Enron Company Fraud Case
Enron is an American energy company which headquarters are in Houston, Texas. The Enron scandal that came to revelation in October 2001 led to the bankruptcy of the Enron Corporation and resulted in the abolishment of Arthur Andersen, which was one of the Big Five auditing firms in the world among KPMG, PWC, Deloitte, and Ernst & Young. Despite being the largest bankruptcy scandal in the American history, Enron is part of the biggest audit failure. Enron was founded in the year 1985 as one of the first electricity, natural gas, pulp, and paper producers before it went bankrupt in the year 2001. As a result of the bankruptcy, the CEO of the firm Jeffrey Skilling resigned due to undisclosed reasons. The company reported the first quarterly loss over the four-year period. The earnings continued to reduce over the years that led the company to file for bankruptcy on December 2, 2001 (Steffensmeier, Schwartz, & Roche, 2013). Despite the government regulations on auditing issues, companies that do not undertake proper auditing processes are at risk of going bankrupt or closure, or both at the same time.
Causes of Enron Bankruptcy
The lack of truthfulness
The top management lacked truthfulness in the operations of the firm which resulted in the decline of Enron in the market. The directors and other top executives had the duty to protect the reputation of the firm just like other directors of successful firms in the U.S. They failed to highlight the change in stock prices and the sale of their shares as they owed the duty of good faith and full disclosure to the shareholders. After the collapse of Enron, the shareholders learned that the management sold shares in the year 2002. There was a delay in detecting the sale of stock in the firm as the stock was sold to repay some amount of money that the top management owed Enron. Their actions led to the bankruptcy and fall of the firm in the market (Morgan, & Burnside, 2014).
Conflict of Interests
Conflict of interests in the management of Enron board resulted in the collapse of the firm. Arthur Anderson, the company external auditor, engaged in two roles for the client. The roles included consultancy and auditing services that resulted in the conflict of interests. The auditor’s conflict of interests compromised the independence of the company, which was one of the causes of collapse. In order to salvage the business, the shareholders decided to dispose of some of their assets and, as a result, filed for bankruptcy that allowed protection from the creditors. The lack of auditor’s professionalism compromised the auditor’s report, which might be caused by the transaction of the related parties, reliance on one client, prolonged audit for another client, and undue influence.
Enron and the Reputation of Arthur Andersen
Accounting irregularities in Enron in the third quarter of 2001 led to regulators and the media focusing their attention on Andersen, the firm external auditor. Accounting errors together with Andersen’s role as the company auditor and the widespread media attention resulted in the further exploration of the impact of audit reputation on the client’s books of accounts. It came to light on January 10, 2002, that Andersen’s employees had destroyed the documents related to Enron engagement (Hays, & Ariail, 2013). The public image of the auditing firm and its reputation affect the success and reliability of the financial statements prepared by the company accountant.
Market pressure, government regulations, and oversight by the auditors as well as an equity analyst were some of the external sources of governance facing the firm. In order to encourage the investors to provide their money to the company, Enron shareholders were compelled to forecast future high cash flows at a low discount rate in the long run. Future income projections were very optimistic and highly inflated, leading to the fall of the company.
Special Purpose Entity (SPE)
Accounting rules allow any company to exclude special-purpose entities from its financial statements. If there is an independent party in control of SPE and the party owns more than 3% of SPE, they should be reported. Enron should look for ways to hide their high debt levels since it lowers the investment and triggers the financial institution to recall the money invested. The debt and assets bought by SPE headed by the CFO Fastow were not reported in the Enron financial statement, and the shareholders were misled by the illusion that the revenue was increasing while the debt was decreasing (Albrecht, Albrecht, Albrecht, & Zimbelman, 2011).
Non-Transparent Financial Statement
Properly maintained books of accounts that are accurate are the key for the prosperity of any company. Enron non-transparent financial statement did not portray its operations and finances to the shareholders. Improper preparation of the books of accounts led to the bankruptcy of the Enron company. Employees of the firm had a duty to disclose fully any necessary financial information that the external auditor might require. The lack of proper cooperation with the auditors indicated the presence of fraud in the books of account.
People Responsible for the Collapse of Enron
- From an Individual Angle: Employees of the firm are the primary people responsible for the collapse of the company. The Chairperson of the Board, Kenneth Lay, and the CFO are some of the individuals who violated their professional ethics, and their actions resulted in the collapse of the firm. They should have maintained professionalism in their duties to prevent the decline of the company.
- From Company Angle: The actions of the Enron executives resulted in the collapse of the company as they were not acting for the shareholders welfare. Therefore, the company was not responsible for any audit fraud facing Enron as the managers were primarily responsible.
Federal securities laws require the financial statement of any public traded company that is certified by an independent external auditor. Enron external audits received keen attention from the media. As the external auditors failed to prevent the organization from making financial errors and mistakes apart from the bankruptcy issues, the Enron audit fraud led to the rapid rise and the dramatic fall in the stock prices. Outside investors such as financial institutions were misled about Enron net income, which was adjusted, and liabilities, which were inflated. The firm external auditor admitted the financial mistakes that took place in the financial statements. On January 15, 2002, the partner in charge of Enron audit was sacked, and the firm external auditors were dismissed on January 17. Arthur Andersen’s consultancy work compromised their judgment in evaluating the extent of audit procedures regarding the financial statements of the firm. The audit act of destroying the audit material and other emails related to the audit raised questions about fraud in the books of accounts and the audit report.
