LESSONS FOR AUDITORS AND REGULATORS FROM THE ENRON FRAUD

 

LESSONS FOR AUDITORS AND REGULATORS FROM THE ENRON FRAUD

 

 

 

 

 

 

 

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LESSONS FOR AUDITORS AND REGULATORS FROM THE ENRON FRAUD

INTRODUCTION

The collapse of the Enron Corporation serves to reflect how the actions undertaken by the board of directors can affect the business continuity of a corporation. In addition, a board of directors that is devoted is a crucial requirement for sound corporate governance (Arrunada 2000). The downfall of the Enron Corporation can be clearly attributed to audit failures, whereby its financial statements did not accurately reflect the company operations and finances with its respective shareholders and analysts. This paper describes and considers the lessons for auditors and regulators from the Enron fraud. The paper provides a background to the case, lessons and considerations for auditors and regulators and how such failures can be avoided in future.

BACKGROUND TO THE CASE

Prior to the collapse of the Enron Corporation during 2001 after the scandal, the company was considered to be one of the most innovative, fast-growing and deployed the best management practices among business enterprises in the United States. It can be argued that the financial statements failed to provide a true picture of the financial status of the corporation. In addition, the independent auditors and the board of directors failed to challenge the company’s management is among the core contributors of the Enron fraud that resulted to the collapse of the corporation (Banerjee 2002).

Since its formation in 1985 towards late 2001, the company had witnessed an outstanding success, as cited by the professional Wall Street analysts. The collapse of the corporation saw diverse speculations regarding the contributing factors towards its downfall. The underlying financial issue posed by the Enron Corporation is that whether the quality of information represented in financial statements regarding public corporations require significant improvements (Alkhafaji 2003). Additionally, the complex business model adopted by the corporation and the unethical business practices imposed the need for the Enron Corporation to make use of accounting limitations with the main objective of misrepresenting the company’s earnings and modifying the financial statements such as the balance sheet. This was deployed in order to conceal the actual financial position of the company and depict a favorable financial position. Hamilton (2004) argues that the Enron Fraud was as a result of cumulative effects of the habits, actions and unethical values that commenced early and got out of hand. Hamilton further argues that the prior to its downfall, the main objective of the Enron Corporation’s accounting and financial transactions appeared to report that the revenue and the cash flow were up, the asset values for the company was inflated and the liabilities were off the accounting books (Baum 1996). The combination of the above issues resulted to the company becoming bankrupt, with most of the unethical actions and business practices being attributed to the failures of the board of directors. In order to conceal the huge debt that the company was facing, the executives deployed market-to-market accounting in order to conceal the company’s debt. This resulted to the use of off-balance sheet accounting methods, complicated financing approaches and deals that were not consistent with the accounting standards for public corporations (Board of Directors of Enron Corporation 2002).

Irrespective of the diverse speculations regarding the collapse of Enron Corporation, it is arguably evident that the board of directors played a significant role in setting the pace for the Enron fraud. This is mainly attributed to the board’s actions, which failed to criticize the off-book transactions undertaken by the company and the high risk accounting practices that were implemented adopted by the company. In addition, the board signed the partnerships and failed to handle the internal abuses and the questioning of business practices that were potentially harmful to business continuity of the firm (Ashish & Lauren 2006).

AUDITORS

The collapse of the Enron Corporation can be largely attributed to audit failures, which resulted to one of the largest corporation collapses in business history involving USD 8.5 billion hidden debt. This is significantly attributed to the company’s auditor malfunction to conduct in depth investigations and report any signs of suspicious accounting procedures and methods that had been long practiced by the company. One of the reasons why the audit failures resulted to the Enron fraud and ultimately collapse is that the auditor’s acceptance of non-audit engagement together with audit engagement; this served to put at risk the autonomy and reputation of the auditing process (Bovaird & Loffler 2000). The second reason why the auditing failures occurred is the intimate relationship that exists between the external auditor and the client, which lead to the viewpoint that the collapse of Enron Corporation can be significantly attributed to the lack of auditor independence. A friendly relationship between the external auditor and the client places the auditor in a complex situation and makes it difficult to establish probes and query any possibility of suspicious accounting policies adopted by the Enron Corporation (Chatterjee 2003). This resulted to what Andersen, the company’s external auditor referred to as high risk accounting practices. The third reason why the auditing failures at Enron Corporation happened is because of the fact the external auditors were fee dependent on the client, which was Enron Corporation. This immense reliance on fees from clients implies that the auditor’s ability to deploy impartial judgment and objectivity is significantly reduced when giving their audit opinions. This is because in most auditing cases involving audit engagement, company auditors are usually unwilling to risk their share of the money acquired from audit services and the revenue generated from services that are not audit-oriented. I addition, long audit tenure with Enron Corporation resulted a situation characterized with over-familiarity of company’s control system and the business context of the corporation. As a result, the audit failures of the Enron Corporation were because Andersen underestimated any instances suspicious activities and shortages found in the internal control system of the company. These reasons are a significant threat to auditor independence (Curall & marc 2003).

