Factors That Led to Enron Downfall in 2001 Essay

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Enron Corporation was the American company that specialized in supplying of energy.



Prior to its collapse in 2001, Enron was one of the most admired companies in the United States recording superior profits year by year, however, in 2001, series of the Enron questionable financial transactions were finally made opened when the company's stock price collapsed within one day. This study investigates several factors that led to the fall of Enron Corporation, the outcome of the investigation reveals that the top management did not promote culture of ethics within the organization. The paper reveals that the management was intoxicated with power manipulating information to their benefits. Moreover, top officials used power ruthlessly intimidating the subordinated. The company did not promote the culture of checks and balances by allowing only one entity performing both the functions of internal and external auditing. The study recommends that integration of ethical business is an effective method in promoting sound business practice.



Introduction



Enron is a natural gas pipeline company established in 1985, and pioneered the deregulation of the energy market. Within 15 years of its establishment, Enron became a leader in the international energy construction with a reported operating revenue of more than $100.8 billion in 2000. In the same year, Enron was rated as the most innovative company. Between 1990 and 1998, the value of their stock rose by 311%, a model growth rate described by the Standard & Poor. Before the collapse of Enron Corporation, Enron was rated one of the most profitable companies. The market environment perceived Enron management as aggressive and talented for the application of the cutting edge innovative business model. In 1990, the Enron stock price was $7 and increased to $83 in 2000. However, the company recorded its substantial increase in the stock price in 1997. In 2000, Enron stocks 'outperformed the U.S. NASDAQ composite index, and Enron footprint was everywhere in North America.



Despite the success of Enron in the 1990s, the company's reputation was shattered after 2000 forcing many of the Enron's executives to leave the company. In late 2001, the Enron's problem compounded because several of its business models were not performing as being programmed making the company initiating series of asset write down.



Several factors are responsible for the Enron downfall.



Internal Environment: The intermediation and governance failure was one of the major factors that led to the fall of Enron. The problem was attributed to the activity of Arthur Andersen that assisted in falsifying the auditing books. Essentially, Arthur Andersen was the major player in the Enron accounting scandal because the company approved Enron accounting practice despite Enron poor practices. The stamp approval from Arthur Anderson made many analysts start questioning the transparency of Enron's profit earnings, which consequently led to Enron and Andersen to be prosecuted for their reckless behaviors.



Top management compensation was another factor leading to the fall of Enron. Similar to many top companies in the United States, Enron heavily compensated their management using the stock options to compensate the top management. Based on the company proxy statement in 2001, Enron offered 5.3 Million shares for Ken Lay, and 824,038 shares for Jeff Skilling. Typically, the company offered 12,611,385 shares for all its officers. Although, the stock offering program for the management was geared to motivate the management, however, management failed to create medium and long-term values for the company.



Cuong, (2011) argued that Board of Director of the Enron company failed to fulfill their fiduciary duties towards the shareholders because the top executives were greedy and acted solely to protect their personal interests. Moreover, the company did not put an effective internal auditing mechanism in place because they outsourced the internal auditing system that allowed the company to perform the fraudulent and questionable financial reporting.



The poor role of the audit committee was also attributed to the downfall of Enron Corporation. Typically, the corporate audit committee had only a modest knowledge of accounting and finance. Thus, they only rely on information from the management, and internal and external auditors to make decisions. Thus, the audit committee would not be able to detect a fraud from the management based on their limited knowledge of accounting. The external auditor also contributed to the fall of Enron Corporation because Arthur Anderson was being accused of contributing to frauds.

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In 2000, Enron paid Arthur Anderson $27 million as consulting fees and $25 million as auditing fees, which were the financial incentives to retain Arthur Andersen as an auditing client. However, the company did not implement a sound business practice in their auditing report, which assisted Enron to compete for the questionable accounting practice.



