CORPORATE GOVERNANCE AND ENRON CASE

Corporate governance is a system of practices, processes and rules that direct or control a

company or an organization. It essentially involves considering the interests of a company’s

stakeholders. These stakeholders include the management, shareholders, suppliers, customers,

government, financiers and the community (Martin, 2006). The corporate governance principles

provide guidelines on how to control a company to ensure that its objectives are fulfilled in a

way that is beneficial to the company and adds long-term value to the interests of the company’s

stakeholders. In corporate governance, the company’s management takes a trustee’s role for other

parties that have interests in the company. Corporate governance is majorly based on principles

like conducting business with fairness and integrity, transparency in handling transactions,

complying with laws governing operation of companies, making sound decisions and necessary

disclosures, ethical issues in conducting business and responsibility and accountability towards

stakeholders. There is also need to clearly distinguish between corporate funds and personal

funds when managing a company.

Enron Corporation was a company dealing in services, commodities and energy based in

Houston, Texas state in America. It had approximately 20,000 staff members and was among the

world’s major natural gas, electricity, pulp and paper and communications companies before its

bankruptcy in December 2001. After 2001, it was found that the company’s financial condition

was majorly sustained by a systematic, institutionalized and planned accounting fraud that was

termed as Enron scandal (Sterling, 2002).

a) Enron Case Analysis

and dissolution of Arthur Andersen, an entity that was among the five largest accountancy and

audit partnerships worldwide by then. Enron is rated the biggest failure in audit apart from

leading as the largest bankrupt company in the history of America by then. The case analyzes the

cause of this failure in details.

Causes of the company’s bankruptcy

Lack of truthfulness. According to the report given by Kirk Hanson, the executive

director of Markkula, a center for Applied Ethics, the Enron management did not give true

information concerning the company’s health (Canadian Center of Science & Education, 2010).

The senior executives developed a belief that Enron had to take the first position in relation to

other companies and also they had to maintain their reputations as well performing executives in

the United States. The executives did not observe the duty of full disclosure and good faith. No

clear justification was gotten to support allegatins that the CEO was selling stock and that he

informed the employees about future rise of the stock. The investigations about the company’s

bankruptcy revealed the stock sell-off by the CEO before February 2002. This is the time the

sell-off would have been disclosed. The shares were sold to Enron in repayment of the money

owing to the company by the CEO. Selling of company’s stock is an exception falling under the

ordinary officer and director disclosure requirement.

Interest. Lack of autonomy in management by the company’s board and conflicts of

interest contributed to the collapse of the firm. Some researchers suggested that the company’s

compensation policies caused a negative impact on stock price and earnings growth. Recent
changes on regulation have been aiming at strengthening and enhancing internal control and

accounting systems. There was a conflict of interest arising between Arthur Andersen’s two roles

i.e. consultant and auditor of the company. While investigations continue, the company sought

made steps to spin off various assets. Enron filed for bankruptcy to be allowed to reorganize and

at the same time be protected from creditors (Rapoport, Vanniel &Dharan, 2009). Kenneth Lay,

the then chief executive resigned and a restructuring expert Stephen Cooper was appointed to be

the interim chief executive. The company’s core business of energy trading was tied in a

complex case with UBS Warburg. The bank did not make payment for trading but shared profits

with Enron company.

Arthur Andersen’s reputation and Enron. Discovery of irregularities in accounting at

Enron Company in the year 2001 caused the media and regulators to give extensive attention and

focus on Anderson (Sterling, 2002). The magnitude of accounting errors, together with the role

of Andersen as the company’s auditor and the media attention offer a powerful setting to find out

the impact of the reputation of the auditor on market prices around the failure of the audit.

Andersen damaged its reputation after admitting in January 2002 that its employees destroyed

correspondence and documents related to Enron engagement.

Accounting fraud. Basing on Special Purpose Entity (SPE), Enron’s high levels of debt

would pull down the grade of investment and trigger money lending institutions to recall money.

