Enron Scandal: Impact on Accounting

Enron Scandal Impact on lineage relationship score for Enron1. Why is telephone circuit relationship exis ecstasyce blamed for the losings preserve by investors as a result of the collapse of Enron? Is this criticism fair and do pecuniary business relationship and embraceing drills quest to be reformed? be has been blamed for the losses sustain by Enron, as it allowed the telephoner to under sp are details of its dealings from its investors, until the caller-ups pecuniary situation was so bad that the whole was forced to go bankrupt almost everyplacenight. Enrons downfall has been characterised as excessive interest by management in importanttaining stock price or earnings tr culmination by dint of the exercising of unusually aggressive history practices. (Healy, 2003) As part of this, Enron enforced mark-to- market method of account statement for the energy trading business in the mid-1990s and expenditured it on an peculiar scale for its trading proceed ings. (Thomas, 2002) Under mark-to-market method of accounting practices, companies with bulgestanding derived function contracts or purchases on their relaxation sheets when accounts are being prepared must localise them to fair market place (Thomas, 2002) As a result, predicted foresightful term gains or losses on these contract are applied to the come withs profits promptly, similar to depreciation, or asset write downs. The main difficulty encountered when doing this for long-term futures contracts in energy markets is that there are much no quoted prices upon which to base valuations. Companies having these types of derivative instruments are free to develop and use discretionary valuation models based on their own assumptions and methods, as Enron did. (Healy, 2003) some otherwise accounting technique Enron used to hide significant debts was the use of supernumerary purpose entities (SPEs), which Enron took to crude heights of complexity and sophistication, cap italizing them with not only a variety of hard assets and liabilities, but alike extremely complex derivative fiscal instruments, its own restricted stock, rights to acquire its stock and connect liabilities. (Thomas, 2002) Enron also used these SPEs to hide details of assets which were excessively declining in judge, thus avoiding having losses from asset write down and depreciation charges on the company books. This practice was applied to certain everywhereseas energy facilities, the broadband operation or stock in companies that had been spun polish get through to the macrocosm. (Thomas, 2002) The accounting treatments around SPEs meant that the losses sustained on these asset write downs would not appear on Enrons accounts. Enron promised share issues to the investors in the SPEs to compensate them for taking these assets on but, as the value of the assets fell even further, Enron found itself unable to meet these commitments from share issues.These fictive accounting t echniques began to be suspected by investors in October 2001, when Enron several(prenominal) new businesses failed to perform as salubrious as expected. Enron was hoping these new businesses would cover its losses on the SPEs but, in October 2001 the company was forced to announce a study series of write-downs of its own assets, including by and by tax charges of $2.87 million for Azurix, the water business acquired in 1998, $180 million for broadband investings and $544 million for other investments. (Healy, 2003) These write downs metreed to twenty two percent of the capital spent by Enron on developing its business amongst 1998 and 2000. In addition, Enron sold Portland General Corp., the galvanic power plant it had acquired in 1997, for $1.9 trillion, at a loss of $1.1 billion over the acquisition price. (Healy, 2003) The losses incurred as a result of this caused investors to oppugn whether Enrons strategy was feasible in the long tem, and in markets other than derivati ves.In summary, whilst the accounting concepts and strategy underlying the gas derivatives trading was a reasonable attempt to produce value for investors, extensions of this idea into other markets and outside(a) expansion were unsuccessful. (Healy, 2003) However, whilst the mark to market and SPE accounting techniques used by the company helped hide this fact from investors, the stock markets as a whole were finable of macroscopicly ignored red flags associated with Enrons spectacular report performance (Thomas, 2002). This back up and, in the eyes of the management at Enron, vindicated the companys expansion strategy by allowing Enron access to plenty of capital tattily and easily. As much(prenominal), accounting cannot be entirely blamed for the losses sustained by investors, as the investors themselves simply assumed that the value Enron appeared to be generating would be sustained re snuff itd into the future, despite little economic basis for such a projection. (Thoma s, 2002) As a result, whilst accounting made it easier for Enron to mislead its investors, the facts generate that investors themselves were more(prenominal) concerned with Enrons reported profits and growth, than analysing the roots causes and business model.2. Does it matter what accounting policies are adopted by a company as long as they are decorously disclosed?A very confusing foot annotating in Enrons 2000 pecuniary statements (Thomas, 2002) described the exploits in question one, until now according to analysts, most people would be hard pressed to understand the