron to cheat the investors and public for a long time period. Enron auditor, namely Arthur Anderson should also be blamed for the serious frauds and scandals in Enron, for approving the aggressive accounting practices as well as supporting the accounting manipulations acts by Enron management. Theoretically speaking, auditors should plat their roles and responsibilities in checking against the accuracy of the accounting and financial reports presented to investors and public. However, not only did Arthur Anderson never warm or indicate the many questionable accounting practices in Enron, the audit firms had actually participated in several fraudulent accounting manipulations acts together with Enron. One of the often quoted reasons on why the external auditors of Enron, namely Arthur Andersen tend to approve the questionable accounting practices in Enron is due to serious conflict of interests among the two corporations (Madsen et. al., 2009). It is mentioned that a large proportion of revenue of Arthur Andersen are derived from audit fees and consulting fees from Enron. Thus, the auditors are not likely to be harsh with the management, as they might lose their profitable business with Enron should they investigate hard and refuse to approve the accounting practices performed by the senior management.

Weak corporate structure in Enron. In a properly governed company, the external auditors, independent board of directors, as well as any other internal governance agents shall play the duties to foresee operations of Enron, and to safeguard the company assets from misappropriation of management team. In Enron, the management had designed and influenced the board structure in such a way that the board of directors in Enron is predominantly occupied by outsiders, where may are perceived as talented audit committee by the investing fraternity. However, in reality, the board structure in Enron is not truly independent (Madsen et. al., 2009). All these caused the management to be able to carry out unethical and questionable business models and operations as well as aggressive and outright fraud accounting practices for such a long time period.

Excessive executive compensation contributes to a corporate culture of greed and shot term profits. Ironically, the factors contributing to Enron collapse is similar to the factors giving rise to moral hazard creating financial crises in US in 2008 recently. Specifically, the excessive executives’ compensation, which was argued to be required to retain top talents in the corporation, is one of the root causes creating a profit centered and short term oriented corporate culture in Enron (Kuliks, 2005). The problem of such compensation scheme, whereby executives are loaded with huge stock options and incorrectly designed compensation, motivated the management team as well as other employees to focus only on hitting short term targets to maximize their bonuses or compensations (Brewer, 2007). As those conditions were allowed for a long period, employees (primarily those serving int top management positions) seemingly adopted and created a new corporate culture of greed – to maximize their own earnings potential without considering the long term sustainability and ethical aspects of Enron. Deal making is being focused, while the qualities of the profits or cash flows are ignored. As the compensation is tightly tied to the stock prices of Enron in the stock market, management team is motivated to recognize revenue as early as possible, which such habits turn out into seriously illegal practices of creating revenue with special purposes entities for Enron; in order to meet the expectation of stock analysts, so that the management can be benefited through stock options of the company (Moriceau, 2005). When the corporate culture of greed is formed, it can be observed that the executives in Enron had been able to create compensation twice the rate received by executives in the competitor companies. The situation is most serious with high stock option by senior management. For example, as of 2001, the value of stock options owned by Lay was $659 million; while that was $174 million for Skilling.

Reckless and aggressive usages of derivatives. In Enron, a lot of sophisticated financial risk management tools are applied. Initially, the applications of these sophisticated derivatives for hedging purposes are nothing wrong, as it is argued that Enron would need such instruments to protect the company from volatility of future energy prices. However, one mistake the company did was to hedge the risks through its own special purpose entities. As such, in effect, the company is essentially not being hedged properly. The situation easily went out of control because it is mentioned that the company finance board committee has no proper background in derivatives and hedging, and blindly approve the usages of derivative despite the complexities of such instruments (Kobrak, 2007).

Conclusion

Overall, as discussed in the case above, it can be seen that the collapse of Enron is not the wrong doings of a particular team of people. However, the collapse of Enron is an events that was caused by many parties, which include wrong or reckless behaviors from the senior management, auditors, board of directors, Wall Stress analyst and certain employees in the company. At first, the management of Enron enrolled in unethical and questionable behaviors, such as aggressive accounting practices, but later, when they built up the habits of accounting manipulation, they directly engage in serious misrepresentation and provision of misleading information to the investors, analysts and public. For these, it can be seen that the philosophy of continuous improvement is applied in exactly the wrong context. The management is getting more sophisticated and more creative in manipulating the accounts (Dnes, 2005), and deriving more complex business model and transactions to serve their personal needs. As the other parties, such as external auditors, independent directors as well as the investors of Enron, fail to stop these from happening, the entire issues escalated and spiraled out of control, towards the bankruptcy and collapse of Enron in the year 2001 (Murphy, 2006). When such crises occurred, it is hard to blame on certain parties, as people involved should ultimately shoulder the responsibilities to prevent the crises from happening. Everything starts small, as we can see from the Enron case. Unguarded greed, if not controlled and contained, will lead to huge disaster in the long run.

References & Bibliography

Baker, C. R., & Hayes, R. (2005). The Enron Fallout: Was Enron an Accounting Failure? Managerial Finance, 31(9), 5-28.

Brewer, L. (2007). Is There a Little Bit of Enron in All of Us? The Journal for Quality and Participation, 30(1), 26-28,48.

Brown, R. E. (2005). Enron/Andersen: Crisis in U.S. Accounting and Lessons for Government. Public Budgeting & Finance, 25(3), 20-32.

Dnes, A. W.  (2005). Enron, corporate governance and deterrence. Managerial and Decision Economics, 26(7), 421-429.

Gillespie, D. T.  (2004). The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron. The Academy of Management Executive, 18(3), 163-165.

Kobrak, C. (2009). Innovation Corrupted: The Origins and Legacy of Enron’s Collapse. Business History Review, 83(1), 173-177.

Kulik, B., O’fallon, M., & Salimath, M. (2008). Do Competitive Environments Lead to the Rise and Spread of Unethical Behavior? Parallels from Enron. Journal of Business Ethics, 83(4), 703-723.

Kuliks, B. W. (2005). Agency Theory, Reasoning and Culture at Enron: In Search of a Solution. Journal of Business Ethics, 59(4), 347-360.

Li, Y. (2010). The Case Analysis of the Scandal of Enron. International Journal of Business and Management, 5(10), 37-41.

Madsen, S., & Vance, C. (2009). Unlearned lessons from the past: an insider’s view of Enron’s downfall. Corporate Governance, 9(2), 216-227.

Moriceau, J. L.  (2005). What can we learn from a singular case like Enron? Critical Perspectives on Accounting, 16(6), 787-796.

Murphy, J. E.  (2006). The Lesson of Enron. Journal of Accountancy, 202(2), 16.

Newman, N.  (2007). ENRON AND THE SPECIAL PURPOSE ENTITIES-USE OR ABUSE?-THE REAL PROBLEM-THE REAL FOCUS. Law and Business Review of the Americas, 13(1), 97-137.

Nigrini, M. J.  (2005). An Assessment of the Change in the Incidence of Earnings Management Around the Enron-Andersen Episode. Review of Accounting & Finance, 4(1), 92-110.

Premeaux, S. (2009). The Link Between Management Behavior and Ethical Philosophy in the Wake of the Enron Convictions. Journal of Business Ethics, 85(1), 13-25.

Schneider, J. D.  (2004). THE SMARTEST GUYS IN THE ROOM: THE AMAZING RISE AND THE SCANDALOUS FALL OF ENRON. Energy Law Journal, 25(2), 441-445.

Trinkaus, J. & Giacalone, J. (2005). The Silence of the Stakeholders: Zero Decibel Level at Enron. Journal of Business Ethics, 58(1-3), 237-248.

 

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