Enron borrowed a lot of funds to balance its overvalued contracts. The SPE thus, enabled the

company to convert assets with debt obligations and borrowed money into income. In addition,

The company transferred more of its stock to SPE. However, the assets and debt bought by the

SPE, that were burdened with significant debt amounts, were never reported on the financial

report of Enron. This condition misled the shareholders that the debt was decreasing and revenue
was increasing. Basing on market to market element of accounting fraud, Enron, as a public

company was exposed to external governance sources such as market forces, oversight by

regulators and private entities like auditors, credit rating agencies and equity analysts (Rapoport,

Vanniel & Dharan, 2009). To convince investors to maintain a profiting situation that is

consistent, the company’s traders were forced to forecast low discount rate and high cash flows

on their long-term dealing with Enron. The difference between originally paid net present value

and the calculated value was considered as Enron’s profit. In fact, the reported net present value

might never happen in the coming years of the contract.

Prisoner’s dilemma in Enron’s case.

When it collapsed, Enron was involved in different lines of production like energy and

trading of commodities and derivatives that are energy-related. Many of its dealings were being

monitored by the Federal Energy Regulatory Commission (FERC) or Commodities and Futures

Trading Commission (CFTC). The primary role of CFTC is ensuring that market options and

commodity futures operate in a competitive and open manner while the FERC regulates market

and transmission of energy products (Canadian Center of Science and Education, 2010). To

achieve maximum, wrong acts such as fraud in accounting will cause harm to the shareholders’

interests. Arthur Andersen, as Enron’s consultant and at the same time auditor, has to take

responsibility for both shareholders and managers since the accounting information provided has

a direct impact on the economic benefits of these parties. Clearly, Arthur Anderson and the

managers chose to betray shareholders to achieve their maximum self-interests.

Who carried the moral responsibility of Enron’s collapse?

Lay allowed Andrew Fastow, the then CFO to secretly build a private corporate institution and

transfer it illegally. Andrew Fastow committed a crime of malfeasance and violated the ethics of

his profession. When the board chairman and CEO ordered conspiratorial workers to perform an

act which both of them knew was wrong, the employees also take moral responsibility for the

act. Regardless of the court’s ruling, the company’s senior managers get a low grade on the

principle of truth and disclosure. Andersen violated its market specifications as a well-known

certified public accountant.

From Corporate’s Angle: The managers’ actions are taken to be the corporation’s actions only if

the managers act within their stipulated authority (Bierman, 2008). However, Enron’s

shareholders did not realize this fact from the high stock price. Therefore, Enron as a corporation

was not responsible for the scandal. Actually, if the shareholders and the board paid proper

attention to the decisions of the CEO, CFO, chief and relevant staffs, then Enron could avoid this

scandal.

b) Effectiveness of the amendments to the legislation/code.

After the collapse of Enron, many attempts have been made by agencies to ensure a

positive change in corporate governance. Reforms have been formulated and implemented to

ensure effectiveness in corporate governance in the United States and around the world. The

Enron scandal is among the major accounting and auditing scandals involving US corporations.

In response to this scandal, the 107th Congress passed an act termed as Sarbanes-Oxley Act

known as the most sweeping amendments to securities laws since 1930 (University of Maryland

School of Law, 2003). This Act was formed by the Congress in July 2002 to create reforms in
accounting. The 108th Congress stressed on several accounting issues like financial derivatives

contracts and stock options, replacing rules with principles in the accounting system and an

oversight to ensure implementation of the reforms in accounting as stated by Sarbanes-Oxley

Act. The main intention of the Congress in passing this Act was to restore truth and confidence in

financial and stock markets by enhancing corporate accountability, strengthening corporate

governance and improving the degree of public disclosures of accounting information.