External Environment: In the United States, the accounting standards are both inflexible and mechanical. Typically, the financial engineering was being controlled by knife-edge rules, and Enron was to follow these rules in their financial transactions. While the company was able to design their transaction to follow these rules, the company balance sheet did not reflect its financial risks. The FASB ("Financial Accounting Standards Board") is an accounting governing body that oversees the accounting standards, however, Enron did not follow the laid down rules and regulation in the financial reporting.



Moreover, Moncarz, Moncarz, Cabello, et al. (2006) believed that deregulation of the energy market affected Enron business transactions because the deregulation lowered the prices of gas and increased the supply of gas leading to the volatility in gas prices. Thus, the deregulation forced Enron to "offer a long-term fixed price contract for natural gas." (Moncarz, Moncarz, Cabello, et al. 2006 p 25). Moreover, the company used the financial derivatives such as future swap, forward contract, and swap to guide against the fluctuation of the prices of the natural gas, however, Enron was unable to manage a continued fluctuation of the natural gas. The issues made the company lose its market value and profitability. In 2001, Enron stock price fell from $26.05 to $5.40 in one day. On October 19, 2001, Enron announced a debt of $9 billion, and filed for bankruptcy in November 2001.



2. How Enron's internal checks and balances Fail to prevent the Demise



A weak internal control was one of the strongest factors that led to the collapse of Enron Corporation. After the collapse of Enron, it was revealed that the internal control system of Enron was vulnerable. For example, the Arthur Andersen served as both the internal auditor and external auditor. However, there is a clear difference between the internal auditing and external auditing functions. The company merged the functions of the internal auditing and external auditing practice blurring a division between the method the company employed in assuring the completeness and honesty in financial reporting.



It is essential to realize that senior management ought to design the structure of the internal control system to make it effective. Moreover, the company should not allow the same entity to perform both the internal and external auditing functions to make an auditing system be effective. The checks and balances can only be effective if the internal auditor is separated from the external auditor because the external auditor will serve as a check on the activity of the internal auditor. Since both the internal and external auditors are professional accountants, they will be able to detect frauds if committed. However, Enron did not allow the checks and balances to operate in the company because the same entity performed both the internal and external auditing functions.



Moreover, Enron management failed to identify the risks associated with the internal control practices. Typically, Enron management did not understand the importance of effective internal control, and did not possess skills in designing effective internal control systems. Moreover, the management as unable to maintain and establish adequate internal control to establish effective financial reporting.



"Enron's board "waived the company's conflict of interest policy to allow its CFO to invest in the corporation's special purpose entities, then failed to follow up to ensure the mandated compensating controls were being adhered to" (Locatelli, 2002, p. 2).



3. How Enron top Board of Directors/Leadership Undermine the foundational values of the Enron Code of Ethics



The Enron Corporation laid down a comprehensive code of ethics that all employees and management must follow. However, the management abused their power by manipulating information to their benefits. The company Chief Executive Officer used power ruthlessly, eliminated corporate rivals as well as intimidating the subordinated. Moreover, the management did not understand the employee's conducts. Board members seem to exercise oversight on the management functions however rarely challenged management. Enron conducts were unethical, the company officials manipulated financial information.....

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Reference


Cuong, N.H. (2011). Factors Causing Enron's Collapse: An Investigation into Corporate Governance and Company Culture. Corporate Ownership & Control Journal, 8,(3).

Duffy, M., & Dickerson, J. F. (2002). Enron spoils the party. Time, pp. 18-25.

Elliott, A. L, & Schroth, R. J. (2002). How companies lie: Why Enron is just the tip of the iceberg. New York: Crown Business.

Healy, Paul, and Krishna Palepu. "The Fall of Enron." Harvard Business School Case 109-039, November 2008. (Revised May 2016.)

Locatelli, M. (2002). Good internal controls and auditor independence. The CPA Journal,

Kanungo, R. N., & Mendoca, M. (1996). Ethical dimensions of leadership. Thousand Oaks, CA: Sage.

Moncarz, E.S. Moncarz, R. Cabello, A. et al. (2006). The Rise and Collapse of Enron: Financial Innovation, Errors and Lessons. Contaduria y Administracion. (218).

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