Limitatitons of the Accounting Code of Ethics
Professional values, ethics, and attitudes. (AC 423) Group Assignment QUESTION: With the advantage of hindsight, what advice would you have given the Enron Board to avoid the 2001 disaster? GROUP MEMBERS 1. Augustine KuparaR082559R 2.
or any similar topic only for you
Tonderai NyamadzawoR082987G 3. Simbarashe ChakaR089613J 4 Brighton Nzvuvu R089824H 5. Walter DangerR082990X 6. Simon ChigwandaR075968L 7. Ashley MurisaR082991Y 8. Frank Garatsa R082988H 9. Presely NheweyembwaR076037L 10. Peter DonaldR055241G 11. Shingirayi GweteR089773H BACKGROUND Enron Corporation was formed in 1985 from a merger of Houston Natural Gas and Internorth, Enron Corp.
By early 2001, Enron had grown into the 7th largest U. S. Company, and the largest U. S. buyer/seller of natural gas and electricity. It was heavily involved in energy brokering, electronic energy trading, global commodity and options trading, etc. in 2001 Enron started to show major signs of trouble by announcing a huge third-quarter loss of $618 million. On October 22, 2001, the Securities and Exchange Commission (SEC) began an inquiry into Enron’s accounting practices and later that year the company filed for Bankruptcy.
Key investigations revealed many shortcomings which include the use of complex & dubious accounting schemes to reduce Enron’s tax payments; to inflate Enron’s income and profits; to inflate Enron’s stock price and credit rating; to hide losses in off-balance-sheet subsidiaries; to engineer off-balance-sheet schemes to funnel money to themselves, friends, and family; to fraudulently misrepresent Enron’s financial Enron also used complex dubious energy trading schemes for instance the “Death Star” Energy Trading Strategy which was aimed at taking advantage of a loophole in the market rules governing energy trading in California.
This essay will attempt to advice the Enron Board to avoid the 2001 disaster with the advantage of hindsight by focusing on the major areas in the paragraphs which follow RECOMMENDATIONS THE BOARD OF DIRECTORS AND ITS FIDUCIARY DUTIES The Board, as the head of the organization is supposed to execute its duties and roles professionally and make sure that the company is run efficiently and effectively. It’s supposed to exercise oversight over all the operations of the organization.
These duties includes adopting of corporate strategy, annual budget and formal organisational structure, ensuring that risk management structures are in place, the company is complying with the relevant laws and regulations and that adequate controls are in place, to exercise oversight over management operations, to act as a communication channel between management and shareholders and to ensure that financial information of the organisation is reliable and credible. There is need to ensure that the board is properly structured so that t it adds value to the organization.
This means that it was supposed to have a chair, at least one the members is financially literate and some of its members are non-executive directors. This would ensure that an independent perspective is brought into the board’s operations that would bring experience and expertise to the board The board supposed to follow its code of conduct in carrying out their duties. This ensures that all the activities it undertakes are in the best interest of the shareholders not themselves.
For example, in carrying out their duties, all the board members are supposed to exhibit due care and diligence, to be honest and loyal, to exercise confidentiality on the organizational information and to disclose any conflict of interest. Some of the board members had financial interests in the Special Purpose Entities (SPEs) making large profits but they did not disclose this conflict of interest to the board. This would compromise their objectivity and independence in carrying out their duties.
Some of the members of the board were not exercising due care and diligence in their operations. They were aware of the unethical and risky business operations that were taking place within the organisation but they took no action and did not bring it to the attention of the board. These included transactions through SPEs and the paying of unauthorised bonuses to senior officials. They even connived with the auditors to structure and perform some of the illegal transactions that were aimed at falsifying the performance and position of the organisation.
The board is also supposed to have other special subcommittees that are aimed at enhancing the operations of the board in areas that need special attention. These include the Audit Committee that is aimed at overseeing the internal and external audit functions and the Remuneration Committee that will be responsible for the salaries and allowances of managers and other senior officials. The role of a company’s board of directors is to oversee corporate management to interests of shareholders.
However, in 1999 Enron’s board waived protect the conflict of interest rules to allow chief financial officer Andrew Fastow to create private partnerships to do business with the firm? Transactions involving these partnerships concealed debts and losses that would have had a significant impact on Enron’s reported profits. Enron’s collapse raises the issue of how to reinforce directors’ capability and will to challenge questionable dealings by corporate managers. Specific questions involve independent or “outside” directors. Stock exchange rules require that a certain percentage of board members be unaffiliated with the firm and its management. ) Should the way outside directors are selected be changed or regulated? Directors are elected by shareholders, but except in very unusual circumstances these are “Soviet-style” elections, where management’s slate of candidates receives nearly unanimous approval. Should there be restrictions on indirect compensation in the form of, say, consulting contracts or donations to charities where independent board members serve?