Creation of the Public Company Accounting Oversight Board (PCAOB). Implementing

this reform has been a great problem in the US. The goal of this agency is to regulate public

company auditors and ensure that financial statements are subjected to outside and tough

scrutiny and that the client-auditor dealing is free from conflicts of interest. This reform has been

ineffective because many nominees and appointees to this board have been found to have some

conflicts of interests. The first nominee withdrew after sources revealed that he was once a

director of a corporation that was under SEC investigation on grounds of securities fraud

(University of Maryland School of Law, 2003). Harvey Pitt, the SEC chairman also resigned

because of this incident. The effectiveness of this reform has not been properly felt because the

board members have headed several companies and are shareholders of other companies in the

US yet they should monitor the operations of the same companies. The corporate governance

issues may not be clearly resolved due to the main factor of conflicts of interest.

Principles-Based Accounting. This reform was introduced to replace rules-based

accounting because many companies and their auditors ignored accounting rules. Rules were

also very complex such that when fully followed, traders would lose a clear understanding of a

company’s financial position. Companies which adopt Generally Accepted Accounting Principles

(GAAP) are seen to have few financial struggles compared to those that have adopted the full
application of rules. The principle of disclosure requires all public entities to publish their

financial reports so that any potential investor is able to assess the financial positions of these

entities before making a step to invest. The main element that makes the principles-based

accounting effective is flexibility. As the complexity of the financial field increases, it becomes

difficult to formulate standard rules for the economy as a whole. Through the principles-based

accounting, corporations have been able to present their financial reports in the best way they

prefer to ensure accurate and full disclosure of their financial positions (Coe, Schildhouse,

Weygandt, Kimmel & Kieso, 2010). This amendment has been effective in resolving many

corporate governance issues relating to disclosure. The strict adherence to rules and regulations

made disclosure very difficult and sometimes less informative eg a firm could not easily present

industry or market specific information in the best way it thought because of the many rules and

bureaucracies it was bound to.

Auditor independence. This reform is very effective in corporate governance because it

has saved companies from financial losses. This reform requires that a company’s external

auditor should have no other dealings with the company affairs neither any influence by the

company’s management in the exercise of his/ her duty. Arthur Andersen was Enron’s auditor

and at the same time the company’s consultant. This consultancy dealing may have caused an

influence on the audit function of Andersen leading to the Enron scandal. Many firms are

surviving because independent audits serve as a check on directors and workers from engaging in

fund embezzlement or defalcations. It is the duty of an independent auditor to report any detected

frauds that have been committed by a company’s directors (Sterling, 2002). Andersen was

partially held responsible for Enron scandal because of its failure to disclose the misuse of funds

by Enron directors. An independent audit also plays the role of appraisal or evaluation by
reviewing the existence and effectiveness of an organization’s internal controls and reporting any

inadequacies and weaknesses detected. The aspect of independence is meant to prevent any

collusion hence an effective way of solving many corporate governance issues in companies.

Many shareholders have little knowledge about the internal dealings of their companies, more so

in the finance section. This reform was meant to ensure transparency and accountability when

dealing with shareholders’ funds. Internal auditors have no independence because they work

under the control of the management. There is, therefore, need to involve external auditors who

are independent.

Reform on criminal and corporate fraud accountability. This reform majorly targeted

company defrauders and criminals. It is an effective reform to ensure high level of corporate

governance by resolving many issues. The reform was meant to prevent falsification of

company’s documents like income statements and tax returns, bank account records, record

keeping books etc. Forging signatures, using letterheads without permission, distributing fake

documents knowingly and destroying information necessary for an investigation are other

common offences that the reform seeks to minimize. The reform has helped to ensure high

ethical standards among company directors and workers. Criminals having committed these

offences are liable to monetary fine and imprisonment depending on the nature of the offence.

Falsifying of documents may also lead to job termination, lack of access to bank loans and

frequent audits by the Internal Revenue Service IRS (Monks & Minow, 2011). To avoid such

allegations, directors have taken a lot of caution and high degree of care when dealing with

company finances and other resources. No one would want to be held responsible for an offence

due to negligence in performance of duty. There is need for these directors to learn to
differentiate clearly between corporate matters and individual affairs to avoid unnecessary

offences.