effects of these divine revelations on the fiscal statements, casting doubt on both the quality of the companys earnings as well as the business purpose of the transaction. (Thomas, 2002) By early 2001, several market analysts had begun to question the clarity and transparency of Enrons disclosures. One analyst was quoted as saying, The notes just dont make sense, and we read notes for a living. (Thomas, 2002 ) Enron publicly denounced and abused these analysts however, because of these actions, investors began to trance Enrons accounting policies, and disclosures, with great and greater scepticism. Indeed, despite the fact that Enrons disclosures were fair to middling in the regulatory modelling, they were unflurried not in the bosom of managerial responsibility to shareholders.In another sheath of inadequate disclosure policies, Satava et al (2003) examined the celebrated Royal Mail Case and the implications of the case for the accounting practice today. Satavas arguments claimed that the case was not about the utilization of privy(p) reserves, but about the non-disclosure of repayments by the Inland Revenue of over victuals for tax, and that defence counsel for the auditor succeeded because of the weak factual case presented by the prosecution. (Satave et al, 2003) In summary, the duty of accountants to adequately disclose their accounting policies can frequently conflict wit h attempts by the same accountants to use these policies to benefit the company. As a result, these conflicts of interest often result in only materially adequate disclosures of sub bar accounting policies.3. To what close did Enron use withdraw balance-sheet backing in its operations? Were these transactions fitly treated and adequately disclosed in the financial statements of the company? What consequences did the accounting treatment of these transactions abide for Enron and its investors?The main direction Enron used moody balance sheet pay was in its extensive use of SPEs to give it ready access to finance without having to report any debts it incurred in its accounts. The company contributed assets, and debt secured against those assets, to an SPE in exchange for swan of the SPE, and the SPEs past borrowed large touchstones of capital which was used to finance Enron, without any debt or assets present up in Enrons accounts. Enron also sold assets to the SPEs at sup ra market value, and thus reported profits on these changes.Enron used grand numbers of SPEs in this way, the most well known of which were LJM Cayman LP and LJM2 Co-Investment LP. From 1999 through and through July 2001, these entities paid Enron managers more than $30 million in management fees, far more than their Enron salaries, supposedly with the approval of top management and Enrons board of directors. (Healy, 2003) The SPEs in turn created yep more SPEs, known as the Raptor vehicles, which enabled Enron to invest heavy in a bankrupt broadband company, Rhythm NetConnections, during the dotcom boom. To finance this investment Enron made a share issue worth $1.2 billion. However, in rank to complete this deal, Enron increased shareholders equity to consider this transaction, which has been claimed to violate accounting standards and regulations. Additionally, accounting overlooks actually meant that Enron should mystify included information from the LJM and Raptor SPEs in their accounts, or else than continue to use them as off balance sheet financing. (Healy, 2003)In addition to these minor violations, Enron revealed in October 2001 that several other SPEs had violated the accounting standard that required at least 3 percent of the entities to be owned by other investors, with no interest in the promote company. Again, by ignoring this requirement, Enron kept the financing it obtained from these entities off its balance sheet, enabling it to play down its liabilities and losses on this source of financing. However, on October 16, 2001, Enron announced that restatements to its financial statements for age 1997 to 2000 to correct these violations would stretch earnings for the four-year period by $613 million (or 23 percent of reported profits dating the period), increase liabilities at the end of 2000 by $628 million (6 percent of reported liabilities and 5.5 percent of reported equity) and reduce equity at the end of 2000 by $1.2 billion ( 10 percent of reported equity). (Thomas, 2002)In addition to the accounting failures, Enron only disclosed the minimum amount of details on its investments in the SPEs, and the amount of financing it had gained from them. The company claimed that it had weasel-worded some of its investments using special purpose entities, but failed to inform investors that Enron shares were being used as part of this hedge. Moreover, Enron allowed several of its senior managers, including its chief financial officer Andrew Fastow, to become partners of the special purpose entities. Thus, these employees were able to make large amounts of profit, in both cash and shares, from the off balance sheet financing provided by companies they partly owned. (Thomas, 2002) This was a clear failure to fulfil their fiduciary responsibility to Enrons stockholders, and contributed to the extent of the companys downfall.4. Would similar treatment of off balance-sheet transactions be permissible in the UK?Tollingto n (2001) is one of the foremost academics claiming that financial accounts no longer provide a true and accurate model of the value of a business, due to the widening between the