It is a requirement under the Federal securities laws that the financial statements of public corporations to be certified using an independent auditor. Outside audits does not guarantee that that organizations cannot make financial mistakes beyond bankruptcy, issues in auditing at Enron Corporation can be cited to have contributed significantly to the sharp demise and rise of the stock price. This is because there is a misrepresentation of the company’s net revenue and contingent liabilities (Deakin 2001). The corporation’s net revenue was constantly restated, while the contingent liabilities exceeded the amounts known in the accounting books. The fundamental of concern is whether the Arthur Andersen comprehensive consultancy work for Enron Corporation may have imposed a compromising effect on the audit judgment with respect to timing, nature and the extent of the audit policies, practices and procedures in asking adjustments to be made in the company’s financial statements. This is the core responsibility of Enron Corporation’s top management. The oversight of outside auditors is usually vested in the American Institute of Certified Public Accountants and the state boards of accountancy (Doost 1990).

In order to combat the auditing failures, it is imperative that auditor independence be protected, which can be effectively achieved by the adherence to the law and accounting standards by the auditors, failure to do so, they are faced with the risks of undertaking the legal liabilities associated with giving misleading and misinterpreted information to the various users of the accounting statements. Auditors are usually caught in a compromising position that compels them to withhold important information that may jeopardize the reputation of the client; this should be done only when the guidelines and accounting standards are taken into consideration (Ellen & Dana 2009). This implies that external auditors have to take into consideration the fact they hold their accountability to the interested parties who use the company’s financial statements including the shareholders, investors and key stakeholders. It is important for auditors to take note that they have no obligation to their client. Therefore, a significant enforcement of the accounting and auditing policies, procedures and practices is essential in order to ensure that there is efficient implementation of the rules with the main objective of eliminating auditing issues associated with lack of auditor independence (Geiger 2002). This entails the use of disciplinary actions by use of legislations. In addition, the board plays an integral role in supporting the effectiveness of the auditing process through avoiding the creation of an environment through which the auditors can be exploited in accordance with the interests of the client. In addition, the internal control systems are usually at the directives of the board, implying that they have a significant role in ensuring that the process of auditing is undertaken appropriately in accordance with the established accounting guidelines and standards (Gianakis 2004).

REGULATORS

Governments and regulators are persistently enhancing the aspect of auditor independence regimes with the main objective of regaining trust and strengthening the independence of outside auditors. The establishment of the standards policies and practices for accounting has for a long time based on a self-regulative system and a principle-based model. In the United States, the Security and Exchange Commission (SEC) and the American Institute of Certified Public Accountants have the sole responsibility of regulation and evaluation of the auditing practices adopted in the country (Gietzmann & Sen 2002). The companies’ acts usually serve to offer adequate regulatory approaches, that auditor and companied to adhere to. With this respect, it is a requirement of SEC that all public corporations should have outside auditors to undertake the auditing process. This implies that an outside auditor is supposed to offer opinions regarding the precision and reliability of the company’s accounting statements, taking into consideration the principle of objectivity, lack of biasness and avoiding the engagement in activities that are likely to result to lack of auditor independence (Haines 2004). As a result, auditors are required to display utmost ethics and honesty in the code of duties, which requires auditors to display integrity, objectivity and independence. The regulatory oversight that resulted to the Enron fraud is a violation of the aspect of auditor independence as evident by Andersen having an office space in Enron’s headquarters that was permanent. This served to reveal lack of auditor independence (Hill & Cronk 2010). In addition, there is a possibility that Andersen overlooked Enron Corporation’s compliance with the required accounting policies, procedures and practices. In addition, Enron Corporation had relied on the auditing services from Andersen, resulting to him familiarizing with the corporations accounting policies and practices. The Enron scandal served to reveal the significance of auditor independence; as a result, the fraud served to question the efficiency and the adequacy of the present audit independence regulatory frameworks. The auditing procedures prior to the Enron fraud were sufficient to ensure that there is high audit quality, but in some cases fails to identify misappropriations (Hodgetts & Luthans 2003).

There have been significant changes in accounting regulations after the collapse of the Enron Corporation with the main objective of ensuring veracity of the financial statements. This is because most corporations faced accounting issues and poor quality of audit procedures. One of the new accounting regulations after the collapse of the Enron Corporation is the Sarbanes-Oxley Act passed during 2002 and incorporated numerous strictures on audit and accounting policies and practice (Horngren 2003). According to the Sarbanes-Oxley Act, accounting firms have the sole responsibility of auditing committee of the boards and that auditors are not supposed from providing other services that are not related to auditing such as management, investment advice, broker and so on. In addition, audit partners are to be rotated within a period of five years and that auditors are prevented for duration of one year from the acceptance of employment within their client firms in positions such as Chief Executive Officers, Chief Financial Controllers and so on. The Sarbanes-Oxley Act also requires the establishment of an auditor oversight board in accordance with the SEC review (Hubbar & Beamish 2011). This act has been effective in increasing the oversight of the accounting profession by the establishment of an oversight board as stated above. The act has also been helpful in enhancing corporate governance obligations of public corporations, which has helped in increasing the precision of financial statements (Larry & Bob 2003). The act also aimed at increasing the disclosure of auditing information and off-balance sheet transactions undertaken by the company. The imposition of strict criminal penalties in case of violations of the accounting regulations outlined in the act and the present Federal security laws have helped in reducing the auditing failures, which has contributed significantly to the elimination of regulatory oversights during audit practices (Spiegel 2002).