Enhanced financial disclosure. Reforms on this principle have helped to ensure that

material items in the financial statements are brought to the attention of all company

stakeholders. In an attempt to resolve corporate governance issues, there is need for the public to

understand the accounting basis of any corporation through face or footnote disclosure. Users of

accounting information have been able to get information on legal proceedings, contingent asset

and contingent liability details of companies in which they have interests. The users can know

which events have been happening before and after the date of the balance sheet and other

related financial statements before taking any action (Tulsian, 2006). Issues relating to

subsidiaries, associate companies and holding companies can only be brought to shareholders’

attention through full disclosure. This has been an effective way of relating with shareholders

and eliminating any doubts and tension among other company stakeholders. Enron Company

gave wrong disclosure to the shareholders. The shareholders knew very well that the company

was reporting increasing revenues and reduced debts not knowing that the corporation was in a

great financial risk. The directors did not clearly state the financial position of the company to

shareholders. In agency law, directors are agents of the shareholders. It is clearly noted that

Enron directors failed in their agency duty and many companies in the US and around the world

must have learnt from Enron’s collapse. The amendment on disclosure principle is, therefore,

effective in resolving corporate governance issues. This is because the number of companies

collapsing in the US is very minimal since the Enron collapse. Once directors give wrong

information and stakeholders discover, they lose trust in the directors and many are likely to

withdraw from the company.

private companies comply to the taxation law in the United States. It is through filling and

submission of tax return forms that companies can be assessed and their payable taxes

determined . The Internal Revenue Service has the mandate to audit companies and find out

about their tax status. Submission of returns and payment of tax to the government is one way of

upholding corporate governance within organizations. The setting of clear laws by the Internal

Revenue Service is another effective way of resolving corporate governance issues because firms

have clear guidelines on actions to take and actions to avoid ( Bierman, 2008). Taking the

responsibility to pay taxes to the government is an ethical practice that eliminates conflicts

between the United States government and companies. Clear tax penalties have been put in place

to discipline firms which do not observe taxation acts and regulations. Issues like evasion of tax

and non-compliance have reduced since the formulation of reforms on corporate tax returns.

Corporate responsibility reform. The reform was established by the Congress to ensure

that companies and audit firms take responsibility of their actions. The public company audit

committees have greatly streamlined the audit profession in the US. Continuous and final audits

are carried out in all public companies to ensure that errors and frauds are detected before

publishing financial statements. This prevents wrong information being passed to companies’

shareholders. The audit committees have a responsibility to ensure that audit procedures are

conducted in a manner that is recommended and that auditors are free to give a fair view of the

financial statements of any company (Garner, Mckee & Mckee). An auditor who conducts the

audit exercise in a company is held responsible for any outcome because shareholders rely on

his/her report given that he/she is their agent. Responsibility as a corporate governance issue has

been greatly resolved because many audit firms have learnt a lesson from the dissolution of both
Enron and Andersen firms. Highly rated audit firms like Deloitte, Price Water House Coopers

and Ernest and Young are performing well in the audit industry because they are very keen on

preserving their reputation. Many firms entrust them because of their high competence and

integrity in performance. Their practice of highly ethical audit standards has ensured that no firm

which they have audited is financially hit without their notice. If they detect an error or fraud,

they disclose and recommend effective measures to be taken. Through taking responsibility,

corporate governance is upheld in the audit industry because no firm is ready to face compulsory

dissolution due to negligence. The amendment on insider trading has also enhanced fairness in

business dealings by preventing some individuals and companies from having a trading

advantage over the others. This amendment has helped to ensure that all trading entities have

equal information concerning trading activities (Tulsian, 2006). The fair funds for investors is

another reform that was formulated to ensure proper use of investors’ money. It has helped to

ensure that traders use the funds of investors with great care and caution. It is clearly noted that

many of the changes are effective and will help give more resolutions to issues affecting

corporate governance in the US and around the global.

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