Enron: Contribution of Scandals in Financial Reporting

Introduction

Scandals that have arose in the US business circles leading to the collapse of companies like Enron have proved how non-adherence to corporate governance can cause harm and at the same time raised eyebrows over the independence of the auditors to perform their duties. Corporate governance will ensure proper financial management and accountability. Enactment of acts like the Sarbanese-Oxley Act of 2002 resulted due to the scandals happening in the business arena, and the congress through this law wanted a way through which public companies, their employees and agents would be effectively monitored through corporate governance (Harvard Law Review; qtd. in Bruce & Deborah, 2006). The act also addresses some of the stock options and company stock following the arising of questions on these issues in regard to Enron scandal (Stabile, 2002). Such laws would require companies to take more responsibility and even at extent pay the offended such as the requirement by the court to have Worldcom pay $500 million to pay investor victims. Leadership in these corporations need be strong and strategic (Thomas, Schermerhorn, Dienhart, 2004; qtd. in Bruce & Deborah, 2006) so as to ethical decisions which re no longer simple but complex in a complex environment (Trevino and Brown, 2004; qtd. in Bruce & Deborah, 2006). The accountability is further enhanced by proper reporting and auditing mechanisms. This paper will discuss corporate governance principles as provided by the reviewed guidelines, financial reporting and scandals in the business arena and specifically to the case of Enron example.

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Main body

The Enron case is an example of effects lack to grant the shareholders basic rights provided in the section I of the OECD principles where the shareholders can obtain regularly and timely, the relevant information as pertains to company matters. Timely and accurate disclosure of all matters relating to a company is further provided for in section IV. Lack of transparency ruined weighed down the relationship between the firm and its creditors and investors and also affected negatively the relationship within the organization. The organization lacked transparency and disclosure of the information on financial matters by manipulating the earning figures and the balance sheet. Another irregularity was the use of derivatives which was against the reporting or business logic rules or both, and usage of special purp entities (SPEs). The SPEs can allow a company to make financial transactions against its assets, and allow the firms to obtain favorable financial terms through reduction of risks. The company’s executive was said to have been linked to self-enrichment associated with many of the manipulations that happened. At the time of filling for bankruptcy the firm required 54 pages to list the entities it owed money. Excessive trading with creditors may have been demanded by the financial need the company was going through due to its rapid expansion and counterparties’ willingness to trade with the firm. In order to maintain the firm’s credit rating, the management supported to give the company a favorable earning picture without excessive leverage on its balance sheet. The company also is said to have used VPPs (Volumetric Production Payments) in order to lend companies in exchange with oil or gas. The production fields secured the financing. Enron also made transactions that would ensure that debts associated from these transactions were off the balance sheets. These transactions included sale and lease back deals. The company also employed prepaid swaps with companies like Chase and Mahonia which did not meet the following conditions as presented by Arthur Anderson in a document reviewed by the Senate over the Enron matter: for the prepaid swap to qualify being a hedge and not a loan, the agreements there in should not be commercially linked; transfer of the price risk from the supplier to the purchaser should be done; there should exist a business reason on the side of the buyer to the buying of the gas. Continued observance to the sound corporate governance is necessary as one event may lead to another such as the case of Parmalat whose scandals are referred to as been subsequently leading to another from the initial one where the company defaulted on a bond buy back (Krishna & Madhav, 2004). Misrepresentation of the Parmalat bonds also is reported with the American and European and Italian bank through overrating of the bonds than they were worth (Celani, 2004).

A problem in a company may arise as a result of failure to observer or due to a compromise on the application of the established guidelines for corporate governance that seek to achieve, among other the transparency and disclosure of company’s matters, treating the shareholders equitably and recognizing and defending their rights. For example, Enron Company flouted OECD Principles in the following limelight areas; “disclosure and transparency in the company”, board of director responsibilities among issues and the rights of the shareholders. Through formation of various partnerships and linkages in business, the risks of Enron had increased.

Corporate Governance

This is a framework that stipulates the relationships between the company’s management, employees and customers, board of directors, the shareholders and lenders among other people. Study has revealed that corporate governance through introduction of rating services for example Governance Metrics International (GMI) serves as valuable investment management tools. The performance of the company and its corporate governance practices have been linked in a joint study by Brown, Taylor and Institutional Shareholder services, while higher average annual total returns linked with formidable practices of governance through a study by GMI in 2004 (Brown, Muchin & Zavis, n.d.).