Another regulatory oversight during the collapse of Enron Corporation is the potential interference by the United States government in the regulatory process. This serves to eradicate the self-regulatory system, and has received immense criticisms from regulators and professionals citing the complexity of the SEC and AICPA rules. This is perceived to result to more confusion and impose a challenge on the audit practicing community in the United States (Plaats 2000).

Significant changes have also been implemented at the SEC after the collapse of the Enron Corporation (Sherer & Turley 1997). The Sarbanes-Oxley Act served to streamline the changes in order to enhance the effectiveness of the accounting profession at large. The change at the SEC after the collapse of the Enron includes a revision of the requirements that outlines the requirements to be met when offering non-audit services. The SEC was of the opinion that the newly implemented standards and guidelines offer adequate safeguarding steps that are aimed at eliminating the compromising of audit independence (Wells 2009). In addition, the SEC hopes to revise the standards and guidelines every now then in order to address new challenges that may impede audit independence, precision and accuracy of the reporting of financial statements. After the Enron fraud, SEC significantly revised its auditor independence requirements with the main objective of analyzing the efficiencies of the existing standards and constantly suggests adjustments to the rules (Stevenson 2002).

ANALYSIS

There are diverse speculations regarding the perpetrators of the Enron fraud, as a result cumulative practices of unethical business practices. One of the most significant perpetrators of the Enron fraud was Arthur Anderson, who had been the company’s auditor since its establishment. Andersen role in Enron fraud can be significantly attributed to the auditing failures, whereby he failed to highlight the imminent dangers of the accounting practices and policies implemented by the company, which ultimately resulted to bankruptcy. This is because the public lost confidence on auditor’s accuracy, which transformed to a fall of the company’s stock price in the capital market. In addition, Andersen violated most of the SEC requirements for auditor independence (McBarnet 2006). The Enron senior management team is also responsible for the onset of the Enron fraud through concealing the losses imposed by the off-balance sheet transactions and partnerships. The senior management also relied on Andersen high risk accounting policies and procedures in order to obtain financial statements that were favorable, while at the same time hiding the company’s debt that totaled to approximately USD 8.5 billion. The senior management also chose to ignore the increasing risks associated with not complying with the accounting standards (Plaats 2000). The Audit Committee members of the corporation were informed of the high risk accounting elements adopted by the company such as the highly structured and related party transactions. The board did not object to the actions undertaken by Enron, and did not recommend investigations to be conducted on the accounting policies deployed by the Enron Corporation. CFO Jeff Skilling, CEO Kenneth Lay and Timothy Belden also helped in triggering the Enron collapse through setting up of off-balance sheet partnerships and transactions (Spiegel 2002). It is arguably evident that the Enron collapse can be attributed to audit failures, meaning that auditors have a duty to detect and prevent fraud. The conflict of interest rests mainly with the client’s need to maintain positive reputations and have favorable financial statements. The auditors on the other hand fear that they are likely to lose a client if they provide comprehensive accounting information. In addition, there is a possibility that lower audit engagement fee is likely to be offered in the period. As a result, auditors are under immense pressure, placing them in a difficult position to reveal all financial information or disclose accounting information that has been selected in accordance to the interest of the clients. It is therefore important for auditors to take into consideration that they hold their accountability to the interests of the stakeholders and other entities that may use the company’s accounting information. In order to have these challenges, it is important for the auditing independence regulatory framework to be tightened and ensure that firms comply with the established rules (Lytle 2009).

There is also urgency for regulatory bodies to revise their rules and implement strict compliance requirements. The significant challenge associated with the proposed regulatory reforms is the lack of their ability to handle the core problems imposed by auditor independence. Irrespective of the toughness and strictness of the rules, it is the auditors who have an ethical obligation of adhering to the rules. If the guidelines, standards and rules are established without taking into consideration the aspect of independence abuse and failure of markets, they are likely to be ineffective. This implies that regulatory bodies should recognize the various factors of motivation for auditors. In addition, regulatory bodies should recognize the audit quality drivers when establishing regulatory frameworks. It is important to take into consideration the fact that rules can be manipulated and that people have the free will and incentives to manipulate the rules (Hill & Jones 2007).

CONCLUSION

The collapse of the Enron Corporation has offered significant insights to the need to implement changes in the accounting policies and corporate governance in the United States. The downfall of the Enron Corporation can be clearly attributed to audit failures, whereby its financial statements did not accurately reflect the company operations and finances with its respective shareholders and analysts. Therefore, a significant enforcement of the accounting and auditing policies, procedures and practices is crucial with the main objective of ensuring that there is efficient implementation of the rules with the main objective of eliminating auditing issues associated with lack of auditor independence. This entails the use of disciplinary actions by use of legislations.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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