External Auditors’ Responsibility Regarding Fraud
ISA 240 concerning auditors’ responsibility relating to fraud in the financial statement recognizes that any misstatement in the books of accounts can cause the frauds and errors in the financial declarations of a company. The auditors of Enron should have investigated if the misstatements were intentional or unintentional. The auditor must know the impact of the fraud and errors on the accuracy of financial statements. The external auditor in the firm is solely responsible for assuring if the financial statement is free of material misstatements caused by errors or fraud. They should ascertain that the financial statements are fair in the audit report. The auditors must maintain professionalism in their auditing services by following and adhering to the international auditing standards.
- Integrity: Accounting has professional values such as honesty that every auditing firm must maintain. The auditors had the duty of conducting the auditing services with the highest degree of integrity in the books of accounts. Arthur Anderson should never have taken part in any illegal activity or have engaged in acts that were not accepted in the auditing profession. If integrity had been adhered to, collapse or bankruptcy would have been prevented in the firm, thus ensuring the lack of audit frauds (Nguyen, 2014).
- Confidentiality: External auditors should maintain the highest degree of client’s secrecy and should never use the client’s information for any personal gain or in any manner contrary to the law.
- Independence: Enron auditors should have maintained independence in the course of their auditing services. The lack of professional independence resulted in the undue influence on the auditors, making them produce an inaccurate audit report. Independence is compromised by the transaction of the related parties and the conflict of interests in the client firm.
- Single role: Arthur Anderson, who was the Enron external auditor firm, should only have had one role. They should not have provided consultancy and auditing services, and this would have compromises the auditor’s independence (Prasad, & Ahmad, 2014).
Prisoner’s Dilemma in Enron Case
Before the collapse, Enron engaged in a variety of activities such as energy production and trading in the energy-related derivatives. The activities were regulated by Commodities and Futures Trading Commission as well as Federal Energy Regulatory Commission. Both regulators had the duty of ensuring that the market operated in the best open way and competitive manner. Each party was trying to secure gains for themselves in a zero-sum game. Arthur Andersen, who was the consultant and auditor firm to Enron, must have been responsible for both the management and the shareholders. In the end, the auditor and top management betrayed the shareholders by maximizing their selfish interests. They faced an ethical dilemma of choosing between the right and the wrong (Nguyen, 2014).
The Warning of the Enron Scandal
Organizational culture contributed to the collapse of the Enron company. Therefore, the firm must have had a healthy corporate culture to prevent the collapse. The top executives believed that the company had to be the best in everything it did, and the management who were not involved in the fraud scandal were entirely hopeful regarding the activities of the business. When the losses happened and became reflected in the firm financial statement, they covered the losses to protect their public image and reputation in the market. The reported loss should have been corrected rather than faking and falsifying the figures.
A more complete and accurate system is needed for the shareholders of Enron to supervise the management and operators of the company. More governance from the board can help keep the firm from falling to any bankruptcy in the future. The board should pay closer attention to the activities and the behavior of the management to prevent and detect any fraudulent activities. The government should develop better regulations to prevent any fraud occurrences in the future.
Business ethics is the key to conducting any business in the best professional manner. The firm executives who are the true agents of Enron have the duty of serving their employer in the best way possible. They have a role in the company to ensure shareholders’s wealth and maximize profit. The management violated the principle of being loyal to the agency created. The accountant should have prepared the financial statement in the best way possible with due professional care. Therefore, the books of accounts should have been free of and fair without any fraudulent activities detected.
Directors’ Responsibilities in Prevention and Detection of Fraud
Company directors have the role of preventing and detecting any material of financial fraud in the company. The effective internal system of controls should be implemented by the management to reduce any undetected fraud from happening in the financial statements. The management must be aware of all the potential sources of fraud in the books of accounts. They work together with the audit committee to review the procedures set and ensure that they are applied properly (Shinde, Willems, Sallehu, & Merkle, 2015).
The Board of Directors have the duty of setting the priorities: raising the awareness about the risk of fraud in the whole organization will encourage fraud risk management. The leaders need to offer education on antifraud activities and the ethical behavior required in preparation of the financial statement and auditing services. The conflict of interests causes fraud in any company such as Enron, and it is the role of directors to prevent the conflict of interests as they must eliminate any situation where such a conflict may occur in the firm.
On a personal level, Enron company case was one of the largest fraud scandals that damaged the public image and reputation of U.S. companies. In order to prevent future frauds, the government should pass laws to regulate the behavior and activities of auditors in their auditing services. In my opinion, the Enron external auditor should have maintained business ethic and professional values such as integrity, confidentiality, competence, and professional due care. The directors of any company, such as Enron, should ensure that the conflict of interests is eliminated to avoid fraudulent activities occurring. Finally, the external auditors should only be engaged in just one particular role in the company, and they should never conduct non-audit assurance services. Too many roles compromise their independence, thus affecting the auditor’s report.