values accounting policies place on assets, and the market values of said assets. His paper argues that the definitional requirement for transactions or events appears to restrict their cite, and therefore disclosure on balance sheets, which enables similar off balance sheet transactions in the UK.Equally, professional crime has massively increased in modern years, with some estimates stating that over half a trillion pounds of criminal proceedings are laundered through the worlds financial markets each year. (Mitchell et al, 1998) The major(ip)ity of this is moved in large quantities, and this cannot be done successfully without willing accountants, who can use creative accounting to hide any money laundering outside the scope of company accounts. However, new money laundering regulations mean that a ccountants, and related professionals, are now supposed to report any fraud or money laundering wherever they find it, and this applies as much to criminal activity the UK as to anywhere else.Whilst securitization, which incorporates the use of SPEs for off-balance-sheet financing, has been extensively reviewed in new years, there are in date concerns over the extent to which off balance sheet financing can be abused, both in the UK and abroad. The external Accounting streamers Board (IASB) and the US financial Accounting Standards Board (FASB) lately introduced new standards, and modified their existing standards, in companionship to more purely define the acceptable accounting treatments for securities. (Satava et al, 2003) Whilst some accountant and analysts are still hoping to move towards a single, global, set of accounting standards, this is likely to take several times. Other jurisdictions are also keen to create a globally accepted set of standards, and in the UK the Accounting Standards Board (ASB) is converging with supranational Financial Reporting Standards (Ifederal official), commonly referred to as IAS, to minimise the extent to which off balance sheet financing can be practiced.Two other factors drive combined with the restructuring of financial and other industries in a way that has placed additional stress on the corporate governance function, and off balance sheet transactions greater complexity of business structures and greater stress on stock prices. In the last decade or so, business has experienced a surge of fluid organizational arrangements as well as a routinisation of complex transactions, with alliances, vocalize ventures, multifaceted sale arrangements and hybrid, structured finance arrangements becoming commonplace. (Monks and Minow, 2003) The net effect is the economic boundaries of the firm have become ambiguous and extremely fluid, a phenomenon reflected in the marvellously euphemistic phrase off balance-sheet fin ancing, where the firm structures transactions and relationships to avoid their denotive recognition in traditional accounting displays. A typical example is a firm that holds a portfolio of mortgages. It places the portfolio in a free-standing legal entity with clearly limited scope, a precise endeavor Entity, but continues the transaction touch on and possibly provides credit enhancements. In different variations, inventory, research and development or even rights to future revenue cash flows are parked in exceptional Purpose Entities (Griffiths, 1995).Reporting regulations allow the Special Purpose Entity to be kept off of the firms formal financial statements as long as it is disclosed, provided substantive risk has been shifted to an independent third party. (Nelson, 2003) General Electric, an aggressive purveyor of these arrangements, for example, reports sponsored Special Purpose Entities with assets in excess of $50 billion in its 2001 financial report. The independent third party must have (among other things) a minimum of 3 percent ownership of the Special Purpose Entitys equity and debt, although the Financial Accounting Standards Board in the US has belatedly tightened these requirements to resemble that of the UK. (Demski, 2003) However, Special Purpose Entities are only one purview of this wave of organizational and financial innovation.This greater degree of complexity has interacted with a corporate governance environment that has been placing heightened emphasis on shareholder value (Nelson, 2003), including an explosion in the use of option-based compensation. A substantial portion of the greater complexity appears to be motivated by a concern for financial presentation, for example, beautifying ones balance sheet In some cases, the effect may be as simple as a matter of time for instance, the timing of selected expenditures and shipments can affect current period financial results, just as can the time at which a sale is formally bo ok or a loan is consummated. With the assistance of hybrid financial and organizational transactions, a lease can be structured so it does, or does not, show up on the slightees balance sheet, thereby affecting the fit debt that a firm reports, through other methods than off-balance sheet financing. However, fundamentally, Enron, used Special Purpose Entities to disguise significant amounts of debt as commodity prepay transactions. through and through a series of circular or round-trip prepaid transactions, this Special Purpose Entity was the centerpiece in allowing Enron to borrow money but to record the amount borrowed as cash generated by operations, because prepaid commodity contracts are chiefly booked as trades, not loans, a distinction which