- Methods used by Enron to manipulate accounting figures
The fall of Enron was one of the highly publicised corporate failures. The directors of the company manipulated the financial statements of the company to mislead users of accounting information. The methods used by the firm included mark-to-market and off-balance sheet financing as well as interference with auditor independence.
Mark-to-market accounting
Enron changed its revenue recognition policy from the traditional revenue recognition principle to mark-to-market accounting. As an energy company, Enron’s incomes were derived from mainly the sale of natural gas. As a practice, Enron entered into several long-term contracts with clients to supply natural gas. Under the traditional revenue recognition principle, expected revenues from the contract would be spread over the life of the contract. However, Enron applied the aggressive mark-to-market accounting in which the present value of all incomes expected from the contract would be recognised at the time the contract is signed (Jones 87). The effect of this aggressive accounting policy is that it overstates short-term profits at the expense of long-term profits.
The problem with this accounting method is that expected profits may not be realised due to breach of contract by the client, among other factors. In addition, the policy required the company to value long-term natural gas contracts at the time of signing the contract. It was almost impossible for Enron to place an objective value on the contracts. The valuation was based on the best case scenario, which was subjective and prone to deliberate manipulation. This accounting policy enabled the company to report high profits, which were unrealised thereby misleading users of its financial statements.
Off-balance sheet financing
Enron formed special purpose entities to execute the practice of off-balance financing. The company established about 12 special purpose entities to obtain debt off-balance sheet. In this case, Enron borrowed large amounts of debt through the 12 businesses. However, the debt was not included in the consolidated financial statements of the company. This enabled the company to mislead people on its real indebtedness (Jones 88). In this case, the company violated the US accounting rules that required any company owning other businesses to include the financial position and results of operations of the subsidiaries in the consolidated statements of the corporation. At the time of the collapse of the company, it was found that it had about $8.5 billion in debt that was hidden from its balance sheet.
Role of corporate culture and auditors
Corporate culture refers to the beliefs and behaviours that determine the interaction between employees and how employees handle external transactions. The fall of Enron could be attributed to the weak corporate culture. Organizational culture entails the integrity of the corporate leaders. Most of Enron’s top executives were charged with criminal offenses including insider trading, money laundering and fraud (Parboteeah and Cullen 489). In addition, Jeff Skilling, the CEO of the company at the time of collapse, introduce an aggressive performance evaluation basis for employees. The performance evaluation process involved ranking employees by their peers, and it encouraged employees to give lower rankings to their peers to enhance their positions in the company. Furthermore, the compensation plan was aimed at enriching executives rather than increasing shareholders’ profits (Parboteeah and Cullen 489). It also encouraged manipulation of accounting figures using non-standard accounting procedures.
The company’s auditor, Arthur Andersen, also failed to identify errors and fraud in the financial statements. This was attributed to the lack of independence as Andersen had been the auditor of Enron for over 15 years with most of its revenue being derived from Enron (Knapp 14). In addition, the auditor performed non-audit work to the company thereby compromising its independence. The work of the auditor was adversely controlled by the corporation’s top executives. The auditors gave an unqualified report despite that fact that Enron had not included about $8.5 billion of debt in its consolidated financial statements (Knapp 14).
- Regulatory changes
The fall of Enron and other corporate fraud cases led to the introduction of the Sarbanes- Oxley Act (SOX Act). Under this new regulation, the directors of a company have the primary responsibility for the accuracy of financial statements presented to the shareholders of the firm. They also have the responsibility for preventing and detecting fraud as well the establishment and maintenance of effective internal control systems. The new regulation also introduced corporate governance measures which, among other things, improved the role of independent audit committees (Moeller 14). These rules were meant to enhance the independence of the external auditor since members of the audit committee are independent non-executive directors.
The Act also led to the formation of the Public Company Accounting Oversight Board to register and oversee the activities of public accounting firms (Moeller 15). The Board has the authority to revoke the registration of any public accountant that violates the regulations set. In order to enhance the independence of auditors, the SOX Act prohibits auditors from undertaking non-audit services to clients. It also requires auditor rotation to ensure there is no long working relationship with the client that may compromise auditor’s independence. These, among other regulations, have enhanced transparency in corporate financial reporting by companies and have improved corporate governance. They have been effective in preventing cases of corporate failure and fraud.
Works Cited
Jones, Michael. Creative Accounting, Fraud and International Accounting Scandals. Chichester, West Sussex: J. Wiley & Sons, 2011. Print.
Knapp, Michael Chris. Contemporary Auditing: Real Issues and Cases. 9th ed. Australia: Cengage Learning, 2012. Print.
Moeller, Robert R. Sarbanes-Oxley Internal Controls: Effective Auditing with AS5, CobiT and ITIL. Hoboken, NJ: John Wiley & Sons, 2008. Print.
Parboteeah, Praveen, and John B. Cullen. Business Ethics. London: Routledge, 2013. Print.