Should the personal liability of directors in cases of corporate fraud be increased? Do the rules requiring members of the board’s audit committee to be “financially literate” ensure that the board will grasp the innovative and complex financial and accounting strategies employed by companies like Enron. Several of the auditor reform bills cited above would require the audit committee of a corporation’s board of directors to take a more active role in the selection and supervision of audit work.
Enron should have kept an element of professionalism; the board of directors should show independence in decision making. The company must not have any close relationship whatsoever with its auditors. A strict and good system of corporate governance should have been set out , which sets out a clear system of duties of each director. They should have set out a system of segregation of duties that sees each director have an independent duty. AUDIT COMMITTEE Any effective audit committee must have been in place at Enron comprising of purely independent non-executive directors.
Members should have an understanding of internal control system and financial and sustainability reporting experience. This committee reviews the accounting practices and approve the financial statements as integrated reporting. Thus the financial reports of Enron would not have been allowed to be published before the approval of the Audit Committee. Review the effectiveness of the internal control environment as well as oversight over the internal and external audit.
The Audit Committee recommend to the Board of Directors the engagement, removal and liaise the terms and remunerations with the external auditor. The issue of non-audit services, it is also the responsibility of the committee to define the policy and approve the contracts. Hence the pure independent audit committee it would have not allow Arthur Andersen to exercise multiple roles at Enron. Reports Management are received and reviewed to check whether in line with the approved internal Audit plan and the quality and effectiveness of the external audit function.
Risk management is also pivotal in this committee so as to champion the fraud awareness. As an internal auditor, Sherron Watkins should have not directed her anonymous letter to the chairman of the board, Kenneth Lay but to the committee which oversee the internal control system. The Chief Accounting Officer, Richard A Causey who was getting money through the Special Purpose Entities had been once an auditor at Arthur Andersen an issue which should have been closely examined. An effective Audit Committee consider confidential reporting to facilitate whistle blowing.
Overall, Audit committee have a combined assurance role thus monitoring the relations between internal and external audit to reduce duplication efforts as well as enhances transparency. AUDITOR ROTATION. The Issue Of Auditor Rotation Is Of Significant To The Quality Of Financial Reports. Auditors Should Be Rotated Every Few Years To Prevent Long Term, Close Ties Between The Enron And The Arthur Andersen Firm. Arthur Andersen is the firm that audited Enron’s books from its inception in 1985 (it was also global crossing auditor).
Also there was questionable movement of personnel from between the two companies Richard A Causey, the Chief Accounting Officer had come to Enron after working on Enron audits for Andersen this creates a strong relationship, Familiarity threats and it is easy to can collude with Andersen in perpetuating fraudulent activities. Time should be put at least three years before a member can join Enron from auditing firm. Long term audit client relationships significantly increase the like hood of an unqualified opinion or significantly reduce the auditor’s willingness to qualify the audit reports.
Mandatory audit rotation is ideal in maintaining the value of an audit for both the internal and external users. Although recurring auditors have got an advantage to Enron of that they will be auditing the business they know very well its environment and internal controls thereby reducing the chances of the auditor making an audit risk which is the risk that the auditor will give a wrong opinion that the financial statements are not materially misstated when in actual fact they are materially misstated. , however the disadvantages seemingly outweigh the costs of retaining the audits.
According to Wallace, 1980 and De Angelo (1981) audit quality is a market assessed joint probability that an auditor will both discover a breach in the client’s accounting system and report the breach. According to Shockley (1982) a long auditor client relationship can have the effect of complacency, lack of innovation, less rigorous audit procedures and a learned confidence in the client may arise after long association with the client. It also gives auditor time to develop a close relationship with the client in this case Enron employees..
After a number of years there is some kind of turning point in the auditor and client relationship which can be detrimental to the auditor’s independence. Before the decision to rotate there is need to assess the quality of the audit client and this can be done in the following ways according to Shockley and Holt 1983, firstly the perceptions of users should be analysed, the pricing of the audit services has to be analysed and in this case Andersen’s firm was receiving a greater percentage of its revenue from Enron hence there is dependent on the company.