would have been clearer in the UK (Deminski, 2003).5. Are principle based types of accounting standard like federal official 5 more effective in dealing with accounting abuses than the more rule based standards of the US?Although the f oundation of financial accounting and auditing has traditionally been based upon a rule based framework, the concept of a principle based advance has been periodically advocated since being incorporated into the AICPA Code of allot in 1989. Enron and similar events indicated that the accountants and auditors involved have followed rule based honourable perspectives, however these rule based standards have failed to protect investors from accounting abuses. Satava et al (2003) thus described how rule based traditions of auditing became a convenient vehicle that perpetuated the unethical conduct of firms such as Enron and Arthur Andersen. They presented a model of ten ethical perspectives and briefly described how these ten ethical perspectives impact rule based and principle based ethical conduct for accountants and auditors, concluding by identifying six specific suggestions that the accounting and auditing profession should consider to restore public trust and to improve the eth ical conduct of accountants and auditors. Their conclusions showed that principle based standards were less open to abuses that rule based standards, provided the principles were well defined.Indeed, the publication of a late(a) amendment to Financial Reporting Standards (federal official) 5 by Great Britains Accounting Standards Board, sought-after(a) to clarify how to account for SPEs and similar entities, with emphasis on how the principles of the federal official 5 will apply to transactions conducted with these entities. Accountancy (2004) claimed that by publishing an amendment to FRS 5, the United Kingdom Accounting Standards Board was attempting to stop the flow of off balance sheet accounting, despite concerns expressed surrounding the amended FRS 5. The article provided information on an amendment to FRS 5, Reporting the Substance of proceedings, namely the addition of Application Note G, Revenue Recognition.The note has been prepared in response to the need for clarity i n extol to questions that arise concerning the treatment of revenue and, in particular, the treatment of turnover. The amendment was published as an Exposure Draft in February 2003 for public comment and, in finalizing the memorandum the Accounting Standards Board took into consideration the comments received in response to the rough drawing and has consulted interested parties. In FRS 5, in the list of contents immediately preceding the summary, the list of Application Notes is extended by adding at the end, G Revenue Recognition and sets out basic principles of transaction and revenue recognition which should be applied in all cases This thus has increased the extent to which the principle based accountancy legislation in the UK can control the extent of off balance sheet transactions, and correspondingly increased the needed amount of disclosure. (Accountancy, 2004)However, it has been argued by some theorists that the reform efforts may have been inexpedient (Culp and Nickan en, 2003), due to a need to recognise that accounting is retrospective, and Enrons problems were perspicuous to investors if they used more forward looking information. The share price was declining long ahead the disclosures, quick surveys of four issues the state of wholesale electric markets before and after Enron, the state of regulation of wholesale electric markets before and after Enron, online trading before and after Enron, and whether swaps need regulation, shows that accounting abuses must still have an underlying business reason. It has also been argued that Enrons use of special entities for off-balance-sheet financing is a perversion of a useful, and often appropriate, accounting technique and such perversions can equally be applied to other techniques under principle-based standards.Equally, it has been recognise that the latitude inherent in principles, or concepts, based standards can be a double-edged sword. Such latitude allows managers to choose accounting tre atments that reflect their informed understanding of the underlying economics of transactions. (Nelson, 2003) This latitude, however, also permits managers to advocate describe treatments that do not reflect the underlying economics of a transaction. (Maines et al, 2003) both(prenominal) managers and accountants must have strong ethical principles in order for their accounting under principle based standards to reflect the true value of their business, specially in difficult times Both the s and the Auditing Standards Board in America support this view with their focus on the quality, as opposed to simply the acceptability, of financial reportage, as well as placing strong emphasis on the need for expert judgment and unbiased coverage (Maines et al, 2003)Concepts-based standards have the potential to promote the financial inform terminals of the regulatory bodies in ship canal that rules-based standards cannot. However, in order for this to happen, individuals must possess a conceptual framework for financial information in order to use this information appropriately in decision making. Principle-based standards reflect a more consistent use of conceptual framework, and thus enhance individuals understanding of the frameworks. Thus, a concepts based rise is consistent with the FASBs stated goal to