The S&P’s Corporate Governance Score can help improve the performance of a company to favor the shareholder interest, since they provide ratings for companies after assessing their corporate governance practices policies and how far these serve the financial interests of the stakeholders. In addition, the evaluation which among other activities entails document reviews and interviews of creditors, shareholders, the finance director, among other people, can help cement further the linkage between the creditors, shareholders and directors. If adequate information necessary for a meaningful analysis is not provided, the company will score zero of the 10 possible points. Merits for transparency, disclosure and effectiveness; structure of board and effectiveness; the rights of the shareholders and relations with stakeholder; and the structure of ownership and external influence are the four components awarded a score of 1-10 points. The awarding makes it possible for companies to compare themselves with others and rate themselves. In addition, the companies which would wish for example to report on financial improvement can do this in future after scoring poorly in an interest to improve the score. It can also be noted that good score may increase the popularity of a company and would tend to attract investors. This would lead to further improvements since the company can assess more funds as compared to poor performance which may make the investors to rank the venture as a non-viable investment.

Since financial performance of an institution is closely linked to the decisions of the top managers, corporate governance that improves the decision making process and make it accountable will indirectly influence financial performance.

Financial reporting

Financial reports basically present the effects of all the transactions as a result of management activities on the behalf of the owners of firms. The financial reports are crucial to the current and prospective investors and other stakeholders to empower them to make present and future decisions or moves as relates to their analysis on the present and future state of the cash flow of the firm. This information relates to the assets, liabilities and the equity of the firm.

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Financial reporting should not involve any irregularities and minimizing or elimination of scandalous activity can be achieved by improving the quality of the financial reports. The factors that are tied to the financial report and could influence its quality are as follows (Financial Accounting Standards Board, 2006);

  • Relevance; the information presented in the financial reports must be relevant to credit, investment, resource allocation and finances so that such decisions will be made. The relevance of the information is determined by the ability of its users to make evaluation on present, past and future transactions and to take necessary steps as appropriate and in line with the conclusions or details reached at.
  • Faithful representation; The information so presented in financial reporting need to be verifiable, neutral and complete in proving that it is a real representation of the economic resources owned by the firm, its transactions with other entities and the circumstances that affected them. Indirect verification of the applied measurement methods to verify the information presented should be free from material error or bias while the information presented must be found to have no such error or bias when tested with this method. Different professionals or officers verifying the information should rich an agreement in the verification of the information.
  • Consistency and comparable; The information so presented should enable users find the existing “similarities and differences between two sets of economic phenomena” (Financial Accounting Standards Board, 2006), while consistence depicts application of the same policies and procedures in accounting to verify compatibility of information between two or more periods in the same organization or between firms at the same period (Financial Accounting Standards Board, 2006).
  • Understandable; The people who are financially literate should comprehend the information so represented.

Financial reporting may be necessary to help the firm achieve accountability and reduce corruption. Because the economic interests of the management may differ from that of the owners of a firm-management may want to enrich themselves beyond the amount of compensation agreed upon, financial reporting need to have all the necessary aspects disclosed during presentation to the owners of the company to reduce instances of cover-up by those who have already committed these crimes. In fact, the first aspect of achieving proper financial reporting is having or establishing guidelines that govern such reporting, so that any discrepancies may be noted, explained, further advised or corrected. The next step will involve compliance with the set out guidelines by first establishment of a necessary framework and system that would be as much independent in its operations and accountable to the success of the corporation. Independence is to ensure that the top management does not interfere with possesses like auditing and so limit exposure of issues like misuse of funds or channeling away public funds for personal interests.

Financial reporting guidelines spell out a set of rules and requirements that need to be observed in preparation of financial reports. The reports may be prepared on the basis of contractual agreements where the parties specifically agree on the application of the reporting standards including the decision on the use of particular information in a financial report.

The Combined Code

Companies in the UK are required to observe and report on compliance to the standards of good practice set out in the combined code. These practices include issues such as accountability and auditing of firms, company-shareholder relationships, and remuneration. The UK companies listed on the main markets are supposed to report on adherence to the code and where they have fallen short of requirements to give explanation, while those that are oversees companies but listed in the Main Market should disclose how their corporate governance practices differ from the ones stipulated in the code. The code, first issued out in 1998, was revised last year (FRC, 2009).

The combined code lays procedures on what is to be followed while carrying out financial reporting. Among the requirements is that the company board should present a personal assessment of the position and the prospect of the company, an assessment which needs be balanced and understandable. The information to be presented at the statutory, the report to the regulators, as well as interim and other price sensitive public reports are also supposed to be presented as “balanced and understandable” (FRC, 2008).

The provisions of the code include that an explanation of the directors’ role on preparing the accounts in the presented report is supposed to be availed, and accompanying the report is the auditors’ statement on their reporting responsibilities. The company board is required to set an audit committee comprising of 3 or 2 (smaller companies) independent non-executive directors according to the size of the company and financial professionalism is taken care by requiring that the board self-satisfy that one of the members so selected has financial experience that is relevant and recent. In view of financial scandals which would arise as a reason of not applying the laid down procedures either through ignorance or otherwise, ensuring that one of the members has relevant and recent experience would ensure that the working team has an advisor on regulation and compliance or any other related issue of auditing, and that the duty is carried out from a professional and experience perspective to reduce the likelihood of error and non-compliance. The company chairman must not be the chair to this auditing committee unless previously declared an independent chairman on appointment, although he can be chosen as one of the members in this committee. This may be seen as an effort to reduce interference in the committee business and to avoid reducing the independence of the committee through influence. In addition, reporting of the true nature and true auditing would require that the business of the company be as much independent as possible. Thus the likelihood of a scandal would even be more minimal if this is observed. The reporting procedure has also provided accountability of the company board to the shareholders because the reporting guidelines require the directors to report that there is continuity of the business venture with “assumptions” or “qualifications” for supporting as will deem necessary (FRC, 2008).