The nature of the audit opinion has to be analysed it has a greater impact on the reliance with which we can place to the auditing firm. COMPLIANCE TO ACCOUNTING STANDARDS AND REGULATIONS The Enron was involved several accounting issues, one concerns the creation of special purpose entities (SPEs), these were established for the special purpose of covering Enron`s losses and there were also being used to transfer debts outside of the company and would not show up on the balance sheet at year end . The SPEs were supposed to be independent companies however they were headed by Enron former employees, and backed, ultimately, by Enron stock.
The second issue was that Enron was also involved in other accounting scandals for example Enron took advantage of the limitations in the standards governing the energy business therefore over valued assets and selling some of decreasing assets to the SPEs at huge mark-ups and there realising the profits in the financial statements. As a resulted of these accounting misappropriations, Enron produced favourable financial statements leading to unapproved bonuses being claimed by employees and directors also providing themselves with obscenely generous stock option grants.
The Securities and Exchange Commission (SEC) governs the activities of companies registered on the New York stock exchange. Enron`s management should follow the regulations stated by SEC and also to prepare its financial statement according to the generally accepted accounting principles (GAAP). The accounting information produced by Enron should have been restated to show a fair financial position of the company. The SPEs should be liquidated no further transactions should be carried out between Enron and its related parties. In correcting its transactions Enron should other external auditors other than Arthur Andersen.
These investigations should be carried confidentially so as to protect the manage the situation and also to protect Enron`s reputation. COMPENSATION TO EXECUTIVES AND OTHER PERSONNEL Effects of over paying directors it is results in directors losing focus of their core business, that acting their stewardship and accountability functions . Through good corporate governance directors via the agency theory are responsible to the shareholders. Directors are independent form management; they are responsible for making sure management are carrying out their fiduciary duties.
However if they are over compensated they are more likely to be inclined to favour management over shareholders, as they is a rise of a self-interest threat With no proper monitoring of the board through a remuneration committee, overpaying results bad corporate governance which affect the companies risk management. It results in problems not been brought to light, allowing them not been addressed. As directors ignore their duties and focus on short term profits and rather than maximising company growth in the long term, this reduces their ability to focus on strategic issues and establishment of unrealistic standards of performance.
Decision-making is greatly affected as they will be they will be destruction of the authority line by the two boards who will be responsible for the overall well being of the company. As decision making will have been affected corporate and accounting practises will greatly be affected, which will increase the chances of fraud and error. These might include recording profits earlier and recognising expenses late. Overpaying also results in changes in the ethical culture of the organisation, as the board can select bad managers to run the business because they will be sharing a common perception.
Which is lack of concern for long run of the business? Rather the advice would be for Enron to have a director’s board which contains an equal mix of executive and non-executive directors. This would be to ensure independence and accountability at the highest level, this also reduces self-interest threats . It allows for a board which separates itself from the management of the business Rotation of members at frequent intervals to allow for reduction in familiarity threats if members of the board stay for too long ,e. . more than five years they might become familiar with the management Establishment of remuneration committee which monitors the payment of executives, this ensures that directors are paid according to the tasks performed and not for unnecessary duties INDEPENDENCE Independence is when one makes decisions honestly and truthfully both in fact and in appearance and avoids internal and external pressures which may influence the outcome of a decision under review.
The Enron scandal showed a number of independency issues being overlooked by the management of the company and instead concentrated on fraudulent profit making strategies which should have been avoided. These fraudulent activities involved the management of the company and their external auditors (Arthur Andersen), the company’s lawyers, consultants and lenders. The advice that l would have given to the management of Enron concerning independent issues was that they should have at first allowed every employee to exercise his or her duties without influence from anyone either internally or external.
The management of Enron should have exercised their duties of stewardship to their principles without paying much attention to their excessive and self-centred interest of maximising wealth at the expense of their shareholders. The actions by Mr Ken Lay of forcing all employees to book their corporate travel through his sister’s travel agency was nowhere near independency but only self-interest and greed to accumulate wealth. The board members should have critically analysed the source of the monies they were receiving so as to find facts to justify the revenues.
Instead they were only concerned about their packages and approved every idea the management would put before them without taking into consideration the effects of such decisions. This was a clear threat to the board’s independency since they were to choose on whether to be ethical or satisfy their insatiable need for wealth. These high earnings were also received by most of the company’s executives, finance, legal and accounting professionals and they made them to overlook the questionable accounting practices which were yielding these huge packages.