improve the common understanding of the character and purposes of information contained in financial reports. (Maines et al, 2003)Also, principle-based standards are consistent with the stated goal of the FASB to promote convergence of accounting standards worldwide. The European Commission has recently proposed that the U.S. abdicate GAAP in favour of the more flexible IAS, which emphasizes substance over form in auditors inspection of the accounts. (Ampofo and Sellani, 2005) As a result, a concepts-based approach likely will lead to greater agreement in standard setting between the FASB and IASB and thus will also promote international harmonization. ( Maines et al, 2003)6. What has been the overall impact on corporate coverage of Enron and other recent financial scandals?The events surrounding the expiry of Enron have led to corporate reporting procedures being called into question all over the world. It resulted in critics questioning how adequate the disclosure legislation was at the time, and also to query how a major accounting firm could conduct independent audits of a firm they were move in major consulting work for, when the audit fees were tiny in equality to the consulting fees. The scandal threatened to undermine confidence in financial markets in the United States and abroad and the accounting profession and regulatory bodies were forced to act. (Swartz, 2005)In a characteristic move, the SEC and the public accounting profession were among the initiative to respond to the Enron crisis. In a piece for the Wall Street Journal, the SEC Chairman Harvey Pitt called the outdated reporting and financial disclosure system the financial perfect storm. (Thomas, 2002) He stated that under the quarterly and annual reporting system in place at the time, information was often piddle on arrival and mandated financial disclosures were often, arcane and impenetrable (Thomas, 2002) In order to reassure investors and restore confidence in financial reporting, Pitt called for a joint response from the public and private sectors to strengthen regulations and prevent a tax return of these events. (Thomas, 2002)As a result, since the Enron debacle, the global corporate reporting regulators were quick to move to stem the rising tide of public interest against their profession, displaying the banner Enron The AICPA, the Profession, and the commonplace Interest on its Web site. (Shwarz, 2005) It announced the imminent issuance of an picture show draft on a new audit standard on fraud, the third in five years up to 2002, providing more specific guidance on corporate reporting standards than was found at the time i n SAS no. 82, Consideration of Fraud in a Financial Statement Audit. The Institute also promised a revised standard on reviews of quarterly financial statements, (Thomas, 2002) as well as the issuance, in the secondment quarter of 2002, of an exposure draft of a standard to improve the audit, transaction reporting and disclosure process.The major piece of legislation to come out of the Enron scandal was the Sarbanes Oxley (SOX) report, which was passed by the U.S. Congress in 2002 in response to the demise of Enron and the WorldCom scandal. SOX requires firms to vouch for accounting controls and disclose weaknesses to shareholders, and almost all concerned parties have agreed that the SOX was a necessary and useful piece of legislation, that helped restore assurance in U.S. companies and their financial statements. (Swartz, 2005) However, whilst no one disputes the benefits, business leaders have often complained that the costs associated with Section 404 compliance are much high than expected, and are an undue burden on most companies. (Swartz, 2005) Many major companies, and some analysts, have criticised the large increases in auditing expenses, as these expenses create no direct value for businesses, and act to remove money from the economy which would otherwise be invested. dividing line lobbyists have also begun lobbying government bodies in the major financial centres, claiming that SOX slows business expansion and the growth in the number of purchasable jobs (Swartz, 2005)The level of complaints from companies about the increased costs associated with the new corporate reporting standards prompted U. S. auditing regulators, in May 2005, to move to ease the auditing expenses companies were forced to engage in, however regulators also said that the law has greatly benefited investors and there is no need for the U.S. Congress to change it at this time. (Swartz, 2005) Despite the obvious benefits that the increased level of reporting and disclosure p rovides to investors, many companies have complained that the compliance costs are too high, and that auditors force them to go through expensive corporate reporting procedures that accomplished little than to line the auditors pockets.ReferencesAccountancy (2004) November 2003 Amendment to FRS 5 Reporting the substance of transactions Revenue recognition. Vol. 133, going 1325, p. 128.Ampofo, A. and Sellani, R. (2005) Examining the differences between United States Generally Accepted Accounting Principles (U.S. GAAP) and International Accounting Standards (IAS) implications for the harmonization of accounting standards. Accounting Forum (Elsevier) Vol. 29, Issue 2, p. 219.Culp, C.L and Nickanen, W.A. (2003) Corporate aftershock the public constitution lessons from the collapse of Enron.Demski, J. S (2003) Corporate Conflicts of Interest. 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