The guidelines also seek to provide security of the business assets and the shareholders’ investments by placing a requirement on the company’s board to provide an internal control system that is sound. To ensure that this is achieved, company boards must carry out an annual review of the internal control system to determine its effectiveness and report to the shareholders that this was carried out. The requirement to report on the carrying out of the review would ensure that the company does not fail to carry out this activity while the annual review would ensure determination or estimation and continued tracking of the effectiveness of the internal control system. The idea would also make sure that the convinced company directors do not continue employing financial and other control systems that are ineffective, but that discovery of their failure may necessitate quicker change. The company’s financial systems are supposed to be covered in addition to the risk management, compliance controls, and material control systems, during the review so as to ensure that there is a wholesome representation. The integrity of the financial position of the company is monitored by the audit committee (Brown, Muchin & Zavis, n.d.). The reported cases where one person acts as the CEO and the chairman of the directors in 85% of U.S. companies, and where the CEO acts to select outside directors leading to a situation where the CEO would be favored by them (Jenkins, 2003; qtd. in Bruce & Deborah, 2006); would be reduced or eliminated by observing the code.

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The guidelines also require that the appointment and re-appointment of the external auditors be recommended by the audit committee and if the board has not taken the recommendation, an explanation should be availed in the final report. An external auditor is to be engaged in supplying of non-audit services through development and implementation of a policy In addition, the independence and objectivities of the external auditor who is supplying non-audit services to the firm is supposed to be explain to the shareholders in the final report.

Evolution of stricter guidelines has come in the light of scandals in the business sector. Clearly, one of the solutions to occurrence of corporate scandals is the observance of corporate governance that is more open and observant to the ri8ghts and needs of the shareholders, but there is continued need to increase watch on the systems put in place. More manipulations could be used as new ways to invent deceptive techniques to achieve means through ways that may appear legal in the face of the requirements established in the guidelines. This calls for continued research and establishment of stricter guidelines by adjusting the present so as to seal holes that could possibly result in a dilemma. A closer look at the reasons why ethical rules are not strictly followed may to an extent solve the problem. The Academy of Management conducted a study involving more than 100 executives found that social norms practiced within organizations, faulty rules, need to perform due to performance-based systems, among other reasons made the breaking of the rules easier, and these can be linked to unethical practices (Veiga, Golden, & Dechant, 2004; see also Burmeier and Stern, 2004; Adler, 2002 ). There is the necessity to ensure that future leaders (present learners in colleges) are trained to be responsible in business ethical issues and responsible governance.

In order to control some scandals like those of Enron which had become a highly complex network where it was operating businesses transactions even in markets which were not regulated by the SEC or the Commodity Futures Trading Commission (CFTC), it may be advisable to avoid operations where transactions are covered by different regulatory and legal regimes. Formulations of guidelines will also need careful because they may also be influenced by the poor or false financial reporting. An example is where the false statements by the WorldCom on the growth of internet traffic influenced not only the investors to over-invest but also the regulators themselves in their job (Sidak, 2003).

Conclusion

It can be seen here that the systems of governance are prone like any other social and economic societies, to faults and flaws due to human manipulations and error and this would lead to further innovations in the field of corporate finance and further growth of this sector. Here is need for collaboration between those watching to see that these guidelines are followed to before it is too late. While the auditors have been mandated to keep watch to the effectiveness of the financial reporting, directors being mandated to appoint the audit committees among other new developments, issues need be further raised on the extent to which continued transparency and disclosure of all matters relating to the operation of the firm to the shareholder and ensure balance of interest for all stakeholders (Alexiei, 2006; Evan and Freeman, 1993), should be provided for, to make sure that the owners of the company are lesser prone to new forms of manipulations of firms’ operations to advance sinister motives. In addition, the collaboration between the management and the internal auditors may work against the owners of the company which may necessitate direct involvement of the shareholder in the affairs of the organizations. Sometimes misleading concepts may be applied such as refusing to disclose the actual status of the firm because the management fears that such an act would lead to the company risking to loose investors, proper mechanisms must be put in place to ensure that all information is disclosed to the owners of the company as their right. Financial scandals and the related problems do not only carry financial implications but can also cause social and political impacts according to Sridharan (2002). Corporate managers need to keep up with the developments in the ethical practice governance and compliance so as to avoid scandalous events (Strategic Finance, 2008).

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