The management also needed to take note of their auditor’s operations when carrying out his mandate, there was need to segregate duties between auditing and non-auditing services. Arthur Andersen should have been engaged to one assignment only of auditing and leave the non-auditing services to other so that independent decisions could be made. The board should have rotated their auditors after a reasonable period of time to avoid familiarity and some associated threats to independence.
There was need for the board to also discuss the issues of their auditor’s remuneration and other packages they offered so that they could match with the current market trends this would reduce the auditor’s dependency and force them to report any anomalies within the operations of the company. Role of Sell-Side Analysts Sell-side analysts have received considerable criticism for failing to provide an earlier warning of problems at Enron.
On October 31, 2001, just two months before the company filed for bankruptcy, the mean analyst recommendation listed on First Call (which compiles and distributes analyst recommendations) for Enron was 1. 9 out of 5, where 1 is a “strong buy” and 5 is a “sell. ” Even after the accounting problems had been announced in October 2001, reputable institutions such as Lehman Brothers, UBS Warburg and Merrill Lynch issued “strong buy” or “buy” recommendations for Enron. Analysts should have not been slow to recognize the problems at Enron.
The analysts should not have financial incentives to recommend Enron to their clients. Investment banks earned more than $125 million in underwriting fees from Enron in the period 1998 to 2000, and many of the financial analysts working at these banks received bonuses for their efforts in supporting investment banking. Sell-side analysts must be independent and avoid any self-interest threats which may arise. Corporate Culture Enron has been described as having a culture of arrogance that led people to believe that they could handle increasingly greater risk without encountering any danger.
According to Sherron Watkins, “Enron’s unspoken message was, ‘Make the numbers, make the numbers, make the numbers—if you steal, if you cheat, just don’t get caught. If you do, beg for a second chance, and you’ll get one. ’” Enron’s corporate culture did little to promote the values of respect and integrity. These values were undermined through the company’s emphasis on decentralization, its employee performance appraisals, and its compensation program. Each Enron division and business unit was kept separate from the others, and as a result very few people in the organization had a “big picture” perspective of the company’s operations.
Accompanying this emphasis on decentralization were insufficient operational and financial controls as well as “a distracted, hands-off chairman, a compliant board of directors, and an impotent staff of accountants, auditors, and lawyers. ” Jeff Skilling implemented a very rigorous and threatening performance evaluation process for all Enron employees. Known as “rank and yank,” the annual process utilized peer evaluations, and each of the company’s divisions was arbitrarily forced to fire the lowest ranking one-fifth of its employees.
Employees frequently ranked their peers lower in order to enhance their own positions in the company. Enron’s compensation plan “seemed oriented toward enriching executives rather than generating profits for shareholders” and encouraged people to break rules and inflate the value of contracts even though no actual cash was generated. Enron’s bonus program encouraged the use of non-standard accounting practices and the inflated valuation of deals on the company’s books. Indeed, deal inflation became widespread within the company as partnerships were created solely to hide losses and avoid the consequences of owning up to problems.
Conclusion In conclusion, one can see that a variety of perspectives can be applied to the Enron scandal which could have averted the 2001 disaster. If those charged with the governance of the entity had taken necessary steps in line with what is outlined in this essay, the corporation would not have collapsed. However even if Enron and its outside accountants and lawyers had done nothing improper, the sudden collapse of such a large corporation would suggest basic problems with the U. S. ystem of securities regulation, which is based on the full and accurate disclosure of all financial information that market participants need to make informed investment decisions. The overarching issue raised by Enron is how to improve the quality of information available about public corporations. References * Bob Lyke. CRS Report RS21120, Auditing and its Regulators: Proposals for Reform After Enron. * JOINT COMMITTEE ON TAXATION, 2003 Report of investigation of Enron corporation and related entities regarding federal tax and compensation issues, and policy recommendations McLean, Bethany. 2001. “Is Enron Overpriced? ” Fortune. * Paul D. Miller, Brief History of Enron (accessed 27 November 2012) http://www. freegrab. net/enronhist. htm * Paul M. Healy and Krishna G. Palepu, (2003) The Fall of Enron * Powers, William C. , Raymond S. Troubh and Herbert S. Winokur. 2002. “Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp. ” * Steven C. Currall Marc J. Epstein 2003. Lessons From the Rise and Fall of Enron * Watkins, S. , 2002. Email to Eron Chairman Kenneth Lay,