The Enron Company’s Failure and Legal Outcomes

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Introduction

Enron Corporation was an energy supplying company located in Houston, Texas. The company was incorporated in 1985 through a merger between Houston Natural Gas and Omaha-based Inter North companies (Gwilliam and Jackson 240).

Since its formation, the company improved tremendously to become the largest supplier of gas in the United States. However, the company lost its popularity as the world’s supplier of natural gas following huge losses due to wrong decisions made by its managers and it was forced to bankruptcy into 2001(Moriceau 788). The company employed over 20,000 employees and it maintained a record of being the most innovative company in the US for six consecutive years just before its bankruptcy (Gwilliam and Jackson 248). Allegedly, the managers conducted business unethically and they were accused of fraudulent acts. It is alleged that the management colluded with the company’s auditors to defraud the company. This paper will analyze the reasons for the Enron’s failure and the legislations imposed thereafter in response to the issue. The paper will also analyze the effectiveness of the legislations in averting similar cases in the US.

What the company and/or its officers were doing, or not doing, that led to its collapse

One of the reasons that led to the fall of Enron was fraudulent acts by the executives, which caused the company huge losses (Moriceau 787). The management colluded with Andersen, the company’s auditors, to defraud the corporation, thus making it hard for investors and shareholders to detect the malpractices. Andersen received huge amounts of money in return for such manipulations. In addition, the company used the ‘mark to market accounting’ principle that allowed the recognition of profits from contracts before they are actually earned (Culpan and Trussel 65). The profits were determined through estimation and they were included in the company’s profit and loss account.

Such recognition of unearned profits led to overstatement of earnings before interest and tax. The company did not report losses resulting from such contracts later on when they occurred. The company estimated a profit of $110 million from a contract given to it by Blockbuster Video in 2000 (Moriceau 794). The contract was to take a period of 20 years to complete and the company distributed the amount over the period so that a profit of $5.5 million dollars was shown in the company’s financial statements every year (Gwilliam and Jackson 251).

The project later turned to be a failure and Blockbuster Company cancelled the contract. The profits were recognized in the company’s profit and loss account over the remaining period even though it was not actually earned. The recognition of profits before they were earned provided an incentive to managers to embezzle funds and cover it with such nonexistent profits.

The other possible reason for the failure of the company is the incongruence of shareholders and managers’ interests (Moriceau 789). According to the agency theory, managers are supposed to be in a fiduciary relationship with the company and its shareholders. The case was different in Enron since managers made secret profits without full disclosure of such gains to the company’s shareholders (Culpan and Trussel 73).

Shareholders’ wish is to minimize cost and maximize profits. On the other hand, the managers were driven by greed and desire to satisfy their interests. The managers offered huge salaries to its employees in order to hide the truth about the company. In addition, auditors received huge amounts of money in order to issue a positive report on the company’s affairs. Such big salaries added to the cost of the company, thus reducing its profits.

The fall of Enron Corporation can also be attributed to the management culture that facilitated greed and fraud (Culpan and Trussel 59). The company acted unethically and its main aim was to defraud investors. The management only focused on maintaining high prices for its stock rather than creating real value. In a bid to accomplish this goal, the company overstated its revenue through the help of auditors. The accounts hid liabilities and capitalized expenditures that were supposed to be written off the year they were incurred.

In addition, loans were treated as income to the company and not as liabilities as they should have been if the basic accounting principles were followed. In addition, the corporate culture in the company encouraged employees to hide the real affairs of the company in order to keep their jobs. Employees who acted in a manner that did not please the management would be laid off (Culpan and Trussel 70). It is alleged that the company replaced 15% of its employees each year, and thus workers would act as per the management’s will in a bid to buy their job security.

New legislation and/or regulations that have been put in place in response to the Enron debacle

The fall of Enron was a major blow to the accounting profession. The company’s fall prompted the US accounting body to make changes to its reporting standards (Moriceau 790). The changes were facilitated by the enactment of the Sarbanes-Oxley Act that defines the reporting standards. The SOX Act was meant to “improve accuracy of corporate disclosures in order to protect investors” (Gwilliam and Jackson 249). Under the Act, company’s CEOs would be held responsible for losses incurred by an investor who rely on financial statements to make investment in the company in question (Culpan and Trussel 59).

The act also established new reporting standards and imposed penalties for companies for failure to comply with the new requirements. In addition, the Act defined the independence of auditors and set out limits of engagement between auditors and corporate managers. Under the Act, “all companies in the US ought to provide an annual report on the effectiveness of their internal controls” (Culpan and Trussel 66). The Act also established an oversight board in every company to act as watchdogs for large companies. The oversight board is responsible for setting auditing standards, thus leading to uniformity in accounting systems used in different companies. The Act also outlines the “roles of auditors and it prohibits them from offering additional services to their clients in a bid to maintain their independence” (Moriceau 792).

Whether it is believed that such new regulation will make a significant difference in preventing the same kind of thing from happening again

The Sarbanes-Oxley Act enacted in response to the Enron case only reduces cases of fraud, but it does not stop them. Even as the law is in place, new scandals continue to be reported in the US, thus raising questions on the effectiveness of the regulations in combating the issue. The legislature is criticized for its insistence on internal controls. Section 404 of the Act requires managers to set up internal controls in their respective companies (Gwilliam and Jackson 253). The cost of maintaining internal controls is high, and thus most companies cannot afford. However, despite the critics, the Act is seen as effective in averting serious cases of fraud among companies. The Act provides that managers and executives of companies shall be called upon to return any secret profits earned illegally (Gwilliam and Jackson 256).

This provision is effective as it makes CEO’s shy from defrauding companies in fear that they may be asked to pay for any loss suffered. Since its enactment, several CEOs have been forced to return money acquired through fraudulent means. In 2006, Ian McCarthy, an executive at Atlanta-based Beazer USA Inc., was forced to return all his cash and other benefits earned that year (Gwilliam and Jackson 256). McCarthy returned money to the tune of $5.7 million in addition to $772,232 acquired as secret profits from sale of stocks (Gwilliam and Jackson 250). This aspect is a clear indicator that the laws are effective in averting future cases of fraud in the US. The Sarbanes-Oxley Act of 2002 is also effective in providing a solution to the stock-option backdating (Moriceau 787). Under Section 403 of the Act, managers and senior executives are required to report to the US Securities and Exchange Commission immediately after sealing a sale of share agreement.

Conclusion

Enron was an energy supplying company located in the US. The company was one of the biggest firms in the US and it had employed over 200,000 staff members. The company went into bankruptcy in 2001. Its downfall was due to unethical and fraudulent acts by its managers. It is alleged that the company’s managers colluded with the auditors to defraud investors. The company’s fall prompted the federal government to enact the Sarbanes-Oxley Act to prevent the recurrence of such cases in the US. The Act made a number of changes to the accounting and reporting standards in the US. However, the law is not effective since more cases involving such fraudulent acts by managers continue to be reported. Different approaches are needed to address the issue in order to restore the investors’ confidence on the accounting standards in the US.

Works Cited

Moriceau, Jean. “What can we learn from a singular case like Enron?” Critical Perspectives on Accounting 16.6 (2005): 787-796. Print.

Gwilliam, David, and Richard Jackson. “Fair value in financial reporting: Problems and pitfalls in practice: A case study analysis of the use of fair valuation at Enron.” Accounting Forum 32.3 (2008): 240-259. Print.

Culpan, Refik, and John Trussel. “Applying the agency and stakeholder theories to the Enron debacle: An ethical perspective.” Business and Society Review 110.1 (2005): 59-76. Print.

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